There’s Always Something to Do

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 18, 2019

There’s Always Something to Do:  The Peter Cundill Investment Approach, by Christopher Risso-Gill (2011), is an excellent book.  Cundill was a highly successful deep value investor whose chosen method was to buy stocks below their liquidation value.

Here is an outline for this blog post:

  • Peter Cundill
  • Getting to First Base
  • Launching a Value Fund
  • Value Investment in Action
  • Going Global
  • A Decade of Success
  • Investments and Stratagems
  • Learning From Mistakes
  • Entering the Big League
  • There’s Always Something Left to Learn
  • Pan Ocean
  • Fragile X
  • What Makes a Great Investor?
  • Glossary of Terms with Cundill’s Comments

 

PETER CUNDILL

It was December in 1973 when Peter Cundill first discovered value investing.  He was 35 years old at the time.  Up until then, despite a great deal of knowledge and experience, Cundill hadn’t yet discovered an investment strategy.  He happened to be reading George Goodman’s Super Money on a plane when he came across chapter 3 on Benjamin Graham and Warren Buffett.  Cundill wrote about his epiphany that night in his journal:

…there before me in plain terms was the method, the solid theoretical back-up to selecting investments based on the principle of realizable underlying value.  My years of apprenticeship were over:  ‘THIS IS WHAT I WANT TO DO FOR THE REST OF MY LIFE!’

What particularly caught Cundill’s attention was Graham’s notion that a stock is cheap if it sells below liquidation value.  The farther below liquidation value the stock is, the higher the margin of safety and the higher the potential returns.  This idea is at odds with modern finance theory, according to which getting higher returns always requires taking more risk.

Peter Cundill became one of the best value investors in the world.  He followed a deep value strategy based entirely on buying companies below their liquidation values.

We do liquidation analysis and liquidation analysis only.

 

GETTING TO FIRST BASE

One of Cundill’s first successful investments was in Bethlehem Copper.  Cundill built up a position at $4.50, roughly equal to cash on the balance sheet and far below liquidation value:

Both Bethlehem and mining stocks in general were totally out of favour with the investing public at the time.  However in Peter’s developing judgment this was not just an irrelevance but a positive bonus.  He had inadvertently stumbled upon a classic net-net:  a company whose share price was trading below its working capital, net of all its liabilities.  It was the first such discovery of his career and had the additional merit of proving the efficacy of value theory almost immediately, had he been able to recognize it as such.  Within four months Bethlehem had doubled and in six months he was able to start selling some of the position at $13.00.  The overall impact on portfolio performance had been dramatic.

Riso-Gill describes Cundill as having boundless curiosity.  Cundill would not only visit the worst performing stock market in the world near the end of each year in search of bargains.  But he also made a point of total immersion with respect to the local culture and politics of any country in which he might someday invest.

 

LAUNCHING A VALUE FUND

Early on, Cundill had not yet developed the deep value approach based strictly on buying below liquidation value.  He had, however, concluded that most models used in investment research were useless and that attempting to predict the general stock market was not doable with any sort of reliability.  Eventually Cundill immersed himself in Graham and Dodd’s Security Analysis, especially chapter 41, “The Asset-Value Factor in Common-Stock Valuation,” which he re-read and annotated many times.

When Cundill was about to take over an investment fund, he wrote to the shareholders about his proposed deep value investment strategy:

The essential concept is to buy under-valued, unrecognized, neglected, out of fashion, or misunderstood situations where inherent value, a margin of safety, and the possibility of sharply changing conditions created new and favourable investment opportunities.  Although a large number of holdings might be held, performance was invariably established by concentrating in a few holdings.  In essence, the fund invested in companies that, as a result of detailed fundamental analysis, were trading below their ‘intrinsic value.’  The intrinsic value was defined as the price that a private investor would be prepared to pay for the security if it were not listed on a public stock exchange.  The analysis was based as much on the balance sheet as it was on the statement of profit and loss.

Cundill went on to say that he would only buy companies trading below book value, preferably below net working capital less long term debt (Graham’s net-net method).  Cundill also required that the company be profitable—ideally having increased its earnings for the past five years—and dividend-paying—ideally with a regularly increasing dividend.  The price had to be less than half its former high and preferably near its all time low.  And the P/E had to be less than 10.

Cundill also studied past and future profitability, the ability of management, and factors governing sales volume and costs.  But Cundill made it clear that the criteria were not always to be followed precisely, leaving room for investment judgment, which he eventually described as an art form.

Cundill told shareholders about his own experience with the value approach thus far.  He had started with $600,000, and the portfolio increased 35.2%.  During the same period, the All Canadian Venture Fund was down 49%, the TSE industrials down 20%, and the Dow down 26%.  Cundill also notes that 50% of the portfolio had been invested in two stocks (Bethlehem Copper and Credit Foncier).

About this time, Irving Kahn became a sort of mentor to Cundill.  Kahn had been Graham’s teaching assistant at Columbia University.

 

VALUE INVESTMENT IN ACTION

Having a clearly defined set of criteria helped Cundill to develop a manageable list of investment candidates in the decade of 1974 to 1984 (which tended to be a good time for value investors).  The criteria also helped him identify a number of highly successful investments.

For example, the American Investment Company (AIC), one of the largest personal loan companies in the United States, saw its stock fall from over $30.00 to $3.00, despite having a tangible book value per share of $12.00.  As often happens with good contrarian value candidates, the fears of the market about AIC were overblown.  Eventually the retail loan market recovered, but not before Cundill was able to buy 200,000 shares at $3.00.  Two years later, AIC was taken over at $13.00 per share by Leucadia.  Cundill wrote:

As I proceed with this specialization into buying cheap securities I have reached two conclusions.  Firstly, very few people really do their homework properly, so now I always check for myself.  Secondly, if you have confidence in your own work, you have to take the initiative without waiting around for someone else to take the first plunge.

…I think that the financial community devotes far too much time and mental resource to its constant efforts to predict the economic future and consequent stock market beaviour using a disparate, and almost certainly incomplete, set of statistical variables.  It makes me wonder what might be accomplished if all this time, energy, and money were to be applied to endeavours with a better chance of proving reliable and practically useful.

Meanwhile, Cundill had served on the board of AIC, which brought some valuable experience and associations.

Cundill found another highly discounted company in Tiffany’s.  The company owned extremely valuable real estate in Manhattan that was carried on its books at a cost much lower than the current market value.  Effectively, the brand was being valued at zero.  Cundill accumulated a block of stock at $8.00 per share.  Within a year, Cundill was able to sell it at $19.00.  This seemed like an excellent result, except that six months later, Avon Products offered to buy Tiffany’s at $50.00.  Cundill would comment:

The ultimate skill in this business is in knowing when to make the judgment call to let profits run.

Sam Belzberg—who asked Cundill to join him as his partner at First City Financial—described Cundill as follows:

He has one of the most important attributes of the master investor because he is supremely capable of running counter to the herd.  He seems to possess the ability to consider a situation in isolation, cutting himself off from the mill of general opinion.  And he has the emotional confidence to remain calm when events appear to be indicating that he’s wrong.

 

GOING GLOBAL

Partly because of his location in Canada, Cundill early on believed in global value investing.  He discovered that just as individual stocks can be neglected and misunderstood, so many overseas markets can be neglected and misunderstood.  Cundill enjoyed traveling to these various markets and learning the legal accounting practices.  In many cases, the difficulty of mastering the local accounting was, in Cundill’s view, a ‘barrier to entry’ to other potential investors.

Cundill also worked hard to develop networks of locally based professionals who understood value investing principles.  Eventually, Cundill developed the policy of exhaustively searching the globe for value, never favoring domestic North American markets.

 

A DECADE OF SUCCESS

Cundill summarized the lessons of the first 10 years, during which the fund grew at an annual compound rate of 26%.  He included the following:

  • The value method of investing will tend at least to give compound rates of return in the high teens over longer periods of time.
  • There will be losing years; but if the art of making money is not to lose it, then there should not be substantial losses.
  • The fund will tend to do better in slightly down to indifferent markets and not to do as well as our growth-oriented colleagues in good markets.
  • It is ever more challenging to perform well with a larger fund…
  • We have developed a network of contacts around the world who are like-minded in value orientation.
  • We have gradually modified our approach from a straight valuation basis to one where we try to buy securities selling below liquidation value, taking into consideration off-balance sheet items.
  • THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE, AND MORE PATIENCE.  THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.

 

INVESTMENTS AND STRATAGEMS

Buying at a discount to liquidation value is simple in concept.  But in practice, it is not at all easy to do consistently well over time.  Peter Cundill explained:

None of the great investments come easily.  There is almost always a major blip for whatever reason and we have learnt to expect it and not to panic.

Although Cundill focused exclusively on discount to liquidation value when analyzing equities, he did develop a few additional areas of expertise, such as distressed debt.  Cundill discovered that, contrary to his expectation of fire-sale prices, an investor in distressed securities could often achieve large profits during the actual process of liquidation.  Success in distressed debt required detailed analysis.

 

LEARNING FROM MISTAKES

1989 marked the fifteenth year in a row of positive returns for Cundill’s Value Fund.  The compound growth rate was 22%.  But the fund was only up 10% in 1989, which led Cundill to perform his customary analysis of errors:

…How does one reduce the margin of error while recognizing that investments do, of course, go down as well as up?  The answers are not absolutely clear cut but they certainly include refusing to compromise by subtly changing a question so that it shapes the answer one is looking for, and continually reappraising the research approach, constantly revisiting and rechecking the detail.

What were last year’s winners?  Why?—I usually had the file myself, I started with a small position and stayed that way until I was completely satisfied with every detail.

For most value investors, the investment thesis depends on a few key variables, which should be written down in a short paragraph.  It’s important to recheck each variable periodically.  If any part of the thesis has been invalidated, you must reassess.  Usually the stock is no longer a bargain.

It’s important not to invent new reasons for owning the stock if one of the original reasons has been falsified.  Developing new reasons for holding a stock is usually misguided.  However, you need to remain flexible.  Occasionally the stock in question is still a bargain.

 

ENTERING THE BIG LEAGUE

In the mid 1990’s, Cundill made a large strategic shift out of Europe and into Japan.  Typical for a value investor, he was out of Europe too early and into Japan too early.  Cundill commented:

We dined out in Europe, we had the biggest positions in Deutsche Bank and Paribas, which both had big investment portfolios, so you got the bank itself for nothing.  You had a huge margin of safety—it was easy money.  We had doubles and triples in those markets and we thought we were pretty smart, so in 1996 and 1997 we took our profits and took flight to Japan, which was just so beaten up and full of values.  But in doing so we missed out on some five baggers, which is when the initial investment has multiplied five times, and we had to wait at least two years before Japan started to come good for us.

This is a recurring problem for most value investors—that tendency to buy and to sell too early.  The virtues of patience are severely tested and you get to thinking it’s never going to work and then finally your ship comes home and you’re so relieved that you sell before it’s time.  What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.

As for Japan, Cundill had long ago learned the lesson that cheap stocks can stay cheap for “frustratingly long” periods of time.  Nonetheless, Cundill kept loading up on cheap Japanese stocks in a wide range of sectors.  In 1999, his Value Fund rose 16%, followed by 20% in 2000.

 

THERE’S ALWAYS SOMETHING LEFT TO LEARN

Although Cundill had easily avoided Nortel, his worst investment was nevertheless in telecommunications: Cable & Wireless (C&W).  In the late 1990’s, the company had to give up many of its networks in newly independent former British colonies.  The shares dropped from 15 pounds per share to 6 pounds.

A new CEO, Graham Wallace, was brought in.  He quickly and skillfully negotiated a series of asset sales, which dramatically transformed the balance sheet from net debt of 4 billion pounds to net cash of 2.6 billion pounds.  Given the apparently healthy margin of safety, Cundill began buying shares in March 2000 at just over 4 pounds per share.  (Net asset value was 4.92 pounds per share.)  Moreover:

[Wallace was] generally regarded as a relatively safe pair of hands unlikely to be tempted into the kind of acquisition spree overseen by his predecessor.

Unfortunately, a stream of investment bankers, management consultants, and brokers made a simple but convincing pitch to Wallace:

the market for internet-based services was growing at three times the rate for fixed line telephone communications and the only quick way to dominate that market was by acquisition.

Wallace proceeded to make a series of expensive acquisitions of loss-making companies.  This destroyed C&W’s balance sheet and also led to large operating losses.  Cundill now realized that the stock could go to zero, and he got out, just barely.  As Cundill wrote later:

… So we said, look they’ve got cash, they’ve got a valuable, viable business and let’s assume the fibre optic business is worth zero—it wasn’t, it was worth less than zero, much, much less!

Cundill had invested nearly $100 million in C&W, and they lost nearly $59 million.  This loss was largely responsible for the fund being down 11% in 2002.  Cundill realized that his investment team needed someone to be a sceptic for each potential investment.

 

PAN OCEAN

In late 2002, oil prices began to rise sharply based on global growth.  Cundill couldn’t find any net-net’s among oil companies, so he avoided these stocks.  Some members of his investment team argued that there were some oil companies that were very undervalued.  Finally, Cundill announced that if anyone could find an oil company trading below net cash, he would buy it.

Cundill’s cousin, Geoffrey Scott, came across a neglected company:  Pan Ocean Energy Corporation Ltd.  The company was run by David Lyons, whose father, Vern Lyons, had founded Ocelot Energy.  Lyons concluded that there was too much competition for a small to medium sized oil company operating in the U.S. and Canada.  The risk/reward was not attractive.

What he did was to merge his own small Pan Ocean Energy with Ocelot and then sell off Ocelot’s entire North American and other peripheral parts of the portfolio, clean up the balance sheet, and bank the cash.  He then looked overseas and determined that he would concentrate on deals in Sub-Saharan Africa, where licenses could be secured for a fraction of the price tag that would apply in his domestic market.

Lyons was very thorough and extremely focused… He narrowed his field down to Gabon and Tanzania and did a development deal with some current onshore oil production in Gabon and a similar offshore gas deal in Tanzania.  Neither was expensive.

Geoffrey Scott examined Pan Ocean, and found that its share price was almost equal to net cash and the company had no debt.  He immediately let Cundill know about it.  Cundill met with David Lyons and was impressed:

This was a cautious and disciplined entrepreneur, who was dealing with a pool of cash that in large measure was his own.

Lyons invited Cundill to see the Gabon project for himself.  Eventually, Cundill saw both the Gabon project and the Tanzania project.  He liked what he saw.  Cundill’s fund bought 6% of Pan Ocean.  They made six times their money in two and a half years.

 

FRAGILE X

As early as 1998, Cundill had noticed a slight tremor in his right arm.  The condition worsened and affected his balance.  Cundill continued to lead a very active life, still reading and traveling all the time, and still a fitness nut.  He was as sharp as ever in 2005.  Risso-Gill writes:

Ironically, just as Peter’s health began to decline an increasing number of industry awards for his achievements started to come his way.

For instance, he received the Analyst’s Choice award as “The Greatest Mutual Fund Manager of All Time.”

In 2009, Cundill decided that it was time to step down, as his condition had progressively worsened.  He continued to be a voracious reader.

 

WHAT MAKES A GREAT INVESTOR?

Risso-Gill tries to distill from Cundill’s voluminous journal writings what Cundill himself believed it took to be a great value investor.

INSATIABLE CURIOSITY

Curiosity is the engine of civilization.  If I were to elaborate it would be to say read, read, read, and don’t forget to talk to people, really talk, listening with attention and having conversations, on whatever topic, that are an exchange of thoughts.  Keep the reading broad, beyond just the professional.  This helps to develop one’s sense of perspective in all matters.

PATIENCE

Patience, patience, and more patience…

CONCENTRATION

You must have the ability to focus and to block out distractions.  I am talking about not getting carried away by events or outside influences—you can take them into account, but you must stick to your framework.

ATTENTION TO DETAIL

Never make the mistake of not reading the small print, no matter how rushed you are.  Always read the notes to a set of accounts very carefully—they are your barometer… They will give you the ability to spot patterns without a calculator or spreadsheet.  Seeing the patterns will develop your investment insights, your instincts—your sense of smell.  Eventually it will give you the agility to stay ahead of the game, making quick, reasoned decisions, especially in a crisis.

CALCULATED RISK

… Either [value or growth investing] could be regarded as gambling, or calculated risk.  Which side of that scale they fall on is a function of whether the homework has been good enough and has not neglected the fieldwork.

INDEPENDENCE OF MIND

I think it is very useful to develop a contrarian cast of mind combined with a keen sense of what I would call ‘the natural order of things.’  If you can cultivate these two attributes you are unlikely to become infected by dogma and you will begin to have a predisposition toward lateral thinking—making important connections intuitively.

HUMILITY

I have no doubt that a strong sense of self belief is important—even a sense of mission—and this is fine as long as it is tempered by a sense of humour, especially an ability to laugh at oneself.  One of the greatest dangers that confront those who have been through a period of successful investment is hubris—the conviction that one can never be wrong again.  An ability to see the funny side of oneself as it is seen by others is a strong antidote to hubris.

ROUTINES

Routines and discipline go hand in hand.  They are the roadmap that guides the pursuit of excellence for its own sake.  They support proper professional ambition and the commercial integrity that goes with it.

SCEPTICISM

Scepticism is good, but be a sceptic, not an iconoclast.  Have rigour and flexibility, which might be considered an oxymoron but is exactly what I meant when I quoted Peter Robertson’s dictum ‘always change a winning game.’  An investment framework ought to include a liberal dose of scepticism both in terms of markets and of company accounts.

PERSONAL RESPONSIBILITY

The ability to shoulder personal responsibility for one’s investment results is pretty fundamental… Coming to terms with this reality sets you free to learn from your mistakes.

 

GLOSSARY OF TERMS WITH CUNDILL’S COMMENTS

Here are some of the terms.

ANALYSIS

There’s almost too much information now.  It boggles most shareholders and a lot of analysts.  All I really need is a company’s published reports and records, that plus a sharp pencil, a pocket calculator, and patience.

Doing the analysis yourself gives you confidence buying securities when a lot of the external factors are negative.  It gives you something to hang your hat on.

ANALYSTS

I’d prefer not to know what the analysts think or to hear any inside information.  It clouds one’s judgment—I’d rather be dispassionate.

BROKERS

I go cold when someone tips me on a company.  I like to start with a clean sheet: no one’s word.  No givens.  I’m more comfortable when there are no brokers looking over my shoulder.

They really can’t afford to be contrarians.  A major investment house can’t afford to do research for five customers who won’t generate a lot of commissions.

EXTRA ASSETS

This started for me when Mutual Shares chieftain Mike Price, who used to be a pure net-net investor, began talking about something called the ‘extra asset syndrome’ or at least that is what I call it.  It’s taking, you might say, net-net one step farther, to look at all of a company’s assets, figure the true value.

FORECASTING

We don’t do a lot of forecasting per se about where markets are going.  I have been burned often enough trying.

INDEPENDENCE

Peter Cundill has never been afraid to make his own decisions and by setting up his own fund management company he has been relatively free from external control and constraint.  He doesn’t follow investment trends or listen to the popular press about what is happening on ‘the street.’  He has travelled a lonely but profitable road.

Being willing to be the only one in the parade that’s out of step.  It’s awfully hard to do, but Peter is disciplined.  You have to be willing to wear bellbottoms when everyone else is wearing stovepipes.’ – Ross Southam

INVESTMENT FORMULA

Mostly Graham, a little Buffett, and a bit of Cundill.

I like to think that if I stick to my formula, my shareholders and I can make a lot of money without much risk.

When I stray out of my comfort zone I usually get my head handed to me on a platter.

I suspect that my thinking is an eclectic mix, not pure net-net because I couldn’t do it anyway so you have to have a new something to hang your hat on.  But the framework stays the same.

INVESTMENT STRATEGY

I used to try and pick the best stocks in the fund portfolios, but I always picked the wrong ones.  Now I take my own money and invest it with that odd guy Peter Cundill.  I can be more detached when I treat myself as a normal client.

If it is cheap enough, we don’t care what it is.

Why will someone sell you a dollar for 50 cents?  Because in the short run, people are irrational on both the optimistic and pessimistic side.

MANTRAS

All we try to do is buy a dollar for 40 cents.

In our style of doing things, patience is patience is patience.

One of the dangers about net-net investing is that if you buy a net-net that begins to lose money your net-net goes down and your capacity to be able to make a profit becomes less secure.  So the trick is not necessarily to predict what the earnings are going to be but to have a clear conviction that the company isn’t going bust and that your margin of safety will remain intact over time.

MARGIN OF SAFETY

The difference between the price we pay for a stock and its liquidation value gives us a margin of safety.  This kind of investing is one of the most effective ways of achieving good long-term results.

MARKETS

If there’s a bad stock market, I’ll inevitably go back in too early.  Good times last longer than we think but so do bad times.

Markets can be overvalued and keep getting expensive, or undervalued and keep getting cheap.  That’s why investing is an art form, not a science.

I’m agnostic on where the markets will go.  I don’t have a view.  Our task is to find undervalued global securities that are trading well below their intrinsic value.  In other words, we follow the strict Benjamin Graham approach to investing.

NEW LOWS

Search out the new lows, not the new highs.  Read the Outstanding Investor Digest to find out what Mason Hawkins or Mike Price is doing.  You know good poets borrow and great poets steal.  So see what you can find.  General reading—keep looking at the news to see what’s troubled.  Experience and curiosity is a really winning combination.

What differentiates us from other money managers with a similar style is that we’re comfortable with new lows.

NOBODY LISTENING

Many people consider value investing dull and as boring as watching paint dry.  As a consequence value investors are not always listened to, especially in a stock market bubble.  Investors are often in too much of a hurry to latch on to growth stocks to stop and listen because they’re afraid of being left out…

OSMOSIS

I don’t just calculate value using net-net.  Actually there are many different ways but you have to use what I call osmosis—you have got to feel your way.  That is the art form, because you are never going to be right completely; there is no formula that will ever get you there on its own.  Osmosis is about intuition and about discipline and about all the other things that are not quantifiable.  So can you learn it?  Yes, you can learn it, but it’s not a science, it’s an art form.  The portfolio is a canvas to be painted and filled in.

PATIENCE

When times aren’t good I’m still there.  You find bargains among the unpopular things, the things that everybody hates.  The key is that you must have patience.

RISK

We try not to lose.  But we don’t want to try too hard.  The losses, of course, work against you in establishing decent compound rates of return.  And I hope we won’t have them.  But I don’t want to be so risk-averse that we are always trying too hard not to lose.

STEADY RETURNS

All I know is that if you can end up with a 20% track record over a longer period of time, the compound rates of return are such that the amounts are staggering.  But a lot of investors want excitement, not steady returns.  Most people don’t see making money as grinding it out, doing it as efficiently as possible.  If we have a strong market over the next six months and the fund begins to drop behind and there isn’t enough to do, people will say Cundill’s lost his touch, he’s boring.

TIMING: “THERE’S ALWAYS SOMETHING TO DO”

…Irving Kahn gave me some advice many years ago when I was bemoaning the fact that according to my criteria there was nothing to do.  He said, ‘there is always something to do.  You just need to look harder, be creative and a little flexible.’

VALUE INVESTING

I don’t think I want to become too fashionable.  In some ways, value investing is boring and most investors don’t want a boring life—they want some action: win, lose, or draw.

I think the best decisions are made on the basis of what your tummy tells you.  The Jesuits argue reason before passion.  I argue reason and passion.  Intellect and intuition.  It’s a balance.

We do liquidation analysis and liquidation analysis only.

Ninety to 95% of all my investing meets the Graham tests.  The times I strayed from a rigorous application of this philosophy I got myself into trouble.

But what do you do when none of these companies is available?  The trick is to wait through the crisis stage and into the boredom stage.  Things will have settled down by then and values will be very cheap again.

We customarily do three tests: one of them asset-based—the NAV, using the company’s balance sheet.  The second is the sum of the parts, which I think is probably the most important part that goes into the balance sheet I’m creating.  And then a future NAV, which is making a stab (which I am always suspicious about) at what you think the business might be doing in three years from now.

WORKING LIFE

I’ve been doing this for thirty years.  And I love it.  I’m lucky to have the kind of life where the differentiation between work and play is absolutely zilch.  I have no idea whether I’m working or whether I’m playing.

My wife says I’m a workaholic, but my colleagues say I haven’t worked for twenty years.  My work is my play.

 

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.

Business Adventures

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 4, 2019

In 1991, when Bill Gates met Warren Buffett, Gates asked him to recommend his favorite business book.  Buffett immediately replied, “It’s Business Adventures, by John Brooks.  I’ll send you my copy.”  Gates wrote in 2014:

Today, more than two decades after Warren lent it to me—and more than four decades after it was first published—Business Adventures remains the best business book I’ve ever read.  John Brooks is still my favorite business writer.

It’s certainly true that many of the particulars of business have changed.  But the fundamentals have not.  Brooks’s deeper insights about business are just as relevant today as they were back then.  In terms of its longevity, Business Adventures stands alongside Benjamin Graham’s The Intelligent Investor, the 1949 book that Warren says is the best book on investing that he has ever read.

See:  https://www.gatesnotes.com/Books/Business-Adventures

I’ve had the enormous pleasure of reading Business Adventures twice.  John Brooks is quite simply a terrific business writer.

Each chapter of the book is a separate business adventure.  Outline:

  • The Fluctuation
  • The Fate of the Edsel
  • A Reasonable Amount of Time
  • Xerox Xerox Xerox Xerox
  • Making the Customers Whole
  • The Impacted Philosophers
  • The Last Great Corner
  • A Second Sort of Life
  • Stockholder Season
  • One Free Bite

 

THE FLUCTUATION

Brooks recounts J.P. Morgan’s famous answer when an acquaintance asked him what the stock market would do:  “It will fluctuate.”  Brooks then writes:

Apart from the economic advantages and disadvantages of stock exchanges – the advantage that they provide a free flow of capital to finance industrial expansion, for instance, and the disadvantage that they provide an all too convenient way for the unlucky, the imprudent, and the gullible to lose their money – their development has created a whole pattern of social behavior, complete with customs, language, and predictable responses to given events.

Brooks explains that the pattern emerged fully at the first important stock exchange in 1611 in Amsterdam.  Brooks mentions that Joseph de la Vega published, in 1688, a book about the first Dutch stock traders.  The book was aptly titled, Confusion of Confusions.

And the pattern persists on the New York Stock Exchange.  (Brooks was writing in the 1960’s, but many of his descriptions still apply.)  Brooks adds that a few Dutchmen haggling in the rain might seem to be rather far from the millions of participants in the 1960’s.  However:

The first stock exchange was, inadvertently, a laboratory in which new human reactions were revealed.  By the same token, the New York Stock Exchange is also a sociological test tube, forever contributing to the human species’ self-understanding.

On Monday, May 28, 1962, the Dow Jones Average dropped 34.95 points, or more than it had dropped on any day since October 28, 1929.  The volume was the seventh-largest ever.  Then on Tuesday, May 29, after most stocks opened down, the market reversed itself and surged upward with a large gain of 27.03.  The trading volume on Tuesday was the highest ever except for October 29, 1929.  Then on Thursday, May 31, after a holiday on Wednesday, the Dow rose 9.40 points on the fifth-greatest volume ever.

Brooks:

The crisis ran its course in three days, but needless to say, the post-mortems took longer.  One of de la Vega’s observations about the Amsterdam traders was that they were ‘very clever in inventing reasons’ for a sudden rise or fall in stock prices, and the Wall Street pundits certainly needed all the cleverness they could muster to explain why, in the middle of an excellent business year, the market had suddenly taken its second-worst nose dive ever up to that moment.

Many rated President Kennedy’s April crackdown on the steel industry’s planned price increase as one of the most likely causes.  Beyond that, there were comparisons to 1929.  However, there were more differences than similarities, writes Brooks.  For one thing, margin requirements were far higher in 1962 than in 1929.  Nonetheless, the weekend before the May 1962 crash, many securities dealers were occupied sending out margin calls.

In 1929, it was not uncommon for people to have only 10% equity, with 90% of the stock position based on borrowed money.  (The early Amsterdam exchange was similar.)  Since the crash in 1929, margin requirements had been raised to 50% equity (leaving 50% borrowed).

Brooks says the stock market had been falling for most of 1962 up until crash.  But apparently the news before the May crash was good.  Not that news has any necessary relationship with stock movements, although most financial reporting services seem to assume otherwise.  After a mixed opening – some stocks up, some down – on Monday, May 28, volume spiked as selling became predominant.  Volume kept going up thereafter as the selling continued.  Brooks:

Evidence that people are selling stocks at a time when they ought to be eating lunch is always regarded as a serious matter.

One problem in this crash was that the tape – which records the prices of stock trades – got delayed by 55 minutes due to the huge volume.  Some brokerage firms tried to devise their own systems to deal with this issue.  For instance, Merrill Lynch floor brokers – if they had time – would shout the results of trades into a floorside telephone connected to a “squawk box” in the firm’s head office.

Brooks remarks:

All that summer, and even into the following year, security analysts and other experts cranked out their explanations of what had happened, and so great were the logic, solemnity, and detail of these diagnoses that they lost only a little of their force through the fact that hardly any of the authors had had the slightest idea what was going to happen before the crisis occurred.

Brooks then points out that an unprecedented 56.8 percent of the total volume in the crash had been individual investors.  Somewhat surprisingly, mutual funds were a stabilizing factor.  During the Monday sell-off, mutual funds bought more than they sold.  And as stocks surged on Thursday, mutual funds sold more than they bought.  Brooks concludes:

In the last analysis, the cause of the 1962 crisis remains unfathomable;  what is known is that it occurred, and that something like it could occur again.

 

THE FATE OF THE EDSEL

1955 was the year of the automobile, writes Brooks.  American auto makers sold over 7 million cars, a million more than in any previous year.  Ford Motor Company decided that year to make a new car in the medium-price range of $2,400 to $4,000.  Brooks continues:

[Ford] went ahead and designed it more or less in comformity with the fashion of the day, which was for cars that were long, wide, low, lavishly decorated with chrome, liberally supplied with gadgets… Two years later, in September, 1957, Ford put its new car, the Edsel, on the market, to the accompaniment of more fanfare than had attended the arrival of any new car since the same company’s Model A, brought out thirty years earlier.  The total amount spent on the Edsel before the first specimen went on sale was announced as a quarter of a billion dollars;  its launching… was more costly than any other consumer product in history.  As a starter toward getting its investment back, Ford counted on selling at least 200,000 Edsels the first year.

There may be an aborigine somewhere in a remote rainforest who hasn’t yet heard that things failed to turn out that way… on November 19, 1959, having lost, according to some outside estimates, around $350 million on the Edsel, the Ford Company permanently discontinued its production.

Brooks asks:

How could this have happened?  How could a company so mightily endowed with money, experience, and, presumably, brains have been guilty of such a monumental mistake?

Many claimed that Ford had paid too much attention to public-opinion polls and the motivational research it conducted.  But Brooks adds that some non-scientific elements also played a roll.  In particular, after a massive effort to come up with possible names for the car, science was ignored at the last minute and the Edsel was named for the father of the company’s president.  Brooks:

As for the design, it was arrived at without even a pretense of consulting the polls, and by the method that has been standard for years in the designing of automobiles – that of simply pooling the hunches of sundry company committees.

The idea for the Edsel started years earlier.  The company noticed that owners of cars would trade up to the medium-priced car as soon as they could.  The problem was that Ford owners were not trading up to the Mercury, Ford’s medium-priced car, but to the medium-priced cars of its rivals, General Motors and Chrysler.

Late in 1952, a group called the Forward Product Planning Committee gave much of the detailed work to the Lincoln-Mercury Division, run by Richard Krafve (pronounced “Kraffy”).  In 1954, after two years’ work, the Forward Product Planning Committee submitted to the executive committee a six-volume report.  In brief, the report predicted that there would be seventy million cars in the U.S. by 1965, and more than 40 percent of all cars sold would be in the medium-price range.  Brooks:

On the other hand, the Ford bosses were well aware of the enormous risks connected with putting a new car on the market.  They knew, for example, that of the 2,900 American makes that had been introduced since the beginning of the automobile age… only about twenty were still around.

But Ford executives felt optimistic.  They set up another agency, the Special Products Division, again with Krafve in charge.  The new car was referred to as the “E”-Car among Ford designers and workers.  “E” for Experimental.  Roy A. Brown was in charge of the E-car’s design.  Brown stated that they sought to make a car that was unique as compared to the other nineteen cars on the road at the time.

Brooks observes that Krafve later calculated that he and his associates would make at least four thousand decisions in designing the E-Car.  He thought that if they got every decision right, they could create the perfectly designed car.  Krafve admitted later, however, that there wasn’t really enough time for perfection.  They would make modifications, and then modifications of those modifications.  Then time would run out and they had to settle on the most recent modifications.

Brooks comments:

One of the most persuasive and frequently cited explanations of the Edsel’s failure is that it was a victim of the time lag between the decision to produce it and the act of putting it on the market.  It was easy to see a few years later, when smaller and less powerful cars, euphemistically called “compacts,” had become so popular as to turn the old automobile status-ladder upside down, that the Edsel was a giant step in the wrong direction, but it far from easy to see that in fat, tail-finny 1955.

As part of the marketing effort, the Special Products Division tapped David Wallace, director of planning for market research.  Wallace:

‘We concluded that cars are a means to a sort of dream fulfillment.  There’s some irrational factor in people that makes them want one kind of car rather than another – something that has nothing to do with the mechanism at all but with the car’s personality, as the customer imagines it.  What we wanted to do, naturally, was to give the E-Car the personality that would make the greatest number of people want it.’

Wallace’s group decided to get interviews of 1,600 car buyers.  The conclusion, in a nutshell, was that the E-Car could be “the smart car for the younger executive or professional family on its way up.”

As for the name of the car, Krafve had suggested to the members of the Ford family that the new car be named the Edsel Ford – the name of their father.  The three Ford brothers replied that their father probably wouldn’t want the car named after him.  Therefore, they suggested that the Special Products Division look for another name.

The Special Products Division conducted a large research project regarding the best name for the E-Car.  At one point, Wallace interviewed the poet Marianne Moore about a possible name.  A bit later, the Special Products Division contacted Foote, Cone & Belding, an advertising agency, to help with finding a name.

The advertising agency produced 18,000 names, which they then carefully pruned to 6,000.  Wallace told them that was still way too many names from which to pick.  So Foote, Cone & Belding did an all-out three-day session to cut the list down to 10 names.  They divided into two groups for this task.  By chance, when each group produced its list of 10 names, 4 of the names were the same:  Corsair, Citation, Pacer, and Ranger.

Wallace thought that Corsair was clearly the best name.  However, the Ford executive committee had a meeting at a time when all three Ford brothers were away.  Executive vice-president Ernest R. Breech, chairman of the board, led the meeting.  When Breech saw the final list of 10 names, he said he didn’t like any of them.

So Breech and the others were shown another list of names that hadn’t quite made the top 10.  The Edsel had been kept on this second list – despite the three Ford brothers being against it – for some reason, perhaps because it was the originally suggested name.  When the group came to the name “Edsel,” Breech firmly said, “Let’s call it that.”  Breech added that since there were going to be four models of the E-Car, the four favorite names – Corsair, Citation, Pacer, and Ranger – could still be used as sub-names.

Brooks writes that Foote, Cone & Belding presumably didn’t react well to the chosen name, “Edsel,” after their exhaustive research to come up with the best possible names.  But the Special Products Division had an even worse reaction.  However, there were a few, including Krafve, would didn’t object to the name.

Krafve was named Vice-President of the Ford Motor Company and General Manager, Edsel Division.  Meanwhile, Edsels were being road-tested.  Brown and other designers were already working on the subsequent year’s model.  A new set of retail dealers was already being put together.  Foote, Cone & Belding was hard at work on strategies for advertising and selling Edsels.  In fact, Fairfax M. Cone himself was leading this effort.

Cone decided to use Wallace’s idea of “the smart car for the younger executive or professional family on its way up.”  But Cone amended it to: “the smart car for the younger middle-income family or professional family on its way up.”  Cone was apparently quite confident, since he described his advertising ideas for the Edsel to some reporters.  Brooks notes with amusement:

Like a chess master that has no doubt that he will win, he could afford to explicate the brilliance of his moves even as he made them.

Normally, a large manufacturer launches a new car through dealers already handling some of its other makes.  But Krafve got permission to go all-out on the Edsel.  He could contact dealers for other car manufacturers and even dealers for other divisions of Ford.  Krafve set a goal of signing up 1,200 dealers – who had good sales records – by September 4, 1957.

Brooks remarks that Krafve had set a high goal, since a dealer’s decision to sell a new car is major.  Dealers typically have one hundred thousand dollars – more than 8x that in 2019 dollars – invested in their dealerships.

J. C. (Larry) Doyle, second to Krafve, led the Edsel sales effort.  Doyle had been with Ford for 40 years.  Brooks records that Doyle was somewhat of a maverick in his field.  He was kind and considerate, and he didn’t put much stock in the psychological studies of car buyers.  But he knew how to sell cars, which is why he was called on for the Edsel campaign.

Doyle put Edsels into a few dealerships, but kept them hidden from view.  Then he went about recruiting top dealers.  Many dealers were curious about what the Edsel looked like.  But Doyle’s group would only show dealers the car if they listened to a one-hour pitch.  This approach worked.  It seems that quite a few dealers were so convinced by the pitch that they signed up without even looking at the car in any detail.

C. Gayle Warnock, director of public relations at Ford, was in charge of keeping public interest in the Edsel – which was already high – as strong as possible.  Warnock told Krafve that public interest might be too strong, to the extent that people would be disappointed when they discovered that the Edsel was a car.  Brooks:

It was agreed that the safest way to tread the tightrope between overplaying and underplaying the Edsel would be to say nothing about the car as a whole but to reveal its individual charms a little at a time – a sort of automotive strip tease…

Brooks continues:

That summer, too, was a time of speechmaking by an Edsel foursome consisting of Krafve, Doyle, J. Emmet Judge, who was Edsel’s director of merchandise and product planning, and Robert F. G. Copeland, its assistant general sales manager for advertising, sales promotion, and training.  Ranging separately up and down and across the nation, the four orators moved around so fast and so tirelessly, that Warnock, lest he lost track of them, took to indicating their whereabouts with colored pins on a map in his office.  ‘Let’s see, Krafve goes from Atlanta to New Orleans, Doyle from Council Bluffs to Salt Lake City,’ Warnock would muse of a morning in Dearborn, sipping his second cup of coffee and then getting up to yank the pins out and jab them in again.

Needless to say, this was by far the largest advertising campaign ever conducted by Ford.  This included a three-day press preview, with 250 reporters from all over the country.  On one afternoon, the press were taken to the track to see stunt drivers in Edsels doing all kinds of tricks.  Brooks quotes the Foote, Cone man:

‘You looked over this green Michigan hill, and there were those glorious Edsels, performing gloriously in unison.  It was beautiful.  It was like the Rockettes.  It was exciting.  Morale was high.’

Brooks then writes about the advertising on September 3 – “E-Day-minus-one”:

The tone for Edsel Day’s blizzard of publicity was set by an ad, published in newspapers all over the country, in which the Edsel shared the spotlight with the Ford Company’s President Ford and Chairman Breech.  In the ad, Ford looked like a dignified young father, Breech like a dignified gentleman holding a full house against a possible straight, the Edsel just looked like an Edsel.  The accompanying text declared that the decision to produce the car had been ‘based on what we knew, guessed, felt, believed, suspected – about you,’ and added, ‘YOU are the reason behind the Edsel.’  The tone was calm and confident.  There did not seem to be much room for doubt about the reality of that full house.

The interior of the Edsel, as predicted by Krafve, had an almost absurd number of push-buttons.

The two larger models – the Corsair and the Citation – were 219 inches long, two inches longer than the biggest of the Oldsmobiles.  And they were 80 inches wide, “or about as wide as passenger cars ever get,” notes Brooks.  Each had 345 horsepower, making it more powerful than any other American car at the time of launching.

Brooks records that the car received mixed press after it was launched.  In January, 1958, Consumer Reports wrote:

The Edsel has no important basic advantage over other brands.  The car is almost entirely conventional in construction…

Three months later, Consumer Reports wrote:

[The Edsel] is more uselessly overpowered… more gadget bedecked, more hung with expensive accessories than any other car in its price class.

This report gave the Corsair and the Citation the bottom position in its competitive ratings.

Brooks says there were several factors in the downfall of the Edsel.  It wasn’t just that the design fell short, nor was it simply that the company relied too much on psychological research.  For one, many of the early Edsels suffered from a surprising variety of imperfections.  It turned out that only about half the early Edsels functioned properly.

Brooks recounts:

For the first ten days of October, nine of which were business days, there were only 2,751 deliveries – an average of just over three hundred cars a day.  In order to sell the 200,000 cars per year that would make the Edsel operation profitable the Ford Motor Company would have to move an average of between six and seven hundred each business day – a good many more than three hundred a day.  On the night of Sunday, October 13th, Ford put on a mammoth television spectacular for Edsel, pre-empting the time ordinarily allotted to the Ed Sullivan show, but though the program cost $400,000 and starred Bing Crosby and Frank Sinatra, it failed to cause any sharp spurt in sales.  Now it was obvious that things were not going well at all.

Among the former executives of the Edsel Division, opinions differ as to the exact moment when the portents of doom became unmistakable… The obvious sacrificial victim was Brown, whose stock had gone through the roof at the time of the regally accoladed debut of his design, in August, 1955.  Now, without having done anything further, for either better or worse, the poor fellow became the company scapegoat…

Ford re-committed to selling the Edsel in virtually every way that it could.  Sales eventually increased, but not nearly enough.  Ultimately, the company had to stop production.  The net loss for Ford was roughly $350 million.

Krafve rejects that the Edsel failed due to a poor choice of the name.  He maintains that it was a mistake of timing.  Had they produced the car two years earlier, when medium-sized cars were still highly popular, the Edsel would have been a success.  Brown agrees with Krafve that it was a mistake of timing.

Doyle says it was a buyers’ strike.  He claims not to understand at all why the American public suddenly switched its taste from medium-sized cars to smaller-sized cars.

Wallace argued that the Russian launch of the sputnik had caused many Americans to start viewing Detroit products as bad, especially medium-priced cars.

Brooks concludes by noting that Ford did not get hurt by this setback, nor did the majority of people associated with the Edsel.  In 1958, net income per share dropped from $5.40 to $2.12, and Ford stock dropped from a 1957 high of $60 to a low of $40.  However, by 1959, net income per-share jumped to $8.24 and the stock hit $90.

The Ford executives associated with the Edsel advanced in their careers, for the most part.  Moreover, writes Brooks:

The subsequent euphoria of these former Edsel men did not stem entirely from the fact of their economic survival;  they appear to have been enriched spiritually.  They are inclined to speak of their Edsel experience – except for those still with Ford, who are inclined to speak of it as little as possible – with the verve and garrulity of old comrades-in-arms hashing over their most thrilling campaign.

 

A REASONABLE AMOUNT OF TIME

Brooks:

Most nineteenth-century American fortunes were enlarged by, if they were not actually founded on, the practice of insider trading…

Not until 1934 did Congress pass the Securities Exchange Act, which forbids insider trading.  Later, a 1942 rule 10B-5 held that no stock trader could “make any untrue statement of a material fact or… omit to state a material fact.”  However, observes Brooks, this rule had basically been overlooked for the subsequent couple of decades.  It was argued that insiders needed the incentive of being able to profit in order to bring forth their best efforts.  Further, some authorities said that insider trading helped the markets function more smoothly.  Finally, it was held that most stock traders “possess and conceal information of one sort or another.”

In short, the S.E.C. seemed to be refraining from doing anything regarding insider trading.  But this changed when a civil complaint was made against Texas Gulf Sulphur Company.  The case was tried in the United States District Court in Foley Square May 9 to June 21, 1966.  The presiding judge was Dudley J. Bonsal, says Brooks, who remarked at one point, “I guess we all agree that we are plowing new ground here to some extent.”

In March 1959, Texas Gulf, a New York-based company and the world’s leader producer of sulphur, began conducting aerial surveys over a vast area of eastern Canada.  They weren’t looking for sulphur or gold, but for sulphides – sulphur in combination with other useful minerals such as zinc and copper.  Texas Gulf wanted to diversify its production.

These surveys took place over two years.  Many areas of interest were noted.  The company concluded that several hundred areas were most promising, including a segment called Kidd-55, which was fifteen miles north of Timmins, Ontario, an old gold-mining town several hundred miles northwest of Toronto.

The first challenge was to get title to do exploratory drilling on Kidd-55.  It wasn’t until June, 1963, that Texas Gulf was able to begin exploring on the northeast quarter of Kidd-55.  After Texas Gulf engineer, Richard H. Clayton, completed a ground electromagnetic survey and was convinced the area had potential, the company decided to drill.  Drilling began on November 8.  Brooks writes:

The man in charge of the drilling crew was a young Texas Gulf geologist named Kenneth Darke, a cigar smoker with a rakish gleam in his eye, who looked a good deal more like the traditional notion of a mining prospector than that of the organization man that he was.

A cylindrical sample an inch and a quarter in diameter was brought out of the earth.  Darke studied it critically inch by inch using only his eyes and his knowledge.  On November 10, Darke telephoned his immediate superior, Walter Holyk, chief geologist of Texas Gulf, to report the findings at that point.

The same night, Holyk called his superior, Richard D. Mollison, a vice president of Texas Gulf.  Mollison then called his superior, Charles F. Fogarty, executive vice president and the No. 2 man at the company.  Further reports were made the next day.  Soon Holyk, Mollison, and Fogarty decided to travel to Kidd-55 to take a look for themselves.

By November 12, Holyk was on site helping Darke examine samples.  Holyk was a Canadian in his forties with a doctorate in geology from MIT.  The weather had turned bad.  Also, much of the stuff came up covered in dirt and grease, and had to be washed with gasoline.  Nonetheless, Holyk arrived at an initial estimate of the core’s content.  There seemed to be average copper content of 1.15% and average zinc content of 8.64%.  If true and if it was not just in one narrow area, this appeared to be a huge discovery.  Brooks:

Getting title would take time if it were possible at all, but meanwhile there were several steps that the company could and did take.  The drill rig was moved away from the site of the test hole.  Cut saplings were stuck in the ground around the hole, to restore the appearance of the place to a semblance of its natural state.  A second test hole was drilled, as ostentatiously as possible, some distance away, at a place where a barren core was expected – and found.  All of these camouflage measures, which were in conformity with long-established practice among miners who suspect that they have made a strike, were supplemented by an order from Texas Gulf’s president, Claude O. Stephens, that no one outside the actual exploration group, even within the company, should be told what had been found.  Late in November, the core was shipped off, in sections, to the Union Assay Office in Salt Lake City for scientific analysis of its contents.  And meanwhile, of course, Texas Gulf began discreetly putting out feelers for the purchase of the rest of Kidd-55.

Brooks adds:

And meanwhile other measures, which may or may not have been related to the events of north of Timmins, were being taken.  On November 12th, Fogarty bought three hundred shares of Texas Gulf stock;  on the 15th he added seven hundred more shares, on November 19th five hundred more, and on November 26th two hundred more.  Clayton bought two hundred on the 15th, Mollison one hundred on the same day; and Mrs. Holyk bought fifty on the 29th and one hundred more on December 10th.  But these purchases, as things turned out, were only the harbingers of a period of apparently intense affection for Texas Gulf stock among certain of its officers and employees, and even some of their friends.

The results of the sample test confirmed Holyk’s estimates.  Also found were 3.94 ounces of silver per ton.  In late December, while in the Washington, D.C. area, Darke recommended Texas Gulf stock to a girl he knew there and her mother.  They later became known as “tippees,” while a few people they later told naturally became “sub-tippees.”  Between December 30 and February 17, Darke’s tippees and sub-tippees purchased 2,100 shares of Texas Gulf stock and also bought calls on another 1,500 shares.

In the first three months of 1964, Darke bought 300 shares of Texas Gulf stock, purchased calls on 3,000 more shares, and added several more persons to his burgeoning list of tippees.  Holyk and his wife bought a large number of calls on Texas Gulf stock.  They’d hardly heard of calls before, but calls “were getting to be quite the rage in Texas Gulf circles.”

Finally in the spring, Texas Gulf had the drilling rights it needed and was ready to proceed.  Brooks:

After a final burst of purchases by Darke, his tippees, and his sub-tippees on March 30th and 31st (among them all, six hundred shares and calls on 5,100 more shares for the two days), drilling was resumed in the still-frozen muskeg at Kidd-55, with Holyk and Darke both on the site this time.

While the crew stayed on site, the geologists almost daily made the fifteen-mile trek to Simmins.  With seven-foot snowdrifts, the trip took three and a half to four hours.

At some stage – later a matter of dispute – Texas Gulf realized that it had a workable mine of large proportions.  Vice President Mollison arrived on site for a day.  Brooks:

But before going he issued instructions for the drilling of a mill test hole, which would produce a relatively large core that could be used to determine the amenability of the mineral material to routine mill processing.  Normally, a mill test hole is not drilled until a workable mine is believed to exist.  And so it may have been in this case;  two S.E.C. mining experts were to insist later, against contrary opinions of experts for the defense, that by the time Mollison gave his order, Texas Gulf had information on the basis of which it could have calculated that the ore reserves at Kidd-55 had a gross assay value of at least two hundred million dollars.

Brooks notes:

The famous Canadian mining grapevine was humming by now, and in retrospect the wonder is that it had been relatively quiet for so long.

On April 10, President Stephens had become concerned enough to ask a senior member of the board – Thomas S. Lamont of Morgan fame – whether Texas Gulf should issue a statement.  Lamont told him he could wait until the reports were published in U.S. papers, but then he should issue a statement.

The following day, April 11, the reports poured forth in the U.S. papers.  The Herald Tribune called it “the biggest ore strike since gold was discovered more than 60 years ago in Canada.”  Stephens instructed Fogarty to begin preparing a statement to be issued on Monday, April 13.  Meanwhile, the estimated value of the mine seemed to be increasing by the hour as more and more copper and zinc ore was brought to the surface.  Brooks writes:

However, Fogarty did not communicate with Timmins after Friday night, so the statement that he and his colleagues issued to the press on Sunday afternoon was not based on the most up-to-the-minute information.  Whether because of that or for some other reason, the statement did not convey the idea that Texas Gulf thought it had a new Comstock Lode.  Characterizing the published reports as exaggerated and unreliable, it admitted that recent drilling on ‘one property near Timmins’ had led to ‘preliminary indications that more drilling would be required for proper evaluation of the prospect;’  went on to say that ‘the drilling done to date has not been conclusive;’  and then, putting the same thought in what can hardly be called another way, added that ‘the work done to date has not been sufficient to reach definitive conclusions.’

The wording of this press release was sufficient to put a damper on any expectations that may have arisen due to the newspaper stories the previous Friday.  Texas Gulf stock had gone from around $17 the previous November to around $30 just before the stories.  On Monday, the stock went to $32, but then came back down and even dipped below $29 in the subsequent two days.

Meanwhile, at Kidd-55, Mollison, Holyk, and Darke talked with a visiting reporter who had been shown around the place.  Brooks:

The things they told the reporter make it clear, in retrospect, that whatever the drafters of the release may have believed on Sunday, the men at Kidd-55 knew on Monday that they had a mine and a big one.  However, the world was not to know it, or at least not from that source, until Thursday morning, when the next issue of the Miner would appear in subscribers’ mail and on newstands.

Mollison and Holyk flew to Montreal Tuesday evening for the annual convention of the Canadian Institute of Mining and Metallurgy.  They had arranged for that Wednesday, in the company of the Minister of Mines of the Province of Ontario and his deputy, to attend the convention.  En route, they briefed the minister on Kidd-55.  The minister decided he wanted to make an announcement as soon as possible.  Mollison helped the minister draft the statement.

According to the copy Mollison kept, the announcement stated that “the information now in hand… gives the company confidence to allow me to announce that Texas Gulf Sulphur has a mineable body of zinc, copper, and silver ore of substantial dimensions that will be developed and brought to production as soon as possible.”  Mollison and Holyk believed that the minister would make the announcement that evening.  But for some reason, the minister didn’t.

Texas Gulf was to have a board of directors meeting that Thursday.  Since better and better news had been coming in from Kidd-55, the company officers decided they should write a new press release, to be issued after the Thursday morning board meeting.  This statement was based on the very latest information and it read, in part, “Texas Gulf Sulphur Company has made a major strike of zinc, copper, and silver in the Timmins area… Seven drill holes are now essentially complete and indicate an ore body of at least 800 feet in length, 300 feet in width, and having a vertical depth of more than 800 feet.  This is a major discovery.  The preliminary data indicate a reserve of more than 25 million tons of ore.”

The statement also noted that “considerably more data has been accumulated,” in order to explain the difference between this statement and the previous one.  Indeed, the value of the ore was not the two hundred million dollars alleged to have been estimable a week earlier, but many times that.

The same day, engineer Clayton and company secretary Crawford bought 200 and 300 shares, respectively.  The next morning, Crawford doubled his order.

The directors’ meeting ended at ten o’clock.  Then 22 reporters entered the room.  President Stephens read the new press release.  Most reporters rushed out before he was finished to report the news.

The actions of two Texas Gulf directors, Coates and Lamont, during the next half hour were later to lead to the most controversial part of the S.E.C.’s complaint.  As Brooks writes, the essence of the controversy was timing.  The Texas Gulf news was released by the Dow Jones News Service, the well-known spot-news for investors.  In fact, a piece of news is considered to be public the moment it crosses “the broad tape.”

The morning of April 16, 1964, a Dow Jones reporter was among those who attended the Texas Gulf press conference.  He left early and called in the news around 10:10 or 10:15, according to his recollection.  Normally, a news item this important would be printed on the Dow Jones machines two or three minutes after being phoned in.  But for reasons unknown, the Texas Gulf story did not appear on the tape until 10:54.  This delay was left unexplained during the trial based on irrelevance, says Brooks.

Coates, the Texan, around the end of the press conference, called his son-in-law, H. Fred Haemisegger, a stockbroker in Houston.  Coates told Haemisegger about the Texas Gulf discovery, also saying that he waited to call until “after the public announcement” because he was “too old to get in trouble with the S.E.C.”  Coates next placed an order for 2,000 shares of Texas Gulf stock for four family trusts.  He was a trustee, but not a beneficiary.  The stock had opened at $30.  Haemisegger, by acting quickly, was able to buy a bit over $31.

Lamont hung around the press conference area for 20 minutes or so.  He recounts that he “listened to chatter” and “slapped people on the back.”  Then at 10:39 or 10:40, he called a friend at Morgan Guaranty Trust Company – Longstreet Hinton, the bank’s executive vice president and head of its trust department.  Hinton had asked Lamont earlier in the week if he knew anything about the rumors of an ore discovery made by Texas Gulf.  Lamont had said no then.

But during this phone call, Lamont told Hinton that he had some news now.  Hinton asked whether it was good.  Lamont replied either “pretty good” or “very good.”  (Brooks notes that they mean the same thing in this context.)  Hinton immediately called the bank’s trading department, got a quote on Texas Gulf, and placed an order for 3,000 shares for the account of the Nassau Hospital, of which he was treasurer.  Hinton never bothered to look at the tape – despite being advised to do so by Lamont – because Hinton felt he already had the information he needed.  (Lamont didn’t know about the inexplicable forty minute delay before the Texas Gulf news appeared on the tape.)

Then Hinton went to the office of the Morgan Guaranty officer in charge of pension trusts.  Hinton recommended buying Texas Gulf.  In less than half an hour, the bank had ordered 7,000 shares for its pension fund and profit-sharing account.

An hour after that – at 12:33 – Lamont purchased 3,000 shares for himself and his family, paying $34 1/2 for them.  The stock closed above $36.  It hit a high of over $58 later that month.  Brooks:

…and by the end of 1966, when commercial production of ore was at last underway at Kidd-55 and the enormous new mine was expected to account for one-tenth of Canada’s total annual production of copper and one-quarter of its total annual production of zinc, the stock was selling at over 100.  Anyone who had bought Texas Gulf between November 12th, 1963 and the morning (or even the lunch hour) of April 16th, 1964 had therefore at least tripled his money.

Brooks then introduces the trial:

Perhaps the most arresting aspect of the Texas Gulf trial – apart from the fact that a trial was taking place at all – was the vividness and variety of the defendants who came before Judge Bonsal, ranging as they did from a hot-eyed mining prospector like Clayton (a genuine Welchman with a degree in mining from the University of Cardiff) through vigorous and harried corporate nabobs like Fogarty and Stephens to a Texas wheeler-dealer like Coates and a polished Brahmin of finance like Lamont.

Darke did not appear at the trial, claiming his Canadian nationality.  Brooks continues:

The S.E.C., after its counsel, Frank E. Kennamer Jr. had announced his intention to “drag to light and pillory the misconduct of these defendants,” asked the court to issue a permanent injunction forbidding Fogarty, Mollison, Clayton, Holyk, Darke, Crawford, and several other corporate insiders who had bought stock or calls between November 8th, 1963 and April 15th, 1964, from ever again “engaging in any act… which operates or would operate as a fraud or deceit upon any person in connection with purchase or sale of securities”;  further – and here it was breaking entirely new ground – it prayed that the court order the defendants to make restitution to the persons they had allegedly defrauded by buying stock or calls from them on the basis of inside information.  The S.E.C. also charged that the pessimistic April 12th press release was deliberately deceptive, and asked that because of it Texas Gulf be enjoined from “making any untrue statement of material fact or omitting to state a material fact.”  Apart from any question of loss of corporate face, the nub of the matter here lay in the fact that such a judgment, if granted, might well open the way for legal action against the company by any stockholder who had sold his Texas Gulf stock to anybody in the interim between the first press release and the second one, and since the shares that had changed hands during that period had run into the millions, it was a nub indeed.

Regarding the November purchases, the defense argued that a workable mine was far from a sure thing based only on the first drill hole.  Some even argued that the hole could have turned out to be a liability rather than an asset for Texas Gulf, based on what was known then.  The people who bought stock or calls during the winter claimed that the hole had little or nothing to do with their decision.  They stated that they thought Texas Gulf was a good investment in general.  Clayton said his sudden appearance as a large investor was because he had just married a well-to-do wife.  Brooks:

The S.E.C. countered with its own parade of experts, maintaining that the nature of the first core had been such as to make the existence of a rich mine an overwhelming probability, and that therefore those privy to the facts about it had possessed a material fact.

The S.E.C. also made much of the fact that Fogarty based the initial press release on information that was two days old.  The defense countered that the company had been in a sensitive position.  If it had issued an optimistic report that later turned out to be false, it could well be accused of fraud for that.

Judge Bonsal concluded that the definition of materiality must be conservative.  He therefore decided that up until April 9th, when three converging drill holes positively established the three-dimensionality of the ore deposit, material information had not been in hand.  Therefore, the decisions of insiders to buy stock before that date, even if based on initial drilling results, were legal “educated guesses.”

Case was thus dismissed against all educated guessers who had bought stock or calls, or recommended others do so, before the evening of April 9th.  Brooks:

With Clayton and Crawford, who had been so injudicious as to buy or order stock on April 15th, it was another matter.  The judge found no evidence that they had intended to deceive or defraud anyone, but they had made their purchases with the full knowledge that a great mine had been found and that it would be announced the next day – in short, with material private information in hand.  Therefore they were found to have violated Rule 10B-5, and in due time would presumably be enjoined from doing such a thing again and made to offer restitution to the persons they bought their April 15th shares from – assuming, of course, that such persons can be found…

On the matter of the April 12th press release, the judge found that it was not false or misleading.

Still to be settled was the matter of Coates and Lamont making their purchases.  The question was when it can be said that the information has officially been made public.  This was the most important issue and would likely set a legal precedent.

The S.E.C. argued that the actions of Coates and Lamont were illegal because they occurred before the ore strike news had crossed the Dow Jones broad tape.  The S.E.C. argued, furthermore, that even if Coates and Lamont had acted after the “official” announcement, it still would be illegal unless enough time had passed so that those who hadn’t attended the press conference, or even those who hadn’t seen the initial news cross the broad tape, had enough time to absorb the information.

Defense argued first that Coates and Lamont had every reason to believe that the news was already out, since Stephens said it had been released by the Ontario Minister of Mines the previous evening.  So Coates and Lamont acted in good faith.  Second, counsel argued that for all practical purposes, the news was out, via osmosis and The Northern Miner.  Brokerage offices and the Stock Exchange had been buzzing all morning.  Lamont’s lawyers also argued that Lamont had merely told Hinton to look at the tape, not to buy any stock.  Defense argued that the S.E.C. was asking the court to write new rules and then apply them retroactively, while the plaintiff was merely asking that an old rule 10B-5, be applied broadly.

As for Lamont’s waiting for two hours, until 12:33, before buying stock for himself, the S.E.C. took issue, as Brooks records:

‘It is the Commission’s position that even after corporate information has been published in the news media, insiders, are still under a duty to refrain from securities transactions until there had elapsed a reasonable amount of time in which the securities industry, the shareholders, and the investing public can evaluate the development and make informed investment decisions… Insiders must wait at least until the information is likely to have reached the average investor who follows the market and he has had some opportunity to consider it.’

In the Texas Gulf case, the S.E.C. argued that one hour and thirty-nine minutes was not “a reasonable amount of time.”  What, then, is “a reasonable amount of time,” the S.E.C. was asked?  The S.E.C.’s counsel, Kennamer, said it “would vary from case to case.”  Kennamer added that it would be “a nearly impossible task to formulate a rigid set of rules that would apply in all situations of this sort.”

Brooks sums it up with a hint of irony:

Therefore, in the S.E.C.’s canon, the only way an insider could find out whether he had waited long enough before buying his company’s stock was by being hauled into court and seeing what the judge would decide.

Judge Bonsal rejected this argument by the S.E.C.  Moreover, he took a narrower view that, based on legal precedent, the key moment was when the press release was read.  The judge admitted that a better rule might be formulated according to which insiders had to wait at least some amount time after the initial press release so that other investors could absorb it.  However, he didn’t think he should write such a rule.  Nor should this matter be left up to the judge on a case-by-base basis.  Thus, the complaints against Coates and Lamont were dismissed.

The S.E.C. appealed all the dismissals.  Brooks concludes:

…in August, 1968, the U.S. Court of Appeals for the Second Circuit handed down a decision which flatly reversed Judge Bonsal’s findings on just about every score except the findings against Crawford and Clayton, which were affirmed.  The Appeals Court found that the original November drill hole had provided material evidence of a valuable ore deposit, and that therefore Fogarty, Mollison, Darke, Holyk, and all other insiders who had bought Texas Gulf stock or calls on it during the winter were guilty of violations of the law;  that the gloomy April 12th press release had been ambiguous and perhaps misleading;  and that Coates had improperly and illegally jumped the gun in placing his orders right after the April 16th press conference.  Only Lamont – the charges against whom had been dropped following his death shortly after the lower court decision – and a Texas Gulf office manager, John Murray, remained exonerated.

 

XEROX XEROX XEROX XEROX

There was no economical and practical way of making copies until after 1950.  Brooks writes that the 1950’s were the pioneering years for mechanized office copying.  Although people were starting to show a compulsion to make copies, the early copying machines suffered from a number of problems.  Brooks:

…What was needed for the compulsion to flower into a mania was a technological breakthrough, and the breakthrough came at the turn of the decade with the advent of a machine that worked on a new principle, known as xerography, and was able to make dry, good-quality, permanent copies on ordinary paper with a minimum of trouble.  The effect was immediate.  Largely as a result of xerography, the estimated number of copies (as opposed to duplicates) made annually in the United States sprang from some twenty million in the mid-fifties to nine and a half billion in 1964, and to fourteen billion in 1966 – not to mention billions more in Europe, Asia, and Latin America.  More than that, the attitude of educators towards printed textbooks and of business people toward written communication underwent a discernable change;  avant-garde philosophers took to hailing xerography as a revolution comparable in importance to the invention of the wheel;  and coin-operated copy machines began turning up in candy stores and beauty parlors…

The company responsible for the great breakthrough and the one on whose machines the majority of these billions of copies were made was of course, the Xerox Corporation, of Rochester, New York.  As a result, it became the most spectacular big-business success of the nineteen-sixties.  In 1959, the year the company – then called Haloid Xerox, Inc. – introduced its first automatic xerographic office copier, its sales were thirty-three million dollars.  In 1961, they were sixty-six million, in 1963 a hundred and seventy-six million, and in 1966 over half a billion.

The company was extremely profitable.  It ranked two hundred and seventy-first in Fortune’s ranking in 1967.  However, in 1966 the company ranked sixty-third in net profits and probably ninth in the ratio of profits to sales and fifteenth in terms of market value.  Brooks continues:

…Indeed, the enthusiasm the investing public showed for Xerox made its shares the stock market Golconda of the sixties.  Anyone who bought its stock toward the end of 1959 and held on to it until early 1967 would have found his holding worth about sixty-six times its original price, and anyone who was really fore-sighted and bought Haloid in 1955 would have seen his original investment grow – one might almost say miraculously – a hundred and eighty times.  Not surprisingly, a covey of “Xerox millionaires” sprang up – several hundred of them all told, most of whom either lived in the Rochester area or had come from there.

The Haloid company was started in Rochester in 1906.  It manufactured photographic papers.  It survived OK.  But after the Second World War, due to an increase in competition and labor costs, the company was looking for new products.

More than a decade earlier, in 1938, an obscure thirty-two year-old inventor, Chester F. Carlson, was spending his spare time trying to invent an office copying machine.  Carlson had a degree in physics from the California Institute of Technology.  Carlson had hired Otto Kornei, a German refugee physicist, to help him.  Their initial copying machine was unwieldy and produced much smoke and stench.  Brooks:

The process, which Carlson called electrophotography, had – and has – five basic steps:  sensitizing a photoconductive surface to light by giving it an electrostatic charge (for example, by rubbing it with fur);  exposing this surface to a written page to form an electrostatic image;  developing the latest image by dusting the surface with a powder that will adhere only to the charged areas;  transferring the image to some sort of paper;  and fixing the image by the application of heat.

Although each individual step was already used in other technologies, this particular combination of steps was new.  Carlson carefully patented the process and began trying to sell it.  Over the ensuing five years, Carlson tried to sell the rights to every important office-equipment company in the country.  He was turned down every time.  In 1944, Carlson finally convinced Battelle Memorial Institute to conduct further development work on the process in exchange for three-quarters of any future royalties.

In 1946, various people at Haloid, including Joseph C. Wilson – who was about to become president – had noticed the work that Battelle was doing.  Wilson asked a friend of his, Sol M. Linowitz, a smart, public-spirited lawyer just back from service in the Navy, to research the work at Battelle as a “one-shot” job.  The result was an agreement giving Haloid the rights to the Carlson process in exchange for royalties for Battelle and Carlson.

At one point in the research and development process, the Haloid people got so discouraged that they considered selling most of their xerography rights to International Business Machines.  The research process became quite costly.  But Haloid committed itself to seeing it through.  It took full title of the Carlson process and assumed the full cost of development in exchange for shares in Haloid (for Battelle and Carlson).  Brooks:

…The cost was staggering.  Between 1947 and 1960, Haloid spent about seventy-five million dollars [over $800 million in 2019 dollars] on research in xerography, or about twice what it earned from its regular operations during that period;  the balance was raised through borrowing and through the wholesale issuance of common stock to anyone who was kind, reckless, or prescient enough to take it.  The University of Rochester, partly out of interest in a struggling local industry, bought an enormous quantity for its endowment fund at a price that subsequently, because of stock splits, amounted to fifty cents a share.  ‘Please don’t be mad at us if we have to sell our Haloid stock in a couple of years to cut our losses on it,’ a university official nervously warned Wilson.  Wilson promised not to be mad.  Meanwhile, he and other executives of the company took most of their pay in the form of stock, and some of them went as far as to put up their savings and the mortgages on their houses to help the cause along.

In 1961, the company changed its name to Xerox Corporation.  One unusual aspect to the story is that Xerox became rather public-minded.  Brooks quotes Wilson:

‘To set high goals, to have almost unattainable aspirations, to imbue people with the belief that they can be achieved – these are as important as the balance sheet, perhaps more so.’

This rhetoric is not uncommon.  But Xerox followed through by donating one and a half percent of its profits to educational and charitable institutions in 1965-1966.  In 1966, Xerox committed itself to the “one-per-cent program,” also called the Cleveland Plan, according to which the company gives one percent of its pre-tax income annually to educational institutions, apart from any other charitable activities.

Furthermore, President Wilson said in 1964, “The corporation cannot refuse to take a stand on public issues of major concern.”  As Brooks observes, this is “heresy” for a business because it could alienate customers or potential customers.  Xerox’s chief stand was in favor of the United Nations.  Brooks:

Early in 1964, the company decided to spend four million dollars – a year’s advertising budget – on underwriting a series of network-television programs dealing with the U.N., the programs to be unaccompanied by commercials or any other identification of Xerox apart from a statement at the beginning and end of each that Xerox had paid for it.

Xerox was inundated with letters opposing the company’s support of the U.N.  Many said that the U.N. charter had been written by American Communists and that the U.N. was an instrument for depriving Americans of their Constitutional rights.  Although only a few of these letters came from the John Birch Society, it turned out later that most of the letters were part of a meticulously planned Birch campaign.  Xerox officers and directors were not intimidated.  The U.N. series appeared in 1965 and was widely praised.

Furthermore, Xerox consistently committed itself to informing the users of its copiers of their legal responsibilities.  It took this stand despite their commercial interest.

Brooks visited Xerox in order to talk with some of its people.  First he spoke with Dr. Dessauer, a German-born engineer who had been in charge of the company’s research and engineering since 1938.  It was Dessauer who first brought Carlson’s invention to the attention of Joseph Wilson.  Brooks noticed a greeting card from fellow employees calling Dessauer the “Wizard.”

Dr. Dessauer told Brooks about the old days.  Dessauer said money was the main problem.  Many team members gambled heavily on the xerox project.  Dessauer himself mortgaged his house.  Early on, team members would often say the damn thing would never work.  Even if it did work, the marketing people said there was only a market for a few thousand of the machines.

Next Brooks spoke with Dr. Harold E. Clark, who had been a professor of physics before coming to Haloid in 1949.  Dr. Clark was in charge of the xerography-development program under Dr. Dessauer.  Dr. Clark told Brooks that Chet Carlson’s invention was amazing.  Also, no one else invented something similar at the same time, unlike the many simultaneous discoveries in scientific history.  The only problem, said Dr. Clark, was that it wasn’t a good product.

The main trouble was that Carlson’s photoconductive surface, which was coated with sulphur, lost its qualities after it had made a few copies and became useless.  Acting on a hunch unsupported by scientific theory, the Battelle researchers tried adding to the sulphur a small quantity of selenium, a non-metallic element previously used chiefly in electrical resistors and as a coloring material to redden glass.  The selenium-and-sulphur surface worked a little better than the all-sulphur one, so the Battelle men tried adding a little more selenium.  More improvement.  They gradually kept increasing the percentage until they had a surface consisting entirely of selenium – no sulphur.  That one worked best of all, and thus it was found, backhandedly, that selenium and selenium alone could make xerography practical.

Dr. Clark went on to tell Brooks that they basically patented one of the elements, of which there are not many more than one hundred.  What is more, they still don’t understand how it works.  There are no memory effects – no traces of previous copies are left on the selenium drum.  A selenium-coated drum in the lab can last a million processes, or theoretically an infinite number.  They don’t understand why.  Dr. Clark concluded that they combined “Yankee tinkering and scientific inquiry.”

Brooks spoke with Linowitz, who only had a few minutes because he had just been appointed U.S. Ambassador to the Organization of American States.  Linowitz told him:

…the qualities that made for the company’s success were idealism, tenacity, the courage to take risks, and enthusiasm.

Joseph Wilson told Brooks that his second major had been English literature.  He thought he would be a teacher or work in administration at a university.  Somehow he ended up at Harvard Business School, where he was a top student.  After that, he joined Haloid, the family business, something he’d never planned on doing.

Regarding the company’s support of the U.N., Wilson explained that world cooperation was the company’s business, because without it there would be no world and thus no business.  He went on to explain that elections were not the company’s business.  But university education, civil rights, and employment of African-Americans were their business, to name just a few examples.  So far, at least, Wilson said there hadn’t been a conflict between their civic duties and good business.  But if such a conflict arose, he hoped that the company would honor its civic responsibilities.

 

MAKING THE CUSTOMERS WHOLE

On November 19th, 1963, the Stock Exchange became aware that two of its member firms – J. R. Williston & Beane, Inc., and Ira Haupt & Co. – were in serious financial trouble.  This later became a crisis that was made worse by the assassination of JFK on November 22, 1963.  Brooks:

It was the sudden souring of a speculation that these two firms (along with various brokers not members of the Stock Exchange) had become involved in on behalf of a single customer – the Allied Crude Vegetable Oil & Refining Co., of Bayonne, New Jersey.  The speculation was in contracts to buy vast quantities of cotton-seed oil and soybean oil for future delivery.

Brooks then writes:

On the two previous business days – Friday the fifteenth and Monday the eighteenth – the prices had dropped an average of a little less than a cent and a half per pound, and as a result Haupt had demanded that Allied put up about fifteen million dollars in cash to keep the account seaworthy.  Allied had declined to do this, so Haupt – like any broker when a customer operating on credit has defaulted – was faced with the necessity of selling out the Allied contracts to get back what it could of its advances.  The suicidal extent of the risk that Haupt had undertaken is further indicated by the fact that while the firm’s capital in early November had amounted to only about eight million dollars, it had borrowed enough money to supply a single customer – Allied – with some thirty-seven million dollars to finance the oil speculations.  Worse still, as things turned out it had accepted as collateral for some of these advances enormous amounts of actual cottonseed oil and soybean oil from Allied’s inventory, the presence of which in tanks at Bayonne was attested to by warehouse receipts stating the precise amount and kind of oil on hand.  Haupt had borrowed the money it supplied Allied from various banks, passing along most of the warehouse receipts to the banks as collateral.  All this would have been well and good if it had not developed later that many of the warehouse receipts were forged, that much of the oil they attested to was not, and probably never had been, in Bayonne, and that Allied’s President, Anthony De Angelis (who was later sent to jail on a whole parcel of charges), had apparently pulled off the biggest commercial fraud since that of Ivar Kreuger, the match king.

What began to emerge as the main issue was that Haupt had about twenty thousand individual stock-market customers, who had never heard of Allied or commodity trading.  Williston & Beane had nine thousand individual customers.  All these accounts were frozen when the two firms were suspended by the Stock Exchange.  (Fortunately, the customers of Williston & Beane were made whole fairly rapidly.)

The Stock Exchange met with its member firms.  They decided to make the customers of Haupt whole.  G. Keith Funston, President of the Stock Exchange, urged the member firms to take over the matter.  The firms replied that the Stock Exchange should do it.  Funston replied, “If we do, you’ll have to repay us the amount we pay out.”  So it was agreed that the payment would come out of the Exchange’s treasury, to be repaid later by the member firms.

Funston next led the negotiations with Haupt’s creditor banks.  Their unanimous support was essential.  Chief among the creditors were four local banks – Chase Manhattan, Morgan Guaranty Trust, First National City, and Manufacturers Hanover Trust.  Funston proposed that the Exchange would put up the money to make the Haupt customers whole – about seven and a half million dollars.  In return, for every dollar the Exchange put up, the banks would agree to defer collection on two dollars.  So the banks would defer collection on about fifteen million.

The banks agreed to this on the condition that the Exchange’s claim to get back any of its contribution would come after the banks’ claims for their loans.  Funston and his associates at the Exchange agreed to that.  After more negotiating, there was a broad agreement on the general plan.

Early on Saturday, the Exchange’s board met and learned from Funston what was proposed.  Almost immediately, several governors rose to state that it was a matter of principle.  And so the board agreed with the plan.  Later, Funston and his associates decided to put the Exchange’s chief examiner in charge of the liquidation of Haupt in order to ensure that its twenty thousand individual customers were made whole as soon as the Exchange had put up the cash.  (The amount of cash would be at least seven and a half million, but possibly as high as twelve million.)

Fortunately, the American banks eventually all agreed to the final plan put forth by the Exchange.  Brooks notes that the banks were “marvels of cooperation.”  But agreement was still needed from the British banks.  Initially, Funston was going to make the trip to England, but he couldn’t be spared.

Several other governors quickly volunteered to go, and one of them, Gustave L. Levy, was eventually selected, on the ground that his firm, Goldman, Sachs & Co., had had a long and close association with Kleinwort, Benson, one of the British banks, and that Levy himself was on excellent terms with some of the Kleinwort, Benson partners.

The British banks were very unhappy.  But since their loans to Allied were unsecured, they didn’t have any room to negotiate.  Still, they asked for time to think the matter over.  This gave Levy an opportunity to meet with this Kleinwort, Benson friends.  Brooks:

The circumstances of the reunion were obviously less than happy, but Levy says that his friends took a realistic view of their situation and, with heroic objectivity, actually helped their fellow-Britons to see the American side of the question.

The market was closed Monday for JFK’s funeral.  Funston was still waiting for the call from Levy.  After finally getting agreement from all the British banks, Levy placed the call to Funston.

Funston felt at this point that the final agreement had been wrapped up, since all he needed was the signatures of the fifteen Haupt general partners.  The meeting with the Haupt partners ended up taking far longer than expected.  Brooks:

One startling event broke the even tenor of this gloomy meeting… someone noticed an unfamiliar and strikingly youthful face in the crowd and asked its owner to identify himself.  The unhesitating reply was, ‘I’m Russell Watson, a reporter for the Wall Street Journal.’  There was a short, stunned silence, in recognition of the fact that an untimely leak might still disturb the delicate balance of money and emotion that made up the agreement.  Watson himself, who was twenty-four and had been on the Journal for a year, has since explained how he got into the meeting, and under what circumstances he left it.  ‘I was new on the Stock Exchange beat then,’ he said afterward.  ‘Earlier in the day, there had been word that Funston would probably hold a press conference sometime that evening, so I went over to the Exchange.  At the main entrance, I asked a guard where Mr. Funston’s conference was.  The guard said it was on the sixth floor, and ushered me into an elevator.  I suppose he thought I was a banker, a Haupt partner, or a lawyer.  On the sixth floor, people were milling around everywhere.  I just walked off the elevator and into the office where the meeting was – nobody stopped me.  I didn’t understand much of what was going on.  I got the feeling that whatever was at stake, there was general agreement but still a lot of haggling over details to be done.  I didn’t recognize anybody there but Funston.  I stood around quietly for about five minutes before anybody noticed me, and then everybody said, pretty much at once, “Good God, get out of here!”  They didn’t exactly kick me out, but I saw it was time to go.’

At fifteen minutes past midnight, finally all the parties signed an agreement.

As soon as the banks opened on Tuesday, the Exchange deposited seven and a half million dollars in an account on which the Haupt liquidator – James P. Mahony – could draw.  The stock market had its greatest one-day rise in history.  A week later, by December 2, $1,750,000 had been paid out to Haupt customers.  By December 12, it was $5,400,000.  And by Christmas, it was $6,700,000.  By March 11, the pay-out had reached nine and a half million dollars and all the Haupt customers had been made whole.

  • Note:  $9.5 million in 1963 would be approximately $76 million dollars today (in 2018), due to inflation.

Brooks describes the reaction:

In Washington, President Johnson interrupted his first business day in office to telephone Funston and congratulate him.  The chairman of the S.E.C., William L. Cary, who was not ordinarily given to throwing bouquets at the Stock Exchange, said in December that it had furnished ‘a dramatic, impressive demonstration of its strength and concern for the public interest.’

Brooks later records:

Oddly, almost no one seems to have expressed gratitude to the British and American banks, which recouped something like half of their losses.  It may be that people simply don’t thank banks, except in television commercials.

 

THE IMPACTED PHILOSOPHERS

Brooks opens this chapter by observing that communication is one of the biggest problems in American industry.  (Remember he was writing in the 1960’s).  Brooks:

This preoccupation with the difficulty of getting a thought out of one head and into another is something the industrialists share with a substantial number of intellectuals and creative writers, more and more of whom seemed inclined to regard communication, or the lack of it, as one of the greatest problems not just of industry, but of humanity.

Brooks then adds:

What has puzzled me is how and why, when foundations sponsor one study of communication after another, individuals and organizations fail so consistently to express themselves understandably, or how and why their listeners fail to grasp what they hear.

A few years ago, I acquired a two-volume publication of the United States Government Printing Office entitled Hearings Before the Subcommittee on Antitrust and Monopoly of the Committee on the Judiciary, United States Senate, Eighty-Seventh Congress, First Session, Pursuant to S. Res. 52, and after a fairly diligent perusal of its 1,459 pages I thought I could begin to see what the industrialists are talking about.

The hearings were conducted in April, May, and June of 1961 under the chairmanship of Senator Estes Kefauver of Tennessee.  They concerned price-fixing and bid-rigging in conspiracies in the electrical-manufacturing industry.  Brooks:

…Senator Kefauver felt that the whole matter needed a good airing.  The transcript shows that it got one, and what the airing revealed – at least within the biggest company involved – was a breakdown in intramural communication so drastic as to make the building of the tower of Babel seem a triumph of organizational rapport.

Brooks explains a bit later:

The violations, the government alleged, were committed in connection with the sale of large and expensive pieces of apparatus of a variety that is required chiefly by public and private electric-utility companies (power transformers, switchgear assemblies, and turbine-generator units, among many others), and were the outcome of a series of meetings attended by executives of the supposedly competing companies – beginning at least as early as 1956 and continuing into 1959 – at which noncompetitive price levels were agreed upon, nominally sealed bids on individual contracts were rigged in advance, and each company was allocated a certain percentage of the available business.

Brooks explains that in an average year at the time of the conspiracies, about $1.75 billion – $14 billion in 2019 dollars – was spent on the sorts of machines in question, with nearly a quarter of that local, state, and federal government spending.  Brooks gives a specific example, a 500,000-kilowatt turbine-generator, which sold for about $16 million (nearly $130 million in 2019 dollars), but was often discounted by 25 percent.  If the companies wanted to, they could effectively charge $4 million extra (nearly $32 million extra in 2019 dollars).  Any such additional costs as a result of price-fixing would, in the case of government purchases, ultimately fall on the taxpayer.

Brooks again:

To top it all off, there was a prevalent suspicion of hypocrisy in the very highest places.  Neither the chairman of the board nor the president of General Electric, the largest of the corporate defendants, had been caught on the government’s dragnet, and the same was true of Westinghouse Electric, the second-largest;  these four ultimate bosses let it be known that they had been entirely ignorant of what had been going on within their commands right up to the time the first testimony on the subject was given to the Justice Department.  Many people, however, were not satisfied by these disclaimers, and, instead, took the position that the defendant executives were men in the middle, who had broken the law only in response either to actual orders or to a corporate climate favoring price-fixing, and who were now being allowed to suffer for the sins of their superiors.  Among the unsatisfied was Judge Ganey himself, who said at the time of the sentencing, ‘One would be most naive indeed to believe that these violations of the law, so long persisted in, affecting so large a segment of the industry, and, finally, involving so many millions upon millions of dollars, were facts unknown to those responsible for the conduct of the corporation… I am convinced that in the great number of these defendants’ cases, they were torn between conscience and approved corporate policy, with the rewarding objectives of promotion, comfortable security, and large salaries.’

General Electric got most of the attention.  It was, after all, by far the largest of those companies involved.  General Electric penalized employees who admitted participation in the conspiracy.  Some saw this as good behavior, while others thought it was G.E. trying to save higher-ups by making a few sacrifices.

G.E. maintained that top executives didn’t know.  Judge Ganey thought otherwise.  But Brooks realized it couldn’t be determined:

…For, as the testimony shows, the clear waters of moral responsibility at G.E. became hopelessly muddied by a struggle to communicate – a struggle so confused that in some cases, it would appear, if one of the big bosses at G.E. had ordered a subordinate to break the law, the message would somehow have been garbled in its reception, and if the subordinate had informed the boss that he was holding conspiratorial meetings with competitors, the boss might well have been under the impression that the subordinate was gossiping idly about lawn parties or pinochle lessons.

G.E., for at least eight years, has had a rule, Directive Policy 20.5, which explicitly forbids price-fixing, bid-rigging, and similar anticompetitive practices.  The company regularly reissued 20.5 to new executives and asked them to sign their names to it.

The problem was that many, including those who signed, didn’t take 20.5 seriously.  They thought it was just a legal device.  They believed that meeting illegally with competitors was the accepted and standard practice.  They concluded that if a superior told them to comply with 20.5, he was actually ordering him to violate it.  Brooks:

Illogical as it might seem, this last assumption becomes comprehensible in light of the fact that, for a time, when some executives orally conveyed, or reconveyed, the order, they were apparently in the habit of accompanying it with an unmistakable wink.

Brooks gives an example of just such a meeting of sales managers in May 1948.  Robert Paxton, an upper-level G.E. executive who later became the company’s president, addressed the group and gave the usual warnings about antitrust violations.  William S. Ginn, a salesman under Paxton, interjected, “We didn’t see you wink.”  Paxton replied, “There was no wink.  We mean it, and these are the orders.”

Senator Kefauver asked Paxton how long he had known about such winks.  Paxton said that in 1935, he saw his boss do it following an order.  Paxton recounts that he became incensed.  Since then, he had earned a reputation as an antiwink man.

In any case, Paxton’s seemingly unambiguous order in 1948 failed to get through to Ginn, who promptly began pricing-fixing with competitors.  When asked about it thirteen years later, Ginn – having recently gotten out of jail and having lost his $135,000 a year job at G.E. – said he had gotten a contrary order from two other superiors, Henry V. B. Erben and Francis Fairman.  Brooks:

Erben and Fairman, Ginn said, had been more articulate, persuasive, and forceful in issuing their order than Paxton had been in issuing his;  Fairman, especially, Ginn stressed, had proved to be ‘a great communicator, a great philosopher, and, frankly, a great believer in stability of prices.’  Both Erben and Fairman had dismissed Paxton as naive, Ginn testified, and, in further summary of how he had been led astray, he said that ‘the people who were advocating the Devil were able to sell me better than the philosophers that were selling me the Lord.’

Unfortunately, Erben and Fairman had passed away before the hearing.  So we don’t have their testimonies.  Ginn consistently described Paxton as a philosopher-salesman on the side of the Lord.

In November, 1954, Ginn was made general manager of the transformer division.  Ralph J. Cordiner, chairman of the board at G.E. since 1949, called Ginn down to New York to order him to comply strictly with Directive 20.5.  Brooks:

Cordiner communicated this idea so successfully that it was clear enough to Ginn at the moment, but it remained so only as long as it took him, after leaving the chairman, to walk to Erben’s office.

Erben, Ginn’s direct superior, countermanded Cordiner’s order.

Erben’s extraordinary communicative prowess carried the day, and Ginn continued to meet with competitors.

At the end of 1954, Paxton took over Erben’s job and was thus Ginn’s direct superior.  Ginn kept meeting with competitors, but he didn’t tell Paxton about it, knowing his opposition to the practice.

In January 1957, Ginn became general manager of G.E.’s turbine-generator division.  Cordiner called him down again to instruct him to follow 20.5.  This time, however, Ginn got the message.  Why?  “Because my air cover was gone,” Ginn explained to the Subcommittee.  Brooks:

If Erben, who had not been Ginn’s boss since late in 1954, had been the source of his air cover, Ginn must have been without its protection for over two years, but, presumably, in the excitement of the price war he had failed to notice its absence.

In any case, Ginn apparently had reformed.  Ginn circulated copies of 20.5 among all his division managers.  He then instructed them not to even socialize with competitors.

It appears that Ginn had not been able to impart much of his shining new philosophy to others, and that at the root of his difficulty lay that old jinx, the problem of communicating.

Brooks quotes Ginn:

‘I have got to admit that I made a communication error.  I didn’t sell this thing to the boys well enough… The price is so important in the complete running of a business that, philosophically, we have got to sell people not only just the fact that it is against the law, but… that it shouldn’t be done for many, many reasons.  But it has got to be a philosophical approach and a communication approach…’

Frank E. Stehlik was general manager of the low-voltage-switchgear department from May, 1956 to February, 1960.  Stehlik not only heard 20.5 directly from his superiors in oral and written communications.  But, in addition, Stehlik was open to a more visceral type of communication he called “impacts.”  Brooks explains:

Apparently, when something happened within the company that made an impression on him, he would consult an internal sort of metaphysical voltmeter to ascertain the force of the jolt he had received, and, from the reading he got, would attempt to gauge the true drift of company policy.

In 1956, 1957, and for most of 1958, Stehlik believed that company policy clearly required compliance with 20.5.  But in the fall of 1958, Stehlik’s immediate superior, George E. Burens, told him that Paxton had told him (Burens) to have lunch with a competitor.  Paxton later testified that he categorically told Burens not to discuss prices.  But Stehlik got a different impression.

In Stehlik’s mind, this fact made an “impact.”  He felt that company policy was now in favor of disobeying 20.5.  So, late in 1958, when Burens told him to begin having price meetings with a competitor, he was not at all surprised.  Stehlik complied.

Brooks next describes the communication problem from the point of view of superiors.  Raymond W. Smith was general manager of G.E.’s transformer division, while Arthur F. Vinson was vice-president in charge G.E.’s apparatus group.  Vinson ended up becoming Smith’s immediate boss.

Smith testified that Cordiner gave him the usual order on 20.5.  But late in 1957, price competition for transformers was so intense that Smith decided on his own to start meeting with competitors to see if prices could be stabilized.  Smith thought company policy and industry practice both supported his actions.

When Vinson became Smith’s boss, Smith felt he should let him know what he was doing.  So on several occasions, Smith told Vinson, “I had a meeting with the clan this morning.”

Vinson, in his testimony, said he didn’t even recall Smith use the phrase, “meeting of the clan.”  Vinson only recalled that Smith would say things like, “Well, I am going to take this new plan on transformers and show it to the boys.”  Vinson testified that he thought Smith meant the G.E. district salespeople and the company’s customers.  Vinson claimed to be shocked when he learned that Smith was referring to price-fixing meetings with competitors.

But Smith was sure that his communication had gotten through to Vinson.  “I never got the impression that he misunderstood me,” Smith testified.

Senator Kefauver asked Vinson if he was so naive as to not know to whom “the boys” referred.  Vinson replied, “I don’t think it is too naive.   We have a lot of boys… I may be naive, but I am certainly telling the truth, and in this kind of thing I am sure I am naive.”

Kefauver pressed Vinson, asking how he could have become vice-president at $200,000 a year if he were naive.  Vinson:  “I think I could well get there by being naive in this area.  It might help.”

Brooks asks:

Was Vinson really saying to Kefauver what he seemed to be saying – that naivete about antitrust violations might be a help to a man in getting and holding a $200,000-a-year job at General Electric?  It seems unlikely.  And yet what else could he have meant?

Vinson was also implicated in another part of the case.  Four switchgear executives – Burens, Stehlik, Clarence E. Burke, and H. Frank Hentschel – testified before the grand jury (and later before the Subcommittee) that in mid-1958, Vinson had lunch with them in Dining Room B of G.E.’s switchgear works in Philadelphia, and that Vinson told them to hold price meetings with competitors.

This led the four switchgear executives to hold a series of meetings with competitors.  But Vinson told prosecutors that the lunch never took place and that he had had no knowledge at all of the conspiracy until the case broke.  Regarding the lunch, Burens, Stehlik, Burke, and Hentschel all had lie-detector tests, given by the F.B.I., and passed them.

Brooks writes:

Vinson refused to take a lie-detector test, at first explaining that he was acting on advice of counsel and against his personal inclination, and later, after hearing how the four other men had fared, arguing that if the machine had not pronounced them liars, it couldn’t be any good.

It was shown that there were only eight days in mid-1958 when Burens, Stehlik, Burke, and Hentschel all had been together at the Philadelphia plant and could have had lunch together.  Vinson produced expense accounts showing that he had been elsewhere on each of those eight days.  So the Justice Department dropped the case against Vinson.

The upper level of G.E. “came through unscathed.”  Chairman Cordiner and President Paxton did seem to be clearly against price-fixing, and unaware of all the price-fixing that had been occurring.  Paxton, during his testimony, said that he learned from his boss, Gerard Swope, that the ultimate goal of business was to produce more goods for people at lower cost.  Paxton claimed to be deeply impacted by this philosophy, explaining why he was always strongly against price-fixing.

Brooks concludes:

Philosophy seems to have reached a high point at G.E., and communication a low one.  If executives could just learn to understand one another, most of the witnesses said or implied, the problem of antitrust violations would be solved.  But perhaps the problem is cultural as well as technical, and has something to do with a loss of personal identity that comes with working in a huge organization.  The cartoonist Jules Feiffer, contemplating the communication problem in a nonindustrial context, has said, ‘Actually, the breakdown is between the person and himself.  If you’re not able to communicate successfully between yourself and yourself, how are you supposed to make it with the strangers outside?’  Suppose, purely as a hypothesis, that the owner of a company who orders his subordinates to obey the antitrust laws has such poor communication with himself that he does not really know whether he wants the order to be complied with or not.  If his order is disobeyed, the resulting price-fixing may benefit his company’s coffers;  if it is obeyed, then he has done the right thing.  In the first instance, he is not personally implicated in any wrongdoing, while in the second he is positively involved in right doing.  What, after all, can he lose?  It is perhaps reasonable to suppose that such an executive will communicate his uncertainty more forcefully than his order.

 

THE LAST GREAT CORNER

Piggly Wiggly Stores – a chain of retail self-service markets mostly in the South and West, and headquartered in Memphis – was first listed on the New York Stock Exchange in June, 1922.  Clarence Saunders was the head of Piggly Wiggly.  Brooks describes Saunders:

…a plump, neat, handsome man of forty-one who was already something of a legend in his home town, chiefly because of a house he was putting up there for himself.  Called the Pink Palace, it was an enormous structure faced with pink Georgia marble and built around an awe-inspiring white-marble Roman atrium, and, according to Saunders, it would stand for a thousand years.  Unfinished though it was, the Pink Palace was like nothing Memphis had ever seen before.  Its grounds were to include a private golf course, since Saunders liked to do his golfing in seclusion.

Brooks continues:

The game of Corner – for in its heyday it was a game, a high-stakes gambling game, pure and simple, embodying a good many of the characteristics of poker – was one phase of the endless Wall Street contest between bulls, who want the price of a stock to go up, and bears, who want it to go down.  When a game of Corner was underway, the bulls’ basic method of operation was, of course, to buy stock, and the bears’ was to sell it.

Since most bears didn’t own the stock, they would have to conduct a short sale.  This means they borrow stock from a broker and sell it.  But they must buy the stock back later in order to return it to the broker.  If they buy the stock back at a lower price, then the difference between where they initially sold the stock short, and where they later buy it back, represents their profit.  If, however, they buy the stock back at a higher price, then they suffer a loss.

There are two related risks that the short seller (the bear) faces.  First, the short seller initially borrows the stock from the broker in order to sell it.  If the broker is forced to demand the stock back from the short seller – either because the “floating supply” needs to be replenished, or because the short seller has insufficient equity (due to the stock price moving to high) – then the short seller can be forced to take a loss.  Second, technically there is no limit to how much the short seller can lose because there is no limit to how high a stock can go.

The danger of potentially unlimited losses for a short seller can be exacerbated in a Corner.  That’s because the bulls in a Corner can buy up so much of the stock that there is very little supply of it left.  As the stock price skyrockets and the supply of stock shrinks, the short seller can be forced to buy the stock back – most likely from the bulls – at an extremely high price.  This is precisely what the bulls are trying to accomplish in a Corner.

On the other hand, if the bulls end up owning most of the publicly available stock, and if the bears can ride out the Corner, then to whom can the bulls sell their stock?  If there are virtually no buyers, then the bulls have no chance of selling most of their holding.  In this case, the bulls can get stuck with a mountain of stock they can’t sell.  The achievable value of this mountain can even approach zero in some extreme cases.

Brooks explains that true Corners could not happen after the new securities legislation in the 1930’s.  Thus, Saunders was the last intentional player of the game.

Saunders was born to a poor family in Amherst County, Virginia, in 1881.  He started out working for practically nothing for a local grocer.  He then worked for a wholesale grocer in Clarksville, Tennessee, and then for another one in Memphis.  Next, he organized a retail food chain, which he sold.  Then he was a wholesale grocer before launching the retail self-service food chain he named Piggly Wiggly Stores.

By the fall of 1922, there were over 1,200 Piggly Wiggly Stores.  650 of these were owned outright by Saunders’ Piggly Wiggly Stores, Inc.  The rest were owned independently, but still paid royalties to the parent company.  For the first time, customers were allowed to go down any aisle and pick out whatever they wanted to buy.  Then they paid on their way out of the store.  Saunders didn’t know it, but he had invented the supermarket.

In November, 1922, several small companies operating Piggly Wiggly Stores in New York, New Jersey, and Connecticut went bankrupt.  These were independently owned, having nothing to do with Piggly Wiggly Stores, Inc.  Nonetheless, several stock-market operators saw what they believed was a golden opportunity for a bear raid.  Brooks:

If individual Piggly Wiggly stores were failing, they reasoned, then rumors could be spread that would lead the uninformed public to believe that the parent firm was failing, too.  To further this belief, they began briskly selling Piggly Wiggly short, in order to force the price down.  The stock yielded readily to their pressure, and within a few weeks its price, which earlier in the year had hovered around fifty dollars a share, dropped to below forty.

Saunders promptly announced to the press that he was going to “beat the Wall Street professionals at their own game” through a buying campaign.  At that point, Saunders had no experience at all with owning stock, Piggly Wiggly being the only stock he had ever owned.  Moreover, there is no reason to think Saunders was going for a Corner at this juncture.  He merely wanted to support his stock on behalf of himself and other stockholders.

Saunders borrowed $10 million dollars – about $140 million in 2019 dollars – from bankers in Memphis, Nashville, New Orleans, Chattanooga, and St. Louis.  Brooks:

Legend has it that he stuffed his ten million-plus, in bills of large denomination, into a suitcase, boarded a train for New York, and, his pockets bulging with currency that wouldn’t fit in the suitcase, marched on Wall Street, ready to do battle.

Saunders later denied this, saying he conducted his campaign from Memphis.  Brooks continues:

Wherever he was at the time, he did round up a corp of some twenty brokers, among them Jesse L. Livermore, who served as his chief of staff.  Livermore, one of the most celebrated American speculators of this century, was then forty-five years old but was still occasionally, and derisively, referred to by the nickname he had earned a couple of decades earlier – the Boy Plunger of Wall Street.  Since Saunders regarded Wall Streeters in general and speculators in particular as parasitic scoundrels intent only on battering down his stock, it seemed likely that his decision to make an ally of Livermore was a reluctant one, arrived at simply with the idea of getting the enemy chieftain into his own camp.

Within a week, Saunders had bought 105,000 shares – more than half of the 200,000 shares outstanding.  By January 1923, the stock hit $60 a share, its highest level ever.  Reports came from Chicago that the stock was cornered.  The bears couldn’t find any available supply in order to cover their short positions by buying the stock back.  The New York Stock Exchange immediately denied the rumor, saying ample amounts of Piggly Wiggly stock were still available.

Saunders then made a surprising but exceedingly crafty move.  The stock was pushing $70, but Saunders ran advertisements offering to sell it for $55.  Brooks explains:

One of the great hazards in Corner was always that even though a player might defeat his opponents, he would discover that he had won a Pyrrhic victory.  Once the short sellers had been squeezed dry, that is, the cornerer might find that the reams of stock he had accumulated in the process were a dead weight around his neck;  by pushing it all back into the market in one shove, he would drive its price down close to zero.  And if, like Saunders, he had had to borrow heavily to get into the game in the first place, his creditors could be expected to close in on him and perhaps not only divest him of his gains but drive him into bankruptcy.  Saunders apparently anticipated this hazard almost as soon as a corner was in sight, and accordingly made plans to unload some of his stock before winning instead of afterward.  His problem was to keep the stock he sold from going right back into the floating supply, thus breaking his corner;  and his solution was to sell his fifty-five-dollar shares on the installment plan.

Crucially, the buyers on the installment plan wouldn’t receive the certificates of ownership until they had paid their final installment.  This meant they couldn’t sell their shares back into the floating supply until they had finished making all their installment payments.

By Monday, March 19, Saunders owned nearly all of the 200,000 shares of Piggly Wiggly stock.  Livermore had already bowed out of the affair on March 12 because he was concerned about Saunders’ financial position.  Nonetheless, Saunders asked Livermore to spring the bear trap.  Livermore wouldn’t do it.  So Saunders himself had to do it.

On Tuesday, March 20, Saunders called for delivery all of his Piggly Wiggly stock.  By the rules of the Exchange, stock so called for had to be delivered by 2:15 the following afternoon.  There were a few shares around owned in small amounts by private investors.  Short sellers were frantically trying to find these folks.  But on the whole, there were basically no shares available outside of what Saunders himself owned.

This meant that Piggly Wiggly shares had become very illiquid – there were hardly any shares trading.  A nightmare, it seemed, for short sellers.  Some short sellers bought at $90, some at $100, some at $110.  Eventually the stock reached $124.  But then a rumor reached the floor that the governors of the Exchange were considering a suspension of trading in Piggly Wiggly, as well as an extension of the deadline for short sellers.  Piggly Wiggly stock fell to $82.

The Governing Committee of the Exchange did, in fact, made such an announcement.  They claimed that they didn’t want to see a repeat of the Northern Pacific panic.  However, many wondered whether the Exchange was just helping the short sellers, among whom were some members of the Exchange.

Saunders still hadn’t grasped the fundamental problem he now faced.  He still seemed to have several million in profits.  But only if he could actually sell his shares.

Next, the Stock Exchange announced a permanent suspension of trading in Piggly Wiggly stock and a full five day extension for short sellers to return their borrowed shares.  Short sellers had until 2:15 the following Monday.

Meanwhile, Piggly Wiggly Stores, Inc., released its annual financial statement, which revealed that sales, profits, and assets had all sharply increased from the previous year.  But everyone ignored the real value of the company.  All that mattered at this point was the game.

The extension allowed short sellers the time to find shareholders in a variety of locations around the country.  These shareholders were of course happy to dig out their stock certificates and sell them for $100 a share.  In this way, the short sellers were able to completely cover their short positions by Friday evening.  And instead of paying Saunders cash for some of his shares, the short sellers gave him more shares to settle their debt, which is the last thing Saunders wanted just then.  (A few short sellers had to pay Saunders directly.)

The upshot was that all the short sellers were in the clear, whereas Saunders was stuck owning nearly every single share of Piggly Wiggly stock.  Saunders, who had already started complaining loudly, repeated his charge that Wall Street had changed its own rule in order to let “a bunch of welchers” off the hook.

In response, the Stock Exchange issued a statement explaining its actions:

‘The enforcement simultaneously of all contracts for the return of stock would have forced the stock to any price that might be fixed by Mr. Saunders, and competitive bidding for the insufficient supply might have brought about conditions illustrated by other corners, notably the Northern Pacific corner in 1901.’

Furthermore, the Stock Exchange pointed out that its own rules allowed it to suspend trading in a stock, as well as to extend the deadline for the return of borrowed shares.

It is true that the Exchange had the right to suspend trading in a stock.  But it is unclear, to say the least, about whether the Exchange had any right to postpone the deadline for the delivery of borrowed shares.  In fact, two years after Saunders’ corner, in June, 1925, the Exchange felt bound to amend its constitution with an article stating that “whenever in the opinion of the Governing Committee a corner has been created in a security listed on the Exchange… the Governing Committee may postpone the time for deliveries on Exchange contracts therein.”

 

A SECOND SORT OF LIFE

According to Brooks, other than FDR himself, perhaps no one typified the New Deal better than David Eli Lilienthal.  On a personal level, Wall Streeters found Lilienthal a reasonable fellow.  But through his association with Tennessee Valley Authority from 1933 to 1946, Lilienthal “wore horns.”  T.V.A. was a government-owned electric-power concern that was far larger than any private power corporation.  As such, T.V.A. was widely viewed on Wall Street as the embodiment of “galloping Socialism.”

In 1946, Lilienthal became the first chairman of the United States Atomic Energy Commission, which he held until February, 1950.

Brooks was curious what Lilienthal had been up to since 1950, so he did some investigating.  He found that Lilienthal was co-founder and chairman of Development & Resources Corporation.  D. & R. helps governments set up programs similar to the T.V.A.  Brooks also found that as of June, 1960, Lilienthal was a director and major shareholder of Minerals & Chemicals Corporation of America.

Lastly, Brooks discovered Lilienthal had published his third book in 1953, “Big Business: A New Era.”  In the book, he argues that:

  • the productive superiority of the United States depends on big business;
  • we have adequate safeguards against abuses by big business;
  • big businesses tend to promote small businesses, not destroy them;
  • and big business promotes individualism, rather than harms it, by reducing poverty, disease, and physical insecurity.

Lilienthal later agreed with his family that he hadn’t spent enough time on the book, although its main points were correct.  Also, he stressed that he had conceived of the book before he ever decided to transition from government to business.

In 1957, Lilienthal and his wife Helen Lamb Lilienthal had settled in a house in Princeton.  It was a few years later, at this house, that Brooks went to interview Lilienthal.  Brooks was curious to hear about how Lilienthal thought about his civic career as compared to his business career.

Lilienthal had started out as a lawyer in Chicago and he done quite well.  But he didn’t want to practice the law.  Then – in 1950 – his public career over, he was offered various professorship positions at Harvard.  He didn’t want to be a professor.  Then various law firms and businesses approached Lilienthal.  He still had no interest in practicing law.  He also rejected the business offers he received.

In May, 1950, Lilienthal took a job as a part-time consultant for Lazard Freres & Co., whose senior partner, Andre Meyer, he had met through Albert Lasker, a mutual friend.  Through Lazard Freres and Meyer, Lilienthal became a consultant and then an executive of a small company, the Minerals Separation North American Corporation.  Lazard Freres had a large interest in the concern.

The company was in trouble, and Meyer thought Lilienthal was the man to solve the case.  Through a series of mergers, acquisitions, etc., the firm went through several name changes ending, in 1960, with the name, Minerals & Chemicals Philipp Corporation.  Meanwhile, annual sales for the company went from $750,000 in 1952 to more than $274,000,000 in 1960.  (In 2019 dollars, this would be a move from $6,750,000 to $2,466,000,000.)  Brooks writes:

For Lilienthal, the acceptance of Meyer’s commission to look into the company’s affairs was the beginning of a four-year immersion in the day-to-day problems of managing a business;  the experience, he said decisively, turned out to be one of his life’s richest, and by no means only in the literal sense of that word.

Minerals Separation North American, founded in 1916 as an offshoot from a British company, was a patent firm.  It held patents on processes used to refine copper ore and other nonferrous minerals.  In 1952, Lilienthal became the president of the company.  In order to gain another source of revenue, Lilienthal arranged a merger between Minerals Separation and Attapulgus Clay Company, a producer of a rare clay used in purifying petroleum products and also a manufacturer of various household products.

The merger took place in December, 1952, thanks in part to Lilienthal’s work to gain agreement from the Attapulgus people.  The profits and stock price of the new company went up from there.  Lilienthal managed some of the day-to-day business.  And he helped with new mergers.  One in 1954, with Edgar Brothers, a leading producer of kaolin for paper coating.  Two more in 1955, with limestone firms in Ohio and Virginia.  Brooks notes that the company’s net profits quintupled between 1952 and 1955.

Lilienthal received stock options along the way.  Because the stock went up a great deal, he exercised his options and by August, 1955, Lilienthal had 40,000 shares.  Soon the stock hit $40 and was paying a $0.50 annual dividend.  Lilienthal’s financial worries were over.

Brooks asked Lilienthal how all of this felt.  Lilienthal:

‘I wanted an entrepreneurial experience.  I found a great appeal in the idea of taking a small and quite crippled company and trying to make something of it.  Building.  That kind of building, I thought, is the central thing in American free enterprise, and something I’d missed in all my government work.  I wanted to try my hand at it.  Now, about how it felt.  Well, it felt plenty exciting.  It was full of intellectual stimulation, and a lot of my old ideas changed.  I conceived a great new respect for financiers – men like Andre Meyer.  There’s a correctness about them, a certain high sense of honor, that I’d never had any conception of.  I found that business life is full of creative, original minds – along with the usual number of second-guessers, of course.  Furthermore, I found it seductive.  In fact, I was in danger of becoming a slave… I found that the things you read – for instance, that acquiring money for its own sake can become an addiction if you’re not careful – are literally true.  Certain good friends helped keep me on track… Oh, I had my problems.  I questioned myself at every step.  It was exhausting.’

A friend of Lilienthal’s told Brooks that Lilienthal had a marvelous ability to immerse himself totally in the work.  The work may not always be important.  But Lilienthal becomes so immersed, it’s as if the work becomes important simply because he’s doing it.

On the matter of money, Lilienthal said it doesn’t make much difference as long as you have enough.  Money was something he never really thought about.

Next Brooks describes Lilienthal’s experience at Development & Resources Corporation.  The situation became ideal for Lilienthal because it combined helping the world directly with the possibility of also earning a profit.

In the spring of 1955, Lilienthal and Meyer had several conversations.  Lilienthal told Meyer that he knew dozens of foreign dignitaries and technical personnel who had visited T.V.A. and shown strong interest.  Many of them told Lilienthal that at least some of their own countries would be interested in starting similar programs.

The idea for D. & R. was to accomplish very specific projects and, incidentally, to make a profit.  Meyer liked the idea – although he expected no profit – so they went forward, with Lazard Freres owning half the firm.  The executive appointments for D.& R. included important alumni from T.V.A., people with deep experience and knowledge in management, engineering, dams, electric power, and related areas.

In September, 1955, Lilienthal was at a World Bank meeting in Istanbul and he ended up speaking with Abolhassan Ebtehaj, head of a 7-year development plan in Iran.  Iran had considerable capital with which to pay for development projects, thanks to royalties from its nationalized oil industry.  Moreover, what Iran badly needed was technical and professional guidance.  Lilienthal and a colleague later visited Iran as guests of the Shah to see what could be done about Khuzistan.

Lilienthal didn’t know anything about the region at first.  But he learned that Khuzistan was in the middle of the Old Testament Elamite kingdom and later of the Persian Empire.  The ruins of Persepolis are close by.  The ruins of Susa, where King Darius had a winter palace, are at the center of Khuzistan.  Brooks quotes Lilienthal (in the 1960’s):

Nowadays, Khuzistan is one of the world’s richest oil fields  – the famous Abadan refinery is at its southern tip – but the inhabitants, two and a half million of them, haven’t benefited from that.  The rivers have flowed unused, the fabulously rich soil has lain fallow, and all but a tiny fraction of the people have continued to live in desperate poverty.

D. & R. signed a 5-year agreement with the Iranian government.  Once the project got going, there were 700 people working on it – 100 Americans, 300 Iranians, and 300 others (mostly Europeans).  In addition, 4,700 Iranian-laborers were on the various sites.  The entire project called for 14 dams on 5 different rivers.  After D. & R. completed its first 5-year contract, they signed a year-and-a-half extension including an option for an additional 5 years.

Brooks records:

While the Iranian project was proceeding, D. & R. was also busy lining up and carrying out its programs for Italy, Colombia, Ghana, the Ivory Coast, and Puerto Rico, as well as programs for private business groups in Chile and the Philippines.  A job that D. & R. had just taken on from the United States Army Corps of Engineers excited Lilienthal enormously – an investigation of the economic impact of power from a proposed dam on the Alaskan sector of the Yukon, which he described as ‘the river with the greatest hydroelectric potential remaining on this continent.’  Meanwhile, Lazard Freres maintained its financial interest in the firm and now very happily collected its share of a substantial annual profit, and Lilienthal happily took to teasing Meyer about his former skepticism as to D. & R. financial prospects.

Lilienthal wrote in his journal about the extreme poverty in Ahwaz, Khuzistan:

…visiting villages and going into mud ‘homes’ quite unbelievable – and unforgettable forever and ever.  As the Biblical oath has it:  Let my right hand wither if I ever forget how some of the most attractive of my fellow human beings live – are living tonight, only a few kilometres from here, where we visited them this afternoon…

And yet I am as sure as I am writing these notes that the Ghebli area, of only 45,000 acres, swallowed in the vastness of Khuzistan, will become as well known as, say, the community of Tupelo… became, or New Harmony or Salt Lake City when it was founded by a handful of dedicated men in a pass of the great Rockies.

 

STOCKHOLDER SEASON

The owners of public businesses in the United States are the stockholders.  But many stockholders don’t pay much attention to company affairs when things are going well.  Also, many stockholders own small numbers of shares, making it not seem worthwhile to exercise their rights as owners of the corporations.  Furthermore, many stockholders don’t understand or follow business, notes Brooks.

Brooks decided to attend several annual meetings in the spring of 1966.

What particularly commended the 1966 season to me was that it promised to be a particularly lively one.  Various reports of a new “hard-line approach” by company managements to stockholders had appeared in the press.  (I was charmed by the notion of a candidate for office announcing his new hard-line approach to voters right before an election.)

Brooks first attended the A. T. & T. annual meeting in Detroit.  Chairman Kappel came on stage, followed by eighteen directors who sat behind him, and he called the meeting to order.  Brooks:

From my reading and from annual meetings that I’d attended in past years, I knew that the meetings of the biggest companies are usually marked by the presence of so-called professional stockholders… and that the most celebrated members of this breed were Mrs. Wilma Soss, of New York, who heads an organization of women stockholders and votes the proxies of its members as well as her own shares, and Lewis D. Gilbert, also of New York, who represents his own holdings and those of his family – a considerable total.

Brooks learned that, apart from prepared comments by management, many big-company meetings are actually a dialogue between the chairman and a few professional stockholders.  So professional stockholders can come to represent, in a way, many other shareholders who might otherwise not be represented, whether because they own few shares, don’t follow business, or other reasons.

Brooks notes that occasionally some professional stockholders get boorish, silly, on insulting.  But not Mrs. Soss or Mr. Gilbert:

Mrs. Soss, a former public-relations woman who has been a tireless professional stockholder since 1947, is usually a good many cuts above this level.  True, she is not beyond playing to the gallery by wearing bizarre costumes to meetings;  she tries, with occasional success, to taunt recalcitrant chairmen into throwing her out;  she is often scolding and occasionally abusive;  and nobody could accuse her of being unduly concise.  I confess that her customary tone and manner set my teeth on edge, but I can’t help recognizing that, because she does her homework, she usually has a point.  Mr. Gilbert, who has been at it since 1933 and is the dean of them all, almost invariably has a point, and by comparison with his colleagues he is the soul of brevity and punctilio as well as of dedication and diligence.

At the A. T. & T. meeting, after the management-sponsored slate of directors had been duly nominated, Mrs. Soss got up to make a nomination of her own, Dr. Frances Arkin, a psychoanalyst.  Mrs. Soss said A. T. & T. ought to have a woman on its board and, moreover, she thought some of the company’s executives would have benefited from periodic psychiatric examinations.  (Brooks comments that things were put back into balance at another annual meeting when the chairman suggested that some of the firm’s stockholders should see a psychiatrist.)  The nomination of Dr. Arkin was seconded by Mr. Gilbert, but only after Mrs. Soss nudged him forcefully in the ribs.

A professional stockholder named Evelyn Y. Davis complained about the meeting not being in New York, as it usually is.  Brooks observed that Davis was the youngest and perhaps the best-looking, but “not the best-informed or the most temperate, serious-minded, or worldly-wise.”  Davis’ complaint was met with boos from the largely local crowd in Detroit.

After a couple of hours, Mr. Kappel was getting testy.  Soon thereafter, Mrs. Soss was complaining that while the business affiliations of the nominees for director were listed in the pamphlet handed out at the meeting, this information hadn’t been included in the material mailed to stockholders, contrary to custom.  Mrs. Soss wanted to know why.  Mrs. Soss adopted a scolding tone and Mr. Kappel an icy one, says Brooks.  “I can’t hear you,” Mrs. Soss said at one point.  “Well, if you’d just listen instead of talking…”, Mr. Kappel replied.  Then Mrs. Soss said something (Brooks couldn’t hear it precisely) that successfully baited the chairman, who got upset and had the microphone in front of Mrs. Soss turned off.  Mrs. Soss marched towards the platform and was directly facing Mr. Kappel.  Mr. Kappel said he wasn’t going to throw her out of the meeting as she wanted.  Mrs. Soss later returned to her seat and a measure of calm was restored.

Later, Brooks attended the annual meeting of Chas. Pfizer & Co., which was run by the chairman, John E. McKeen.  After the company announced record highs on all of its operational metrics, and predicted more of the same going forward, “the most intransigent professional stockholder would have been hard put to it to mount much of a rebellion at this particular meeting,” observes Brooks.

John Gilbert, brother of Lewis Gilbert, may have been the only professional stockholder present.  (Lewis Gilbert and Mrs. Davis were at the U.S. Steel meeting in Cleveland that day.)

John Gilbert is the sort of professional stockholder the Pfizer management deserves, or would like to think it does.  With an easygoing manner and a habit of punctuating his words with self-deprecating little laughs, he is the most ingratiating gadly imaginable (or was on this occasion; I’m told he isn’t always), and as he ran through what seemed to be the standard Gilbert-family repertoire of questions – on the reliability of the firms’s auditors, the salaries of its officers, the fees of its directors – he seemed almost apologetic that duty called on him to commit the indelicacy of asking such things.

The annual meeting of Communications Satellite Corporation had elements of farce, recounts Brooks.  (Brooks refers to Comsat as a “glamorous space-age communications company.”)  Mrs. Davis, Mrs. Soss, and Lewis Gilbert were in attendance.  The chairman of Comsat, who ran the meeting, was James McCormack, a West Point graduate, former Rhodes Scholar, and retired Air Force General.

Mrs. Soss made a speech which was inaudible because her microphone wasn’t working.  Next, Mrs. Davis rose to complain that there was a special door to the meeting for “distinguished guests.”  Mrs. Davis viewed this as undemocratic.  Mr. McCormack responded, “We apologize, and when you go out, please go by any door you want.”  But Mrs. Davis went on speaking.  Brooks:

And now the mood of farce was heightened when it became clear that the Soss-Gilbert faction had decided to abandon all efforts to keep ranks closed with Mrs. Davis.  Near the height of her oration, Mr. Gilbert, looking as outraged as a boy whose ball game is being spoiled by a player who doesn’t know the rules or care about the game, got up and began shouting, ‘Point of order!  Point of order!’  But Mr. McCormack spurned this offer of parliamentary help;  he ruled Mr. Gilbert’s point of order out of order, and bade Mrs. Davis proceed.  I had no trouble deducing why he did this.  There were unmistakable signs that he, unlike any other corporate chairman I had seen in action, was enjoying every minute of the goings on.  Through most of the meeting, and especially when the professional stockholders had the floor, Mr. McCormack wore the dreamy smile of a wholly bemused spectator.

Mrs. Davis’ speech increased in volume and content, and she started making specific accusations against individual Comsat directors.  Three security guards appeared on the scene and marched to a location near Mrs. Davis, who then suddenly ended her speech and sat down.

Brooks comments:

Once, when Mr. Gilbert said something that Mrs. Davis didn’t like and Mrs. Davis, without waiting to be recognized, began shouting her objection across the room, Mr. McCormack gave a short irrepressible giggle.  That single falsetto syllable, magnificently amplified by the chairman’s microphone, was the motif of the Comsat meeting.

 

ONE FREE BITE

Brooks writes about Donald W. Wohlgemuth, a scientist for B. F. Goodrich Company in Akron, Ohio.

…he was the manager of Goodrich’s department of space-suit engineering, and over the past years, in the process of working his way up to that position, he had had a considerable part in the designing and construction of the suits worn by our Mercury astronauts on their orbital and suborbital flights.

Some time later, the International Latex Corporation, one of Goodrich’s three main competitors in the space-suit field, contacted Wohlgemuth.

…Latex had recently been awarded a subcontract, amounting to some three-quarters of a million dollars, to do research and development on space suits for the Apollo, or man-on-the-moon, project.  As a matter of fact, Latex had won this contract in competition with Goodrich, among others, and was thus for the moment the hottest company in the space-suit field.

Moreover, Wohlgemuth was not particularly happy at Goodrich for a number of reasons.  His salary was below average.  His request for air-conditioning had been turned down.

Latex was located in Dover, Delaware.  Wohlgemuth went there to meet with company representatives.  He was given a tour of the company’s space-suit-development facilities.  Overall, he was given “a real red-carpet treatment,” as he later desribed.  Eventually he was offered the position of manager of engineering for the Industrial Products Division, which included space-suit development, at an annual salary of $13,700 (over $109,000 in 2019 dollars) – solidly above his current salary.  Wohlgemuth accepted the offer.

The next morning, Wohlgemuth informed his boss at Goodrich, Carl Effler, who was not happy.  The morning after that, Wohlgemuth told Wayne Galloway – with whom he had worked closely – of his decision.

Galloway replied that in making the move Wohlgemuth would be taking to Latex certain things that did not belong to him – specifically, knowledge of the processes that Goodrich used in making space suits.

Galloway got upset with Wohlgemuth.  Later Effler called Wohlgemuth to his office and told him he should leave the Goodrich offices as soon as possible.  Then Galloway called him and told him the legal department wanted to see him.

While he was not bound to Goodrich by the kind of contract, common in American industry, in which an employee agrees not to do similar work for any competing company for a stated period of time, he had, on his return from the Army, signed a routine paper agreeing ‘to keep confidential all information, records, and documents of the company of which I may have knowledge because of my employment’ – something Wohlgemuth had entirely forgotten until the Goodrich lawyer reminded him.  Even if he had not made that agreement, the lawyer told him now, he would be prevented from going to work on space suits for Latex by established principles of trade-secrets law.  Moreover, if he persisted in his plan, Goodrich might sue him.

To make matters worse, Effler told Wohlgemuth that if he stayed at Goodrich, this incident could not be forgotten and might well impact his future.  Wohlgemuth then informed Latex that he would be unable to accept their offer.

That evening, Wohlgemuth’s dentist put him in touch with a lawyer.  Wohlgemuth talked with the lawyer, who consulted another lawyer.  They told Wohlgemuth that Goodrich was probably bluffing and wouldn’t sue him if he went to work for Latex.

The next morning – Thursday – officials of Latex called him back to assure him that their firm would bear his legal expenses in the event of a lawsuit, and, furthermore, would indemnify him against any salary losses.

Wohlgemuth decided to work for Latex, after all, and left the offices of Goodrich late that day, taking with him no documents.

The next day, R. G. Jeter, general counsel of Goodrich, called Emerson P. Barrett, director of industrial relations for Latex.  Jeter outlined Goodrich’s concern for its trade secrets.  Barrett replied that Latex was not interested in Goodrich trade secrets, but was only interested in Wohlgemuth’s “general professional abilities.”

That evening, at a farewell dinner given by forty or so friends, Wohlgemuth was called outside.  The deputy sheriff of Summit County handed him two papers.

One was a summons to appear in the Court of Common Pleas on a date a week or so off.  The other was a copy of a petition that had been filed in the same court that day by Goodrich, praying that Wohlgemuth be permanently enjoined from, among other things, disclosing to any unauthorized person any trade secrets belonging to Goodrich, and ‘performing any work for any corporation… other than plaintiff, relating to the design, manufacture and/or sale of high-altitude pressure suits, space suits and/or similar protective garments.’

For a variety of reasons, says Brooks, the trial attracted much attention.

On one side was the danger that discoveries made in the course of corporate research might become unprotectable – a situation that would eventually lead to the drying up of private research funds.  On the other side was the danger that thousands of scientists might, through their very ability and ingenuity, find themselves permanently locked in a deplorable, and possibly unconstitutional, kind of intellectual servitude – they would be barred from changing jobs because they knew too much.

Judge Frank H. Harvey presided over the trial, which took place in Akron from November 26 to December 12.  The seriousness with which Goodrich took this case is illustrated by the fact that Jeter himself, who hadn’t tried a case in 10 years, headed Goodrich’s legal team.  The chief defense counsel was Richard A. Chenoweth, of Buckingham, Doolittle & Burroughs – an Akron law firm retained by Latex.

From the outset, the two sides recognized that if Goodrich was to prevail, it had to prove, first, that it possessed trade secrets;  second, that Wohlgemuth also possessed them, and that a substantial peril of disclosure existed;  and, third, that it would suffer irreparable injury if injunctive relief was not granted.

Goodrich attorneys tried to establish that Goodrich had a good number of space-suit secrets.  Wohlgemuth, upon cross-examination from his counsel, sought to show that none of these processes were secrets at all.  Both companies brought their space suits into the courtroom.  Goodrich wanted to show what it had achieved through research.  The Latex space suit was meant to show that Latex was already far ahead of Goodrich in space-suit development, and so wouldn’t have any interest in Goodrich secrets.

On the second point, that Wohlgemuth possessed Goodrich secrets, there wasn’t much debate.  But Wohlgemuth’s lawyers did argue that he had taken no papers with him and that he was unlikely to remember the details of complex scientific processes, even if he wanted to.

On the third point, seeking injunctive relief to prevent irreparable injury, Jeter argued that Goodrich was the clear pioneer in space suits.  It made the first full-pressure flying suit in 1934.  Since then, it has invested huge amounts in space suit research and development.  Jeter characterized Latex as a newcomer intent on profiting from Goodrich’s years of research by hiring Wohlgemuth.

Furthermore, even if Wohlgemuth and Latex had the best of intentions, Wohlgemuth would inevitably give away trade secrets.  But good intentions hadn’t been demonstrated, since Latex deliberately sought Wohlgemuth, who in turn justified his decision in part on the increase in salary.  The defense disagreed that trade secrets would be revealed or that anyone had bad intentions.  The defense also got a statement in court from Wohlgemuth in which he pledged not to reveal any trade secrets of B. F. Goodrich Company.

Judge Harvey reserved the decision for a later date.  Meanwhile, the lawyers for each side fought one another in briefs intended to sway Judge Harvey.  Brooks:

…it became increasingly clear that the essence of the case was quite simple.  For all practical purposes, there was no controversy over facts.  What remained in controversy was the answer to two questions:  First, should a man be formally restrained from revealing trade secrets when he has not yet committed any such act, and when it is not clear that he intends to?  And, secondly, should a man be prevented from taking a job simply because the job presents him with unique temptations to break the law?

The defense referred to “Trade Secrets,” written by Ridsdale Ellis and published in 1953, which stated that usually it is not until there is evidence that the employee has not lived up to the contract, written or implied, that the former employer can take action.  “Every dog has one free bite.”

On February 20, 1963, Judge Harvey delivered his decision in a 9-page essay.  Goodrich did have trade secrets.  And Wohlgemuth could give these secrets to Latex.  Furthermore, there’s no doubt Latex was seeking to get Wohlgemuth for his specialized knowledge in space suits, which would be valuable for the Apollo contract.  There’s no doubt, wrote the judge, that Wohlgemuth would be able to disclose confidential information.

However, the judge said, in keeping with the one-free-bite principle, an injunction against disclosure of trade secrets cannot be issued before such disclosure has occurred unless there is clear and substantial evidence of evil intent on the part of the defendant.  In the view of the court, Wohlgemuth did not have evil intent in this case, therefore the injunction was denied.

On appeal, Judge Arthur W. Doyle partially reversed the decision.  Judge Doyle granted an injunction against Wohlgemuth from disclosing to Latex any trade secrets of Goodrich.  On the other hand, Wohlgemuth had the right to take a job in a competitive industry, and he could use his knowledge and experience – other than trade secrets – for the benefit of his employer.  Wohlgemuth was therefore free to work on space suits for Latex, provided he didn’t reveal any trade secrets of Goodrich.

 

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.

Kahneman and Tversky

(Image:  Zen Buddha Silence by Marilyn Barbone.)

July 28, 2019

If we’re more aware of cognitive biases today than a decade or two ago, that’s thanks in large part to the research of the Israeli psychologists Daniel Kahneman and Amos Tversky.  I’ve written about cognitive biases before, including:

I’ve seen few books that do a good job covering the work of Kahneman and Tversky.  The Undoing Project: A Friendship That Changed Our Minds, by Michael Lewis, is one such book.  (Lewis also writes well about the personal stories of Kahneman and Tversky.)

Why are cognitive biases important?  Economists, decision theorists, and others used to assume that people are rational.  Sure, people make mistakes.  But many scientists believed that mistakes are random: if some people happen to make mistakes in one direction—estimates that are too high—other people will (on average) make mistakes in the other direction—estimates that are too low.  Since the mistakes are random, they cancel out, and so the aggregate results in a given market will nevertheless be rational.  Markets are efficient.

For some markets, this is still true.  Francis Galton, the English Victorian-era polymath, wrote about a contest in which 787 people guessed at the weight of a large ox.  Most participants in the contest were not experts by any means, but ordinary people.  The ox actually weighed 1,198 pounds.  The average guess of the 787 guessers was 1,197 pounds, which was more accurate than the guesses made by the smartest and the most expert guessers.   The errors are completely random, and so they cancel out.

This type of experiment can easily be repeated.  For example, take a jar filled with pennies, where only you know how many pennies are in the jar.  Pass the jar around in a group of people and ask each person—independently (with no discussion)—to write down their guess of how many pennies are in the jar.  In a group that is large enough, you will nearly always discover that the average guess is better than any individual guess.  (That’s been the result when I’ve performed this experiment in classes I’ve taught.)

However, in other areas, people do not make random errors, but systematic errors.  This is what Kahneman and Tversky proved using carefully constructed experiments that have been repeated countless times.  In certain situations, many people will tend to make mistakes in the same direction—these mistakes do not cancel out.  This means that the aggregate results in a given market can sometimes be much less than fully rational.  Markets can be inefficient.

Outline (based on chapters from Lewis’s book):

  • Introduction
  • Man Boobs
  • The Outsider
  • The Insider
  • Errors
  • The Collision
  • The Mind’s Rules
  • The Rules of Prediction
  • Going Viral
  • Birth of the Warrior Psychologist
  • The Isolation Effect
  • This Cloud of Possibility

(Illustration by Alain Lacroix)

 

INTRODUCTION

In his 2003 book, Moneyball, Lewis writes about the Oakland Athletic’s efforts to find betters methods for valuing players and evaluating strategies.  By using statistical techniques, the team was able to perform better than many others teams even though the A’s had less money.  Lewis says:

A lot of people saw in Oakland’s approach to building a baseball team a more general lesson: If the highly paid, publicly scrutinized employees of a business that had existed since the 1860s could be misunderstood by their market, what couldn’t be?  If the market for baseball players was inefficient, what market couldn’t be?  If a fresh analytical approach had led to the discovery of new knowledge in baseball, was there any sphere of human activity in which it might not do the same?

After the publication of Moneyball, people started applying statistical techniques to other areas, such as education, movies, golf, farming, book publishing, presidential campaigns, and government.  However, Lewis hadn’t asked the question of what it was about the human mind that led experts to be wrong so often.  Why were simple statistical techniques so often better than experts?

The answer had to do with the structure of the human mind.  Lewis:

Where do the biases come from?  Why do people have them?  I’d set out to tell a story about the way markets worked, or failed to work, especially when they were valuing people.  But buried somewhere inside it was another story, one that I’d left unexplored and untold, about the way the human mind worked, or failed to work, when it was forming judgments and making decisions.  When faced with uncertainty—about investments or people or anything else—how did it arrive at its conclusions?  How did it process evidence—from a baseball game, an earnings report, a trial, a medical examination, or a speed date?  What were people’s minds doing—even the minds of supposed experts—that led them to the misjudgments that could be exploited for profit by others, who ignored the experts and relied on data?

 

MAN BOOBS

Daryl Morey, the general manager of the Houston Rockets, used statistical methods to make decisions, especially when it came to picking players for the team.  Lewis:

His job was to replace one form of decision making, which relied upon the intuition of basketball experts,  with another, which relied mainly on the analysis of data.  He had no serious basketball-playing experience and no interest in passing himself off as a jock or basketball insider.  He’d always been just the way he was, a person who was happier counting than feeling his way through life.  As a kid he’d cultivated an interest in using data to make predictions until it became a ruling obsession.

Lewis continues:

If he could predict the future performance of professional athletes, he could build winning sports teams… well, that’s where Daryl Morey’s mind came to rest.  All he wanted to do in life was build winning sports teams.

Morey found it difficult to get a job for a professional sports franchise.  He concluded that he’d have to get rich so that he could buy a team and run it.  Morey got an MBA, and then got a job consulting.  One important lesson Morey picked up was that part of a consultant’s job was to pretend to be totally certain about uncertain things.

There were a great many interesting questions in the world to which the only honest answer was, ‘It’s impossible to know for sure.’… That didn’t mean you gave up trying to find an answer; you just couched that answer in probabilistic terms.

Leslie Alexander, the owner of the Houston Rockets, had gotten disillusioned with the gut instincts of the team’s basketball experts.  That’s what led him to hire Morey.

Morey built a statistical model for predicting the future performance of basketball players.

A model allowed you to explore the attributes in an amateur basketball player that led to professional success, and determine how much weight should be given to each.

The central idea was that the model would usually give you a “better” answer than relying only on expert intuition.  That said, the model had to be monitored closely because sometimes it wouldn’t have important information.  For instance, a player might have had a serious injury right before the NBA draft.

(Illustration by fotomek)

Statistical and algorithmic approaches to decision making are more widespread now.  But back in 2006 when Morey got started, such an approach was not at all obvious.

In 2008, when the Rocket’s had the 33rd pick, Morey’s model led him to select Joey Dorsey.  Dorsey ended up not doing well at all.  Meanwhile, Morey’s model had passed over DeAndre Jordan, who ended up being chosen 35th by the Los Angeles Clippers.  DeAndre Jordan ended up being the second best player in the entire draft, after Russell Westbrook.  What had gone wrong?  Lewis comments:

This sort of thing happened every year to some NBA team, and usually to all of them.  Every year there were great players the scouts missed, and every year highly regarded players went bust.  Morey didn’t think his model was perfect, but he also couldn’t believe that it could be so drastically wrong.

Morey went back to the data and ended up improving his model.  For example, the improved model assigned greater weight to games played against strong opponents than against weak ones.  Lewis adds:

In the end, he decided that the Rockets needed to reduce to data, and subject to analysis, a lot of stuff that had never before been seriously analyzed: physical traits.  They needed to know not just how high a player jumped but how quickly he left the earth—how fast his muscles took him into the air.  They needed to measure not just the speed of the player but the quickness of his first two steps.

At the same time, Morey realized he had to listen to his basketball experts.  Morey focused on developing a process that relied both on the model and on human experts.  It was a matter of learning the strengths and weaknesses of the model, as well as the strengths and weaknesses of human experts.

But it wasn’t easy.  By letting human intuition play a role, that opened the door to more human mistakes.  In 2007, Morey’s model highly valued the player Marc Gasol.  But the scouts had seen a photo of Gasol without a shirt.  Gasol was pudgy with jiggly pecs.  The Rockets staff nicknamed Gasol “Man Boobs.”  Morey allowed this ridicule of Gasol’s body to cause him to ignore his statistical model.  The Rockets didn’t select Gasol.  The Los Angeles Lakers picked him 48th.  Gasol went on to be a two-time NBA All-Star.  From that point forward, Morey banned nicknames because they could interfere with good decision making.

Over time, Morey developed a list of biases that could distort human judgment: confirmation bias, the endowment effect, present bias, hindsight bias, et cetera.

 

THE OUTSIDER

Although Danny Kahneman had frequently delivered a semester of lectures from his head, without any notes, he nonetheless always doubted his own memory.  This tendency to doubt his own mind may have been central to his scientific discoveries in psychology.

But there was one experience he had while a kid that he clearly remembered.  In Paris, about a year after the Germans occupied the city, new laws required Jews to wear the Star of David.  Danny didn’t like this, so he wore his sweater inside out.  One evening while going home, he saw a German soldier with a black SS uniform.  The soldier had noticed Danny and picked him up and hugged him.  The soldier spoke in German, with great emotion.  Then he put Danny down, showed him a picture of a boy, and gave him some money.  Danny remarks:

I went home more certain than ever that my mother was right: people were endlessly complicated and interesting.

Another thing Danny remembers is when his father came home after being in  a concentration camp.  Danny and his mother had gone shopping, and his father was there when they returned.  Despite the fact that he was extremely thin—only ninety-nine pounds—Danny’s father had waited for them to arrive home before eating anything.  This impressed Danny.  A few years later, his father got sick and died.  Danny was angry.

Over time, Danny grew even more fascinated by people—why they thought and behaved as they did.

When Danny was thirteen years old, he moved with his mother and sister to Jerusalem.  Although it was dangerous—a bullet went through Danny’s bedroom—it seemed better because they felt they were fighting rather than being hunted.

On May 14, 1948, Israel declared itself a sovereign state.  The British soldiers immediately left.  The armies from Jordan, Syria, and Egypt—along with soldiers from Iraq and Lebanon—attacked.  The war of independence took ten months.

Because he was identified as intellectually gifted, Danny was permitted to go to university at age seventeen to study psychology.  Most of his professors were European refugees, people with interesting stories.

Danny wasn’t interested in Freud or in behaviorism.  He wanted objectivity.

The school of psychological thought that most charmed him was Gestalt psychology.  Led by German Jews—its origins were in the early twentieth century Berlin—it sought to explore, scientifically, the mysteries of the human mind.  The Gestalt psychologists had made careers uncovering interesting phenomena and demonstrating them with great flair: a light appeared brighter when it appeared from total darkness; the color gray looked green when it was surrounded by violet and yellow if surrounded by blue; if you said to a person, “Don’t step on the banana eel!,” he’d be sure that you had said not “eel” but “peel.”  The Gestalists showed that there was no obvious relationship between any external stimulus and the sensation it created in people, as the mind intervened in many curious ways.

(Two faces or a vase?  Illustration by Peter Hermes Furian)

Lewis continues:

The central question posed by Gestalt psychologists was the question behaviorists had elected to ignore: How does the brain create meaning?  How does it turn the fragments collected by the senses into a coherent picture of reality?  Why does the picture so often seem to be imposed by the mind upon the world around it, rather than by the world upon the mind?  How does a person turn the shards of memory into a coherent life story?  Why does a person’s understanding of what he sees change with the context in which he sees it?

In his second year at Hebrew Univeristy, Danny heard a fascinating talk by a German neurosurgeon.  This led Danny to abandon psychology in order to pursue a medical degree.   He wanted to study the brain.  But one of his professors convinced him it was only worth getting a medical degree if he wanted to be a doctor.

After getting a degree in psychology, Danny had to serve in the Israeli military.  The army assigned him to the psychology unit, since he wasn’t really cut out for combat.  The head of the unit at that time was a chemist.  Danny was the first psychologist to join.

Danny was put in charge of evaluating conscripts and assigning them to various roles in the army.  Those applying to become officers had to perform a task: to move themselves over a wall without touching it using only a log that could not touch the wall or the ground.  Danny and his coworkers thought that they could see “each man’s true nature.”  However, when Danny checked how the various soldiers later performed, he learned that his unit’s evaluations—with associated predictions—were worthless.

Danny compared his unit’s delusions to the Müller-Lyer optical illusion.  Are these two lines the same length?

(Müller-Lyer optical illusion by Gwestheimer, Wikimedia Commons)

The eye automatically sees one line as longer than the other even though the lines have equal length.  Even after you use a ruler to show the lines are equal, the illusion persists.  If we’re automatically fooled in such a simple case, what about in more complex cases?

Danny thought up a list of traits that seemed correlated with fitness for combat.  However, Danny was concerned about how to get an accurate measure of these traits from an interview.  One problem was the halo effect: If people see that a person is strong, they tend to see him as impressive in other ways.  Or if people see a person as good in certain areas, then they tend to assume that he must be good in other areas.  More on the halo effect: http://boolefund.com/youre-deluding-yourself/

Danny developed special instructions for the interviewers.  They had to ask specific questions not about how subjects thought of themselves, but rather about how they actually had behaved in the past.  Using this information, before moving to the next question, the interviewers would rate the subject from 1 to 5.  Danny’s essential process is still used in Israel today.

 

THE INSIDER

To his fellow Israelis, Amos Tversky somehow was, at once, the most extraordinary person they had ever met and the quintessential Israeli.  His parents were among the pioneers who had fled Russian anti-Semitism in the early 1920s to build a Zionist nation.  His mother, Genia Tversky, was a social force and political operator who became a member of the first Israeli Parliament, and the next four after that.  She sacrificed her private life for public service and didn’t agonize greatly about the choice…

Amos was raised by his father, a veterinarian who hated religion and loved Russian literature, and who was amused by things people say:

…His father had turned away from an early career in medicine, Amos explained to friends, because “he thought animals had more real pain than people and complained a lot less.”  Yosef Tversky was a serious man.  At the same time, when he talked about his life and work, he brought his son to his knees with laughter about his experiences, and about the mysteries of existence.

Although Amos had a gift for math and science—he may have been more gifted than any other boy—he chose to study the humanities because he was fascinated by a teacher, Baruch Kurzweil.  Amos loved Kurzweil’s classes in Hebrew literature and philosophy.  Amos told others he was going to be a poet or literary critic.

Amos was small but athletic.  During his final year in high school, he volunteered to become an elite soldier, a paratrooper.  Amos made over fifty jumps.  Soon he was made a platoon commander.

By late 1956, Amos was not merely a platoon commander but a recipient of one of the Israeli army’s highest awards for bravery.  During a training exercise in front of the General Staff of the Israeli Defense Forces, one of his soldiers was assigned to clear a barbed wire fence with a bangalore torpedo.  From the moment he pulled the string to activate the fuse, the soldier had twenty seconds to run for cover.  The soldier pushed the torpedo under the fence, yanked the string, fainted, and collapsed on top of the explosive.  Amos’s commanding officer shouted for everyone to stay put—to leave the unconscious soldier to die.  Amos ignored him and sprinted from behind the wall that served as cover for his unit, grabbed the soldier, picked him up, hauled him ten yards, tossed him on the ground, and threw himself on top of him.  The shrapnel from the explosion remained in Amos for the rest of his life.  The Israeli army did not bestow honors for bravery lightly.  As he handed Amos his award, Moshe Dayan, who had watched the entire episode, said, “You did a very stupid and brave thing and you won’t get away with it again.”

Amos was a great storyteller and also a true genius.  Lewis writes about one time when Tel Aviv University threw a party for a physicist who had just won the Wolf Prize.  Most of the leading physicists came to the party.  But the prizewinner, by chance, ended up in a corner talking with Amos.  (Amos had recently gotten interested in black holes.)  The following day, the prizewinner called his hosts to find out the name of the “physicist” with whom he had been talking.  They realized he had been talking with Amos, and told him that Amos was a psychologist rather than a physicist.  The physicist replied:

“It’s not possible, he was the smartest of all the physicists.”

Most people who knew Amos thought that Amos was the smartest person they’d ever met.  Moreover, he kept strange hours and had other unusual habits.  When he wanted to go for a run, he’d just sprint out his front door and run until he could run no more.  He didn’t pretend to be interested in whatever others expected him to be interested in.  Rather, he excelled at doing exactly what he wanted to do and nothing else.  He loved people, but didn’t like social norms and he would skip family vacation if he didn’t like the place.  Most of his mail he left unopened.

People competed for Amos’s attention.  As Lewis explains, many of Amos’s friends would ask themselves: “I know why I like him, but why does he like me?”

While at Hebrew University, Amos was studying both philosophy and psychology.  But he decided a couple of years later that he would focus on psychology.  He thought that philosophy had too many smart people studying too few problems, and some of the problems couldn’t be solved.

Many wondered how someone as bright, optimistic, logical, and clear-minded as Amos could end up in psychology.  In an interview when he was in his mid-forties, Amos commented:

“It’s hard to know how people select a course in life.  The big choices we make are practically random.  The small choices probably tell us more about who we are.  Which field we go into may depend upon which high school teacher we happen to meet.  Who we marry may depend on who happens to be around at the right time of life.  On the other hand, the small decisions are very systematic.  That I became a psychologist is probably not very revealing.  What kind of psychologist I am may depend upon deep traits.”

Amos became interested in decision making.  While pursuing a PhD at the University of Michigan, Amos ran experiments on people making decisions involving small gambles.  Economists had always assumed that people are rational.  There were axioms of rationality that people were thought to follow, such as transitivity:  if a person prefers A to B and B to C, then he must prefer A to C.  However, Amos found that many people preferred A to B when considering A and B, B to C when considering B and C, and C to A when considering A and C.  Many people violated transitivity.  Amos didn’t generalize his findings at that point, however.

(Transitivity illustration by Thuluviel, Wikimedia Commons)

Next Amos studied how people compare things.  He had read papers by the Berkeley psychologist Eleanor Rosch, who explored how people classified objects.

People said some strange things.  For instance, they said that magenta was similar to red, but that red wasn’t similar to magenta.  Amos spotted the contradiction and set out to generalize it.  He asked people if they thought North Korea was like Red China.  They said yes.  He asked them if Red China was like North Korea—and they said no.  People thought Tel Aviv was like New York but that New York was not like Tel Aviv.  People thought that the number 103 was sort of like the number 100, but that 100 wasn’t like 103.  People thought a toy train was a lot like a real train but that a real train was not like a toy train.

Amos came up with a theory, “features of similarity.”  When people compare two things, they make a list of noticeable features.  The more features two things have in common, the more similar they are.  However, not all objects have the same number of noticeable features.  New York has more than Tel Aviv.

This line of thinking led to some interesting insights:

When people picked coffee over tea, and tea over hot chocolate, and then turned around and picked hot chocolate over coffee—they weren’t comparing two drinks in some holistic manner.  Hot drinks didn’t exist as points on some mental map at fixed distances from some ideal.  They were collections of features.  Those features might become more or less noticeable; their prominence in the mind depended on the context in which they were perceived.  And the choice created its own context: Different features might assume greater prominence in the mind when the coffee was being compared to tea (caffeine) than when it was being compared to hot chocolate (sugar).  And what was true of drinks might also be true of people, and ideas, and emotions.

 

ERRORS

Amos returned to Israel after marrying Barbara Gans, who was a fellow graduate student in psychology at the University of Michigan.  Amos was now an assistant professor at Hebrew University.

Israel felt like a dangerous place because there was a sense that if the Arabs ever united instead of fighting each other, they could overrun Israel.  Israel was unusual in how it treated its professors: as relevant.  Amos gave talks about the latest theories in decision-making to Israeli generals.

Furthermore, everyone who was in Israel was in the army, including professors.  On May 22, 1967, the Egyptian president Gamal Abdel Nasser announced that he was closing the Straits of Tiran to Israeli ships.  Since most Israeli ships passed through the straits, Israel viewed the announcement as an act of war.  Amos was given an infantry unit to command.

By June 7, Israel was in a war on three fronts against Egypt, Jordan, and Syria.  In the span of a week, Israel had won the war and the country was now twice as big.  679 had died.  But because Israel was a small country, virtually everyone knew someone who had died.

Meanwhile, Danny was helping the Israeli Air Force to train fighter pilots.  He noticed that the instructors viewed criticism as more useful than praise.  After a good performance, the instructors would praise the pilot and then the pilot would usually perform worse on the next run.  After a poor performance, the instructors would criticize the pilot and the pilot would usually perform better on the next run.

Danny explained that pilot performance regressed to the mean.  An above average performance would usually be followed by worse performance—closer to the average.  A below average performance would usually be followed by better performance—again closer to the average.  Praise and criticism had little to do with it.

Illustration by intheskies

Danny was brilliant, though insecure and moody.  He became interested in several different areas in psychology.  Lewis adds:

That was another thing colleagues and students noticed about Danny: how quickly he moved on from his enthusiasms, how easily he accepted failure.  It was as if he expected it.  But he wasn’t afraid of it.  He’d try anything.  He thought of himself as someone who enjoyed, more than most, changing his mind.

Danny read about research by Eckhart Hess focused on measuring the dilation and contraction of the pupil in response to various stimuli.  People’s pupils expanded when they saw pictures of good-looking people of the opposite sex.  Their pupils contracted if shown a picture of a shark.  If given a sweet drink, their pupils expanded.  An unpleasant drink caused their pupils to contract.  If you gave people five slightly differently flavored drinks, their pupils would faithfully record the relative degree of pleasure.

People reacted incredibly quickly, before they were entirely conscious of which one they liked best.  “The essential sensitivity of the pupil response,” wrote Hess, “suggests that it can reveal preferences in some cases in which the actual taste differences are so slight that the subject cannot even articulate them.”

Danny tested how the pupil responded to a series of tasks requiring mental effort.  Does intense mental activity hinder perception?  Danny found that mental effort also caused the pupil to dilate.

 

THE COLLISION

Danny invited Amos to come to his seminar, Applications in Psychology, and talk about whatever he wanted.

Amos was now what people referred to, a bit confusingly, as a “mathematical psychologist.”  Nonmathematical psychologists, like Danny, quietly viewed much of mathematical psychology as a series of pointless exercises conducted by people who were using their ability to do math as camouflage for how little of psychological interest they had to say.  Mathematical psychologists, for their part, tended to view nonmathematical psychologists as simply too stupid to understand the importance of what they were saying.  Amos was then at work with a team of mathematically gifted American academics on what would become a three-volume, molasses-dense, axiom-filled textbook called Foundations of Measurement—more than a thousand pages of arguments and proofs of how to measure stuff.

Instead of talking about his own research, Amos talked about a specific study of decision making and how people respond to new information.  In the experiment, the psychologists presented people with two bags full of poker chips.  Each bag contained both red poker chips and white poker chips.  In one bag, 75 percent of the poker chips were white and 25 percent red.  In the other bag, 75 percent red and 25 percent white.  The subject would pick a bag randomly and, without looking in the bag, begin pulling poker chips out one at a time.  After each draw, the subject had to give her best guess about whether the chosen bag contained mostly red or mostly white chips.

There was a correct answer to the question, and it was provided by Bayes’s theorem:

Bayes’s rule allowed you to calculate the true odds, after each new chip was pulled from it, that the book bag in question was the one with majority white, or majority red, chips.  Before any chips had been withdrawn, those odds were 50:50—the bag in your hands was equally likely to be either majority red or majority white.  But how did the odds shift after each new chip was revealed?

That depended, in a big way, on the so-called base rate: the percentage of red versus white chips in the bag… If you know that one bag contains 99 percent red chips and the other, 99 percent white chips, the color of the first chip drawn from the bag tells you a lot more than if you know that each bag contains only 51 percent red or white… In the case of the two bags known to be 75 percent-25 percent majority red or white, the odds that you are holding the bag containing mostly red chips rise by three times every time you draw a red chip, and are divided by three every time you draw a white chip.  If the first chip you draw is red, there is a 3:1 (or 75 percent) chance that the bag you are holding is majority red.  If the second chip you draw is also red, the odds rise to 9:1, or 90 percent.  If the third chip you draw is white, they fall back to 3:1.  And so on.

Were human beings good intuitive statisticians?

(Image by Honina, Wikimedia Commons)

Lewis notes that these experiments were radical and exciting at the time.  Psychologists thought that they could gain insight into a number of real-world problems: investors reacting to an earnings report, political strategists responding to polls, doctors making a diagnosis, patients reacting to a diagnosis, coaches responding to a score, et cetera.  A common example is when a woman is diagnosed with breast cancer from a single test.  If the woman is in her twenties, it’s far more likely to be a misdiagnosis than if the woman is in her forties.  That’s because the base rates are different:  there’s a higher percentage of women in their forties than women in their twenties who have breast cancer.

Amos concluded that people do move in the right direction, however they usually don’t move nearly far enough.  Danny didn’t think people were good intuitive statisticians at all.  Although Danny was the best teacher of statistics at Hebrew University, he knew that he himself was not a good intuitive statistician because he frequently made simple mistakes like not accounting for the base rate.

Danny let Amos know that people are not good intuitive statisticians.  Uncharacteristically, Amos didn’t argue much, except he wasn’t inclined to jettison the assumption of rationality:

Until you could replace a theory with a better theory—a theory that better predicted what actually happened—you didn’t chuck a theory out.  Theories ordered knowledge, and allowed for better prediction.  The best working theory in social science just then was that people were rational—or, at the very least, decent intuitive statisticians.  They were good at interpreting new information, and at judging probabilities.  They of course made mistakes, but their mistakes were a product of emotions, and the emotions were random, and so could be safely ignored.

Note: To say that the mistakes are random means that mistakes in one direction will be cancelled out by mistakes in the other direction.  This implies that the aggregate market can still be rational and efficient.

Amos left Danny’s class feeling doubtful about the assumption of rationality.  By the fall of 1969, Amos and Danny were together nearly all the time.  Many others wondered at how two extremely different personalities could wind up so close.  Lewis:

Danny was a Holocaust kid; Amos was a swaggering Sabra—the slang term for a native Israeli.  Danny was always sure he was wrong.  Amos was always sure he was right.  Amos was the life of every party; Danny didn’t go to parties.  Amos was loose and informal; even when he made a stab at informality, Danny felt as if he had descended from some formal place.  With Amos you always just picked up where you left off, no matter how long it had been since you last saw him.  With Danny there was always a sense you were starting over, even if you had been with him just yesterday.  Amos was tone-deaf but would nevertheless sing Hebrew folk songs with great gusto.  Danny was the sort of person who might be in possession of a lovely singing voice that he would never discover.  Amos was a one-man wrecking ball for illogical arguments; when Danny heard an illogical argument, he asked, What might that be true of?  Danny was a pessimist.  Amos was not merely an optimist; Amos willed himself to be optimistic, because he had decided pessimism was stupid.

Lewis later writes:

But there was another story to be told, about how much Danny and Amos had in common.  Both were grandsons of Eastern European rabbis, for a start.  Both were explicitly interested in how people functioned when there were in a normal “unemotional” state.  Both wanted to do science.  Both wanted to search for simple, powerful truths.  As complicated as Danny might have been, he still longed to do “the psychology of single questions,” and as complicated as Amos’s work might have seemed, his instinct was to cut through endless bullshit to the simple nub of any matter.  Both men were blessed with shockingly fertile minds.

After testing scientists with statistical questions, Amos and Danny found that even most scientists are not good intuitive statisticians.  Amos and Danny wrote a paper about their findings, “A Belief in the Law of Small Numbers.”  Essentially, scientists—including statisticians—tended to assume that any given sample of a large population was more representative of that population than it actually was.

Amos and Danny had suspected that many scientists would make the mistake of relying too much on a small sample.  Why did they suspect this?  Because Danny himself had made the mistake many times.  Soon Amos and Danny realized that everyone was prone to the same mistakes that Danny would make.  In this way, Amos and Danny developed a series of hypotheses to test.

 

THE MIND’S RULES

The Oregon Research Institute is dedicated to studying human behavior.  It was started in 1960 by psychologist Paul Hoffman.  Lewis observes that many of the psychologists who joined the institute shared an interest in Paul Meehl’s book, Clinical vs. Statistical Prediction.  The book showed how algorithms usually perform better than psychologists when trying to diagnose patients or predict their behavior.

In 1986, thirty two years after publishing his book, Meehl argued that algorithms outperform human experts in a wide variety of areas.  That’s what the vast majority of studies had demonstrated by then.  Here’s a more recent meta-analysis: http://boolefund.com/simple-quant-models-beat-experts-in-a-wide-variety-of-areas/

In the 1960s, researchers at the institute wanted to build a model of how experts make decisions.  One study they did was to ask radiologists how they determined if a stomach ulcer was benign or malignant.  Lewis explains:

The Oregon researchers began by creating, as a starting point, a very simple algorithm, in which the likelihood that an ulcer was malignant depended on the seven factors the doctors had mentioned, equally weighted.  The researchers then asked the doctors to judge the probability of cancer in ninety-six different individual stomach ulcers, on a seven-point scale from “definitely malignant” to “definitely benign.”  Without telling the doctors what they were up to, they showed them each ulcer twice, mixing up the duplicates randomly in the pile so the doctors wouldn’t notice they were being asked to diagnose the exact same ulcer they had already diagnosed.

Initially the researchers planned to start with a simple model and then gradually build a more complex model.  But then they got the results of the first round of questions.  It turned out that the simple statistical model often seemed as good or better than experts at diagnosing cancer.  Moreover, the experts didn’t agree with each other and frequently even contradicted themselves when viewing the same image a second time.

Next, the Oregon experimenters explicitly tested a simple algorithm against human experts:  Was a simple algorithm better than human experts?  Yes.

If you wanted to know whether you had cancer or not, you were better off using the algorithm that the researchers had created than you were asking the radiologist to study the X-ray.  The simple algorithm had outperformed not merely the group of doctors; it had outperformed even the single best doctor.

(Algorithm illustration by Blankstock)

The strange thing was that the simple model was built on the factors that the doctors themselves had suggested as important.  While the algorithm was absolutely consistent, it appeared that human experts were rather inconsistent, most likely due to things like boredom, fatigue, illness, or other distractions.

Amos and Danny continued asking people questions where the odds were hard or impossible to know.  Lewis:

…Danny made the mistakes, noticed that he had made the mistakes, and theorized about why he had made the mistakes, and Amos became so engrossed by both Danny’s mistakes and his perceptions of those mistakes that he at least pretended to have been tempted to make the same ones.

Once again, Amos and Danny spent hour after hour after hour together talking, laughing, and developing hypotheses to test.  Occasionally Danny would say that he was out of ideas.  Amos would always laugh at this—he remarked later, “Danny has more ideas in one minute than a hundred people have in a hundred years.”  When they wrote, Amos and Danny would sit right next to each other at the typewriter.  Danny explained:

“We were sharing a mind.”

The second paper Amos and Danny did—as a follow-up on their first paper, “Belief in the Law of Small Numbers”—focused  on how people actually make decisions.  The mind typically doesn’t calculate probabilities.  What does it do?  It uses rules of thumb, or heuristics, said Amos and Danny.  In other words, people develop mental models, and then compare whatever they are judging to their mental models.  Amos and Danny wrote:

“Our thesis is that, in many situations, an event A is judged to be more probable than an event B whenever A appears more representative than B.”

What’s a bit tricky is that often the mind’s rules of thumb lead to correct decisions and judgments.  If that weren’t the case, the mind would not have evolved this ability.  For the same reason, however, when the mind makes mistakes because it relies on rules of thumb, those mistakes are not random, but systematic.

(Image by Argus)

When does the mind’s heuristics lead to serious mistakes?  When the mind is trying to judge something that has a random component.  That was one answer.  What’s interesting is that the mind can be taught the correct rule about how sample size impacts sampling variance; however, the mind rarely follows the correct statistical rule, even when it knows it.

For their third paper, Amos and Danny focused on the availability heuristic.  (The second paper had been about the representativeness heuristic.)  In one question, Amos and Danny asked their subjects to judge whether the letter “k” is more frequently the first letter of a word or the third letter of a word.  Most people thought “k” was more frequently the first letter because they could more easily recall examples where “k” was the first letter.

The more easily people can call some scenario to mind—the more available it is to them—the more probable they find it to be.  An fact or incident that was especially vivid, or recent, or common—or anything that happened to preoccupy a person—was likely to be recalled with special ease and so be disproportionately weighted in any judgment.  Danny and Amos had noticed how oddly, and often unreliably, their own minds recalculated the odds, in light of some recent or memorable experience.  For instance, after they drove past a gruesome car crash on the highway, they slowed down: Their sense of the odds of being in a crash had changed.  After seeing a movie that dramatizes nuclear war, they worried more about nuclear war; indeed, they felt that it was more likely to happen.

Amos and Danny ran similar experiments and found similar results.  The mind’s rules of thumb, although often useful, consistently made the same mistakes in certain situations.  It was similar to how the eye consistently falls for certain optical illusions.

Another rule of thumb Amos and Danny identified was the anchoring and adjustment heuristic.  One famous experiment they did was to ask people to spin a wheel of fortune, which would stop on a number between 0 and 100, and then guess the percentage of African nations in the United Nations.  The people who spun higher numbers tended to guess a higher percentage than those who spun lower numbers, even though the number spun was purely random and was irrelevant to the question.

 

THE RULES OF PREDICTION

For Amos and Danny, a prediction is a judgment under uncertainty.  They observed:

“In making predictions and judgments under uncertainty, people do not appear to follow the calculus of chance or the statistical theory of prediction.  Instead, they rely on a limited number of heuristics which sometimes yield reasonable judgments and sometimes lead to severe and systematic error.”

In 1972, Amos gave talks on the heuristics he and Danny had uncovered.  In the fifth and final talk, Amos spoke about historical judgment, saying:

“In the course of our personal and professional lives, we often run into situations that appear puzzling at first blush.  We cannot see for the life of us why Mr. X acted in a particular way, we cannot understand how the experimental results came out the way they did, etc.  Typically, however, within a very short time we come up with an explanation, a hypothesis, or an interpretation of the facts that renders them understandable, coherent, or natural.  The same phenomenon is observed in perception.  People are very good at detecting patterns and trends even in random data.  In contrast to our skill in inventing scenarios, explanations, and interpretations, our ability to assess their likelihood, or to evaluate them critically, is grossly inadequate.  Once we have adopted a particular hypothesis or interpretation, we grossly exaggerate the likelihood of that hypothesis, and find it very difficult to see things in any other way.”

In one experiment, Amos and Danny asked students to predict various future events that would result from Nixon’s upcoming visit to China and Russia.  What was intriguing was what happened later: If a predicted event had occurred, people overestimated the likelihood they had previously assigned to that event.  Similarly, if a predicted event had not occurred, people tended to claim that they always thought it was unlikely.  This came to be called hindsight bias.

  • A possible event that had occurred was seen in hindsight to be more predictable than it actually was.
  • A possible event that had not occurred was seen in hindsight to be less likely that it actually was.

As Amos said:

All too often, we find ourselves unable to predict what will happen; yet after the fact we explain what did happen with a great deal of confidence.  This “ability” to explain that which we cannot predict, even in the absence of any additional information, represents an important, though subtle, flaw in our reasoning.  It leads us to believe that there is a less uncertain world than there actually is…

Experts from many walks of life—from political pundits to historians—tend to impose an imagined order on random events from the past.  They change their stories to “explain”—and by implication, “predict” (in hindsight)—whatever random set of events occurred.  This is hindsight bias, or “creeping determinism.”

Hindsight bias can create serious problems: If you believe that random events in the past are more predictable than they actually were, you will tend to see the future as more predictable than it actually is.  You will be surprised much more often than you should be.

Image by Zerophoto

 

GOING VIRAL

Part of Don Redelmeier’s job at Sunnybrook Hospital (located in a Toronto suburb) was to check the thinking of specialists for mental mistakes.  In North America, more people died every year as a result of preventable accidents in hospitals than died in car accidents.  Redelmeier focused especially on clinical misjudgment.  Lewis:

Doctors tended to pay attention mainly to what they were asked to pay attention to, and to miss some bigger picture.  They sometimes failed to notice what they were not directly assigned to notice.

[…]

Doctors tended to see only what they were trained to see… A patient received treatment for something that was obviously wrong with him, from a specialist oblivious to the possibility that some less obvious thing might also be wrong with him.  The less obvious thing, on occasion, could kill a person.

When he was only seventeen years old, Redelmeier had read an article by Kahneman and Tversky, “Judgment Under Uncertainty: Heuristics and Biases.”  Lewis writes:

What struck Redelmeier wasn’t the idea that people make mistakes.  Of course people made mistakes!  What was so compelling is that the mistakes were predictable and systematic.  They seemed ingrained in human nature.

One major problem in medicine is that the culture does not like uncertainty.

To acknowledge uncertainty was to admit the possibility of error.  The entire profession had arranged itself as if to confirm the wisdom of its decisions.  Whenever a patient recovered, for instance, the doctor typically attributed the recovery to the treatment he had prescribed, without any solid evidence the treatment was responsible… [As Redelmeier said:]  “So many diseases are self-limiting.  They will cure themselves.  People who are in distress seek care.  When they seek care, physicians feel the need to do something.  You put leeches on; the condition improves.  And that can propel a lifetime of leeches.  A lifetime of overprescribing antibiotics.  A lifetime of giving tonsillectomies to people with ear infections.  You try it and they get better the next day and it is so compelling…”

Photo by airdone

One day, Redelmeier was going to have lunch with Amos Tversky.  Hal Sox, Redelmeier’s superior, told him just to sit quietly and listen, because Tversky was like Einstein, “one for the ages.”  Sox had coauthored a paper Amos had done about medicine.  They explored how doctors and patients thought about gains and losses based upon how the choices were framed.

An example was lung cancer.  You could treat it with surgery or radiation.  Surgery was more likely to extend your life, but there was a 10 percent chance of dying.  If you told people that surgery had a 90 percent chance of success, 82 percent of patients elected to have surgery.  But if you told people that surgery had a 10 percent chance of killing them, only 54 percent chose surgery.  In a life-and-death decision, people made different choices based not on the odds, but on how the odds were framed.

Amos and Redelmeier ended up doing a paper:

[Their paper] showed that, in treating individual patients, the doctors behaved differently than they did when they designed ideal treatments for groups of patients with the same symptoms.  They were likely to order additional tests to avoid raising troubling issues, and less likely to ask if patients wished to donate their organs if they died.  In treating individual patients, doctors often did things they would disapprove of if they were creating a public policy to treat groups of patients with the exact same illness…

The point was not that the doctor was incorrectly or inadequately treating individual patients.  The point was that he could not treat his patient one way, and groups of patients suffering from precisely the same problem in another way, and be doing his best in both cases.  Both could not be right.

Redelmeier pointed out that the facade of rationality and science and logic is “a partial lie.”

In late 1988 or early 1989, Amos introduced Redelmeier to Danny.  One of the recent things Danny had been studying was people’s experience of happiness versus their memories of happiness.  Danny also looked at how people experienced pain versus how they remembered it.

One experiment involved sticking the subject’s arms into a bucket of ice water.

[People’s] memory of pain was different from their experience of it.  They remembered moments of maximum pain, and they remembered, especially, how they felt the moment the pain ended.  But they didn’t particularly remember the length of the painful experience.  If you stuck people’s arms in ice buckets for three minutes but warmed the water just a bit for another minute or so before allowing them to flee the lab, they remembered the experience more fondly than if you stuck their arms in the bucket for three minutes and removed them at a moment of maximum misery.  If you asked them to choose one experience to repeat, they’d take the first session.  That is, people preferred to endure more total pain so long as the experience ended on a more pleasant note.

Redelmeier tested this hypothesis on seven hundred people who underwent a colonoscopy.  The results supported Danny’s finding.

 

BIRTH OF THE WARRIOR PSYCHOLOGIST

In 1973, the armies of Egypt and Syria surprised Israel on Yom Kippur.  Amos and Danny left California for Israeli.  Egyptian President Anwar Sadat had promised to shoot down any commercial airliners entering Israel.  That was because, as usual, Israelis in other parts of the world would return to Israel during a war.  Amos and Danny managed to land in Tel Aviv on an El Al flight.  The plane had descended in total darkness.  Amos and Danny were to join the psychology field unit.

Amos and Danny set out in a jeep and went to the battlefield in order to study how to improve the morale of the troops.  Their fellow psychologists thought they were crazy.  It wasn’t just enemy tanks and planes.  Land mines were everywhere.  And it was easy to get lost.  People were more concerned about Danny than Amos because Amos was more of a fighter.  But Danny proved to be more useful because he had a gift for finding solutions to problems where others hadn’t even noticed the problem.

Soon after the war, Amos and Danny studied public decision making.

Both Amos and Danny thought that voters and shareholders and all the other people who lived with the consequences of high-level decisions might come to develop a better understanding of the nature of decision making.  They would learn to evaluate a decision not by its outcomes—whether it turned out to be right or wrong—but by the process that led to it.  The job of the decision maker wasn’t to be right but to figure out the odds in any decision and play them well.

It turned out that Israeli leaders often agreed about probabilities, but didn’t pay much attention to them when making decisions on whether to negotiate for peace or fight instead.  The director-general of the Israeli Foreign Ministry wasn’t even interested in the best estimates of probabilities.  Instead, he made it clear that he preferred to trust his gut.  Lewis quotes Danny:

“That was the moment I gave up on decision analysis.  No one ever made a decision because of a number.  They need a story.”

Some time later, Amos introduced Danny to the field of decision making under uncertainty.  Many students of the field studied subjects in labs making hypothetical gambles.

The central theory in decision making under uncertainty had been published in the 1730s by the Swiss mathematician Daniel Bernoulli.  Bernoulli argued that people make probabilistic decisions so as to maximize their expected utility.  Bernoulli also argued that people are “risk averse”: each new dollar has less utility than the one before.  This theory seemed to describe some human behavior.

(Utility as a function of outcomes, Global Water Forum, Wikimedia Commons)

The utility function above illustrates risk aversion: Each additional dollar—between $10 and $50—has less utility than the one before.

In 1944, John von Neumann and Oskar Morgenstern published the axioms of rational decision making.  One axiom was “transitivity”: if you preferred A to B, and B to C, then you preferred A to C.  Another axiom was “independence”:  if you preferred A to B, your preference between A and B wouldn’t change if some other alternative (say D) was introduced.

Many people, including nearly all economists, accepted von Neumann and Morgenstern’s axioms of rationality as a fair description for how people actually made choices.  Danny recalls that Amos regarded the axioms as a “sacred thing.”

By the summer of 1973, Amos was searching for ways to undo the reigning theory of decision making, just as he and Danny had undone the idea that human judgment followed the precepts of statistical theory.

Lewis records that by the end of 1973, Amos and Danny were spending six hours a day together.  One insight Danny had about utility was that it wasn’t levels of wealth that represented utility (or happiness); it was changes in wealth—gains and losses—that mattered.

 

THE ISOLATION EFFECT

Many of the ideas Amos and Danny had could not be attributed to either one of them individually, but seemed to come from their interaction.  That’s why they always shared credit equally—they switched the order of their names for each new paper, and the order for their very first paper had been determined by a coin toss.

In this case, though, it was clear that Danny had the insight that gains and losses are more important than levels of utility.  However, Amos then asked a question with profound implications: “What if we flipped the signs?”  Instead of asking whether someone preferred a 50-50 gamble for $1,000 or $500 for sure, they asked this instead:

Which of the following do you prefer?

  • Gift A: A lottery ticket that offers a 50 percent chance of losing $1,000
  • Gift B: A certain loss of $500

When the question was put in terms of possible gains, people preferred the sure thing.  But when the question was put in terms of possible losses, people preferred to gamble.  Lewis elaborates:

The desire to avoid loss ran deep, and expressed itself most clearly when the gamble came with the possibility of both loss and gain.  That is, when it was like most gambles in life.  To get most people to flip a coin for a hundred bucks, you had to offer them far better than even odds.  If they were going to loss $100 if the coin landed on heads, they would need to win $200 if it landed on tails.  To get them to flip a coin for ten thousand bucks, you had to offer them even better odds than you offered them for flipping it for a hundred.

It was easy to see that loss aversion had evolutionary advantages.  People who weren’t sensitive to pain or loss probably wouldn’t survive very long.

A loss is when you end up worse than your status quo.  Yet determining the status quo can be tricky because often it’s a state of mind.  Amos and Danny gave this example:

Problem A.  In addition to whatever you own, you have been given $1,000.  You are now required to choose between the following options:

  • Option 1.  A 50 percent chance to win $1,000
  • Option 2.  A gift of $500

Problem B.  In addition to whatever you own, you have been given $2,000.  You are now required to choose between the following options:

  • Option 3.  A 50 percent chance to lose $1,000
  • Option 4.  A sure loss of $500

In Problem A, most people picked Option 2, the sure thing.  In Problem B, most people chose Option 3, the gamble.  However, the two problems are logically identical:  Overall, you’re choosing between $1,500 for sure versus a 50-50 chance of either $2,000 or $1,000.

What Amos and Danny had discovered was framing.  The way a choice is framed can impact the way people choose, even if two different frames both refer to exactly the same choice, logically speaking.  Consider the Asian Disease Problem, invented by Amos and Danny.  People were randomly divided into two groups.  The first group was given this question:

Problem 1.  Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people.  Two alternative problems to combat the disease have been proposed.  Assume that the exact scientific estimate of the consequence of the programs is as follows:

  • If Program A is adopted, 200 people will be saved.
  • If Program B is adopted, there is a 1/3 probability that 600 people will be saved, and a 2/3 probability that no one will be saved.

Which of the two programs would you favor?

People overwhelming chose Program A, saving 200 people for sure.

The second group was given the same problem, but was offered these two choices:

  • If Program C is adopted, 400 people will die.
  • If Program D is adopted, there is a 1/3 probability that nobody will die and a 2/3 probability that 600 people will die.

People overwhelmingly chose Program D.  Once again, the underlying choice in each problem is logically identical.  If you save 200 for sure, then 400 will die for sure.  Because of framing, however, people make inconsistent choices.

 

THIS CLOUD OF POSSIBILITY

In 1984, Amos learned he had been given a MacArthur “genius” grant.  He was upset, as Lewis explains:

Amos disliked prizes.  He thought that they exaggerated the differences between people, did more harm than good, and created more misery than joy, as for every winner there were many others who deserved to win, or felt they did.

Amos was angry because he thought that being given the award, and Danny not being given the award, was “a death blow” for the collaboration between him and Danny.  Nonetheless, Amos kept on receiving prizes and honors, and Danny kept on not receiving them.  Furthermore, ever more books and articles came forth praising Amos for the work he had done with Danny, as if he had done it alone.

Amos continued to be invited to lectures, seminars, and conferences.  Also, many groups asked him for his advice:

United States congressmen called him for advice on bills their were drafting.  The National Basketball Association called to hear his argument about statistical fallacies in basketball.  The United States Secret Service flew him to Washington so that he could advise them on how to predict and deter threats to the political leaders under their protection.  The North Atlantic Treaty Organization flew him to the French Alps to teach them about how people made decisions in conditions of uncertainty.  Amos seemed able to walk into any problem, and make the people dealing with it feel as if he grasped its essence better than they did.

Despite the work of Amos and Danny, many economists and decision theorists continued to believe in rationality.  These scientists argued that Amos and Danny had overstated human fallibility.  So Amos looked for new ways to convince others.  For instance, Amos asked people: Which is more likely to happen in the next year, that a thousand Americans will die in a flood, or that an earthquake in California will trigger a massive flood that will drown a thousand Americans?  Most people thought the second scenario was more likely; however, the second scenario is a special case of the first scenario, and therefore the first scenario is automatically more likely.

Amos and Danny came up with an even more stark example.  They presented people with the following:

Linda is 31 years old, single, outspoken, and very bright.  She majored in philosophy.  As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which of the two alternatives is more probable?

  • Linda is a bank teller.
  • Linda is a bank teller and is active in the feminist movement.

Eighty-five percent of the subjects thought that the second scenario is more likely than the first scenario.  However, just like the previous problem, the second scenario is a special case of the first scenario, and so the first scenario is automatically more likely than the second scenario.

Say there are 50 people who fit the description, are named Linda, and are bank tellers.  Of those 50, how many are also active in the feminist movement?  Perhaps quite a few, but certainly not all 50.

Amos and Danny constructed a similar problem for doctors.  But the majority of doctors made the same error.

Lewis:

The paper Amos and Danny set out to write about what they were now calling “the conjunction fallacy” must have felt to Amos like an argument ender—that is, if the argument was about whether the human mind reasoned probabilistically, instead of the ways Danny and Amos had suggested.  They walked the reader through how and why people violated “perhaps the simplest and the most basic qualitative law of probability.”  They explained that people chose the more detailed description, even though it was less probable, because it was more “representative.”  They pointed out some places in the real world where this kink in the mind might have serious consequences.  Any prediction, for instance, could be made to seem more believable, even as it became less likely, if it was filled with internally consistent details.  And any lawyer could at once make a case seem more persuasive, even as he made the truth of it less likely, by adding “representative” details to his description of people and events.

Around the time Amos and Danny published work with these examples, their collaboration had come to be nothing like it was before.  Lewis writes:

It had taken Danny the longest time to understand his own value.  Now he could see that the work Amos had done alone was not as good as the work they had done together.  The joint work always attracted more interest and higher praise than anything Amos had done alone.

Danny pointed out to Amos that Amos that been a member of the National Academy of Sciences for a decade, but Danny still wasn’t a member.  Danny asked Amos why he hadn’t put Danny’s name forward.

A bit later, Danny told Amos they were no longer friends.  Three days after that, Amos called Danny.  Amos learned that his body was riddled with cancer and that he had at most six months to live.

 

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.

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 fielded 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 one running 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 for the 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 made a complaint about a Theranos blood test 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’s 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. Betz’s 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 Sonora Quest.  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 the 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.  George and Tyler 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’s parent 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 one 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 of meeting?  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 simple 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 an 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 of 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 billion 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’s sources.  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 story 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.

The story 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 my 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 the 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, Kissinger, 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, took 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.  Another 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. An 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 Tyler nor Carreyrou 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 close 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 grant 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 agreed 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.  Its 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 how was 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.