The One Device

(Image: Zen Buddha Silence, by Marilyn Barbone)

February 11, 2018

Innovation is the primary driver of GDP growth.  If we want to understand how most new wealth is created — and (perhaps) if we want to find inspiration for our own tinkering — we should study history.  Especially economic history, the history of science, and the history of technology.

A new book, The One Device: The Secret History of the iPhone (New York: 2017, Little, Brown and Company), is a fascinating tale by Brian Merchant.

I’ve summarized each chapter (except for one):

  • Introduction
  • Exploring New Rich Interactions (ENRI)
  • A Smarter Phone
  • Minephones
  • Scratchproof
  • Multitouched
  • Prototyping
  • Lion Batteries
  • Image Stabilization
  • Sensing Motion
  • Strong-ARMed
  • Enter the iPhone
  • Hey, Siri
  • Designed in California, Made in China
  • Sellphone
  • The Black Market
  • The One Device

(Photo by Pavel Ševela, Wikimedia Commons)

 

INTRODUCTION

The iPhone is the bestselling product of all time:

In 2016, Horace Dediu, a technology-industry analyst and Apple expert, listed some of the bestselling products in various categories.  The top car brand, the Toyota Corolla: 43 million units.  The bestselling game console, the Sony PlayStation: 382 million.  The number-one book series, Harry Potter: 450 million books.  The iPhone: 1 billion.  That’s nine zeroes.  “The iPhone is not only the bestselling mobile phone but also the bestselling music player, the best selling camera, the bestselling video screen and the bestselling computer of all time,” he concluded.  “It is, quite simply, the bestselling product of all time.”

Merchant cites a study by Nielsen that found that Americans spend an average of 11 hours a day in front of a screen.  About 4.7 of those hours are in front of a phone.  A study by British psychologists discovered that people probably use their phones twice as often as they think.

(Photo by Olena Golubova)

Two-thirds of Apple’s revenues come from the iPhone.  People read news, engage in social media, use Google maps, send and receive messages, check email, employ calendars and workflows, and take pictures.  Merchant:

The iPhone isn’t just a tool; it’s the foundational instrument of modern life.

But the invention of the iPhone — like many inventions — was a culmination of a long series of inventions.

The iPhone intertwines a phenomenal number of prior inventions and insights, some that stretch back into antiquity.  It may, in fact, be our most potent symbol of just how deeply interconnected the engines that drive modern technological advancement have become.

Merchant again:

The iPhone is a deeply, almost incomprehensively, collective achievement… It’s a container ship of inventions, many of which are incompletely understood.  Multitouch, for instance, granted the iPhone its interactive magic, enabling swiping, pinching, and zooming.  And while Jobs publicly claimed the invention as Apple’s own, multitouch was developed decades earlier by a trail of pioneers by places as varied as CERN’s particle-accelerator labs to the University of Toronto to a start-up bent on empowering the disabled.  Institutions like Bell Labs and CERN incubated research and experimentation; governments poured in hundreds of millions of dollars to support them.

Moreover, the mining of the raw materials used in the iPhone, and the factory labor that goes into mass-producing iPhones, are also central to the story.  The result, writes Merchant, is what J.C.R. Licklider called man-computer symbiosis:

A coexistence with an omnipresent digital reference tool and entertainment source, an augmenter of our thoughts and enabler of our impulses.

Although Apple’s policy of secrecy made it difficult for Merchant to interview insiders, he still managed to speak with dozens of people, including iPhone designers, engineers, and executives.

 

EXPLORING NEW RICH INTERACTIONS (ENRI)

(Photo by Peshkova)

A small group — a few young software designers, an industrial engineer, and some input engineers — started meeting to invent new ways of interfacing with machines.  Their mission: “Explore new rich interactions.”  Merchant refers to this group as ENRI.

The team was experimenting with every stripe of bleeding-edge hardware — motion sensors, new kinds of mice, a burgeoning technology known as multitouch — in a quest to uncover a more direct way to manipulate information.  The meetings were so discreet that not even Jobs knew they were taking place.  The gestures, user controls, and design tendencies stitched together here would become the cybernetic vernacular of the new century — because the kernel of this clandestine collaboration would become the iPhone.

Two key engineers in the Human Interface group — also called the UI (User Interface) group — were Bas Ording, a Dutch software designer, and Imran Chaudhri, a British designer.  Greg Christie, who’d come to Apply earlier to work on Newton, ended up in charge of the Human Interface group after the Newton failed to sell well.

Civil engineer Brian Huppi had gone back to school to study mechanical engineering after reading a book about Apple, Steven Levy’s Insanely Great.  The book tells the story of how Jobs separated key Apple players, put a pirate flag above their department, and pushed them to create the pioneering Macintosh.

Huppi got a job at Apple as in input engineer in 1998.  He got to know the Industrial Design (ID) group, headed by Jonathan Ive.  When he grew bored interating laptop hardware, Huppi spoke with Duncan Kerr, who’d worked at the well-known design firm IDEO before coming to Apple.  After Huppi and Kerr talked about innovations to the user experience, Kerr asked Jony Ive if they could form a small group to work on the topic.  Ive liked the idea.

Huppi and Kerr started working with Christie, Ording, and Chaudhri.  And they were joined by Josh Strickon, who came from MIT’s Media Lab.  Strickon’s master’s thesis involved the development of a laser range finder for hand-tracking that could sense multiple fingers.  The ENRI group met weekly in a conference room with their laptops.  They took extensive notes, put drawings on whiteboards, and gave presentations to one another.

There were a lot of ideas.  Some feasible, some boring, some outlandish and boreline sci-fi — some of those, Huppi says, he “probably can’t talk about,” because fifteen years later, they had yet to be developed, and “Apple still might want to do them someday.”

“We were looking at all sorts of stuff,” Strickon says, “from camera-tracking and multitouch and new kinds of mice.”  They studied depth-sensing time-of-flight cameras like the sort that would come to be used in the Xbox Kinect.  They explored force-feedback controls that would allow users to interact directly with virtual objects with the touch of their hands.

In many ways, the group was testing the limits of the old mouse-and-keyboard interface with the computer.  Could there be an easier way to zoom, or to scroll and pan?  Why couldn’t the user just tap, tap, tap on the screen for certain repetitive acts?

Tina Huang, an Apple engineer, had been experiencing wrist problems.  One day, she showed up to work with trackpad made by FingerWorks, a small company in Delaware.  It allowed her to use fluid hand movements to communicate complex commands to her Mac.  The technology was called multitouch finger tracking.

(Image by Willtron, Wikimedia Commons)

FingerWorks was founded by a bright PhD student, Wayne Westerman, and his dissertation advisor.

Resistive touch works by having two layers.  When you push the outer layer, the inner layer registers the touch.  But the resistive touchscreen is frequently inexact and glitchy.  Capacitive touch, by contrast, works when the electricity in a human finger distorts the electrostatic field on the screen.  Merchant:

A new, hands-on approach to computing, free of rodent intermediaries and ancient keyboards, started to seem like the right path to follow, and the ENRI team warmed to the idea of building a new user interface around the finger-based language of multitouch pioneered by Westerman — even if they had to rewrite or simplify the vocabulary.  “It kept coming up — we want to be able to move things on the screen like a piece of paper on the table,” Chaudhri says.

The ENRI group worked very hard.  But they barely noticed the long hours because they were exhilarated.  They could sense the potential importance of new technologies like multitouch.

 

A SMARTER PHONE

In 1994, Frank Canova helped IBM invent a smartphone — the Simon Personal Communicator — that had most of the core functions of an iPhone.  But the Simon was a box that size of a brick.  The iPhone, coming over a decade later, was far more powerful.  And it was thin and easy to use.  The Simon was too far ahead of its time.

(Photo by Bcos47, Wikimedia Commons)

Merchant quotes history of technology scholar Carolyn Marvin:

In a historical sense, a computer is no more than an instantaneous telegraph with a prodigious memory, and all the communications inventions in between have simply been eleborations on the telegraph’s original work.

In the long transformation that begins with the first application of electricity to communication, the last quarter of the nineteenth century has a special importance.  Five proto-mass media were invented during this period: the telephone, phonograph, electric light, wireless, and cinema.

Merchant sums it up:

The smartphone, like every other breakthrough technology, is built on the sweat, ideas, and inspiration of countless people.  Technological progress is incremental, collective, and deeply rhizomatic, not spontaneous…

The technologies that shape our lives rarely emerge suddenly and out of nowhere; they are part of an incomprehensibly lengthy, tangled, and fluid process brought about by contributors who are mostly invisible to us.  It’s a very long road back from the bleeding edge.

 

MINEPHONES

In the old colonial city of Potosí, Bolivia, there is a “rich hill” called Cerro Rico, nicknamed “The Mountain That Eats Men.”

The Mountain That Eats Men bankrolled the Spanish Empire for hundreds of years.  In the sixteenth century, some 60 percent of the world’s silver was pulled out of its depths.  By the seventeenth century, the mining boom had turned Potosí into one of the biggest cities in the world; 160,000 people — local natives, African slaves, and Spanish settlers — lived here, making the industrial hub larger than London at the time.  More would come, and the mountain would swallow many of them.  Between four and eight million people are believed to have perished there from cave-ins, silicosis, freezing, or starvation.

(Photo of Cerro Rico by Mhwater, Wikimedia Commons)

Today fifteen thousand miners — many of them children as young as six years old — continue to work the mines for tin, lead, zinc, and a bit of silver.  Merchant comments:

…metal mined by men and children wielding the most primitive of tools in one of the world’s largest and oldest continuously running mines — the same mine that bankrolled the sixteenth century’s richest empire — winds up inside one of today’s most cutting-edge devices.  Which bankrolls one of the world’s richest companies.

Merchant asked a mining consultant to analyze the chemical composition of the iPhone.  Results:

Element Percent of iPhone by weight Grams used in iPhone Average cost per gram Value of element in iPhone
Aluminum 24.14 31.14 $0.0018 $0.055
Arsenic 0.00 0.01 $0.0022
Gold 0.01 0.014 $40 $0.56
Bismuth 0.02 0.02 $0.0110 $0.0002
Carbon 15.39 19.85 $0.0022
Calcium 0.34 0.44 $0.0044 $0.002
Chlorine 0.01 0.01 $0.0011
Cobalt 5.11 6.59 $0.0396 $0.261
Chrome 3.83 4.94 $0.0020 $0.010
Copper 6.08 7.84 $0.0059 $0.047
Iron 14.44 18.63 $0.0001 $0.002
Gallium 0.01 0.01 $0.3304 $0.003
Hydrogen 4.28 5.52
Potassium 0.25 0.33 $0.0003
Lithium 0.67 0.87 $0.0198 $0.017
Magnesium 0.51 0.65 $0.0099 $0.006
Manganese 0.23 0.29 $0.0077 $0.002
Molybdenum 0.02 0.02 $0.0176 $0.000
Nickel 2.10 2.72 $0.0099 $0.027
Oxygen 14.50 18.71
Phosphorus 0.03 0.03 $0.0001
Lead 0.03 0.04 $0.0020
Sulfur 0.34 0.44 $0.0001
Silicon 6.31 8.14 $0.0001 $0.001
Tin 0.51 0.66 $0.0198 $0.013
Tantalum 0.02 0.02 $0.1322 $0.003
Titanium 0.23 0.30 $0.0198 $0.006
Tungsten 0.02 0.02 $0.2203 $0.004
Vanadium 0.03 0.04 $0.0991 $0.004
Zinc 0.54 0.69 $0.0028 $0.002

The iPhone is 24 percent aluminum, the most abundant metal on earth.  Aluminum is very light and cheap.  It comes from bauxite, which is often strip-mined.  It takes four tons of bauxite to make one ton of aluminum.

The iPhone is 3 percent cobalt.  Most of the cobalt is in the lithium-ion battery and is mined in the Democratic Republic of Congo.  The mines there are almost completely unregulated.  Workers, including children, toil around the clock.  Deaths and injuries are common.

Oxygen, hydrogen, and carbon in the iPhone are associated with different alloys.  Indium tin oxide functions as a conductor for the touchscreen.  Aluminum oxides are in the casing.  Silicon oxides are found in the microchip.  (Small amounts of arsenic and gallium are also in the microchip.)

Silicon makes up 6 percent of the phone.

Merchant discovered that 34 kilograms (75 pounds) of ore would have to be mined to have the materials for one 129-gram iPhone.

A billion iPhones had been sold by 2016, which translates into 34 billion kilos (37 million tons) of mined rock.  That’s a lot of moved earth — and it leaves a mark.  Each ton of ore processed for metal extraction requires around three tons of water.  This means that each iPhone “polluted” around 100 liters (or 26 gallons) of water… Producing 1 billion iPhones has fouled 100 billion liters (or 26 billion gallons) of water.

 

SCRATCHPROOF

In the early 1950s, Don Stookey, an inventor for Corning, discovered a form of glass that didn’t break.  He was experimenting and accidentally heated lithium silicate to 900 degrees Celcius instead of 600.  The silicate changed into an off-white substance which didn’t break when it fell on the floor.

(Photo of Corningware casserole dishes by Splarka, Wikimedia Commons)

In the early 1960s, Corning kept experimenting with the goal of creating even stronger glass.  Eventually they created Chemcor, which is fifteen times stronger than regular glass.

By 1969, 42 million dollars had been invested in Chemcor.  Unfortunately, nobody wanted it.  Chemcor was too strong for car windshields, for instance.  To survive some crashes, the windshield must break.  But with Chemcor, the human skull would break against the windshield.

In 2005, Corning started looking as Chemcor again to see if it could be used as strong, affordable, and scratchproof glass in cellphones.  So-called Gorilla Glass was invented and is now used in iPhones and other smartphones.

(Illustration by Artsiom Kusmartseu)

 

MULTITOUCHED

Brent Stumpe, a Danish engineer working at CERN, invented capacitive multitouch in 1970s.  Steve Jobs later claimed that Apple invented multitouch, but that’s not very accurate.  As with much else in the iPhone, Apple improved the technology and used it in a new way.  But Apple didn’t invent it.

Several people, in addition to Stumpe, invented multitouch or a precursor to multitouch.  Bill Buxton and his team were working on multitouch at the University of Toronto in 1985.  Buxton says that Bob Boie, at Bell Labs, probably came up with the first working multitouch system.

Engineer Eric Arthur Johnson invented a multitouch system for air traffic controllers in 1965.

…We do know what Johnson cited as prior art in his patent, at least: two Otis Elevator patents, one for capacitance-based proximity sensing (the technology that keeps the doors from closing when passengers are in the way) and one for touch-responsive elevator controls.  He also named patents from General Electric, IBM, the U.S. military, and American Mach and Foundry.  All six were filed in the early to mid-1960s; the idea for touch control was “in the air” even if it wasn’t being used to control computer systems.

Finally, he cites a 1918 patent for a “type-writing telegraph system.”  Invented by Frederick Ghio, a young Italian immigrant who lived in Connecticut, it’s basically a typewriter that’s been flattened into a tablet-size grid so each key can be wired into a touch system.  It’s like the analog version of your smartphone’s keyboard.  It would have allowed for the automatic transmission of messages based on letters, numbers, and inputs — the touch-typing telegraph was basically a pre-proto-Instant Messenger.

William Norris, CEO of the supercomputer firm Control Data Corporation (CDC), fervently believed in touchscreens as the key to digital education.  Norris commercialized PLATO — Programmed Logic for Automatic Teaching Operations.  By 1964, PLATO had a touchscreen.  Light sensors on the four sides of the screen registered wherever a finger touched the screen.

Wayne Westerman, an electrical engineering graduate student at the University of Delaware, invented a form of multitouch in his 1999 PhD dissertation.  At last multitouch was poised to go mainstream.

Westerman’s mother had chronic back pain, while Westerman himself developed tendonitis in his wrists.  When Westerman finished undergraduate studies at Purdue, he followed Neal Gallagher, a favorite professor, to the University of Delaware.

Westerman’s wrist pain grew worse, which pushed him to seek a solution.  He invented a set of gestures to supplant the mouse and keyboard.

Westerman founded FingerWorks in 2001 with his dissertation advisor, Dr. John Elias.

At the beginning of 2005, FingerWorks’ iGesture pad won the Best of Innovation award at CES, the tech industry’s major annual trade show.

Still, at the time, Apple execs weren’t convinced that FingerWorks was worth pursuing — until the ENRI group decided to embrace multitouch.

Merchant comments:

Apple made multitouch flow, but they didn’t create it.  And here’s why that matters: Collectives, teams, multiple inventors, build on a shared history.  That’s how a core, universally adopted technology emerges…

(Illustration by Onyxprj)

 

PROTOTYPING

In the summer of 2003, Jony Ive decided the multitouch project was ready to be showed to Steve Jobs.  At first, Jobs dismissed it.  But then he embraced it.  Later, Jobs even claimed that he invented it.

There was still a great deal of work to be done.  The project went on lockdown in order to keep it completely secret.  At this point, the researchers weren’t thinking about a phone at all.

(Image by BP22Heber, Wikimedia Commons)

The project languished until late 2004, when Steve Jobs announced to the group that Apple was going to make a phone.  It would take two years to get Apple’s operating system on to a phone.

Executives would clash; some would quit.  Programmers would spend years of their lives coding around the clock to get the iPhone ready to launch, scrambling their social lives, their marriages, and sometimes their health in the process.

 

LION BATTERIES

Merchant tells of his visit to SQM, or Sociedad Química y Minera de Chile — the Chemical and Mining Society of Chile.  SQM is the leading producer of potassium nitrate, iodine, and lithium.  It’s located in Salar de Atacama in the Atacama Desert, the most arid place on earth.  The desert gets half an inch of rainfall per year, and some areas much less.

Chilean miners work this alien environment every day, harvesting lithium from vast evaporating pools of marine brine.  That brine is a naturally occurring saltwater solution that’s found here in huge underground reserves.  Over the millenia, runoff from the nearby Andes Mountains has carried mineral deposits down to the salt flats, resulting in brines with unusually high lithium concentrations.  Lithium is the lightest metal and least dense solid element, and while it’s widely distributed around the world, it never occurs naturally in pure elemental form; it’s too reactive.  It has to be separated and refined from compounds, so it’s usually expensive to get.  But here, the high concentration of lithium in the salar brines combined with the ultradry climate allows miners to harness good old evaporation to obtain the increasingly precious metal.

(Lithium hydroxide with carbonate growths, Photo by Chemicalinterest, Wikimedia Commons)

Because lithium-ion batteries are essential for smartphones, tablets, laptops, and electric cars, lithium is increasingly referred to as “white petroleum.”  Lithium doubled in value in the past couple years based on a jump in projected demand.

While doing postdoc work at Stanford in the early 1970s, chemist Stan Whittingham discovered a way to store lithium ions in sheets of titanium sulfide.  This formed the basis for a rechargeable battery.

Whittingham developed the lithium-ion battery while working for Exxon.  Hot on the heels of an oil crisis, Exxon had decided that it wanted to be the leading energy company and the leading producer of electric vehicles.  But the lithium-ion battery was expensive to produce.  And it had flammability issues.  Once the oil crisis had passed, Exxon returned to its focus on producing oil.

The recent jumps in projected demand are mostly due to the opening of Tesla’s Gigafactory, which will be the world’s largest lithium-ion-battery factory.  The global lithium-ion-battery market is expected to double to $77 billion by 2024, says Transparency Market Research.

(Photo of Tesla’s Gigafactory by Planet Labs, Wikimedia Commons)

 

IMAGE STABILIZATION

There are obvious similarities for two different mass-market cameras:

  • Exhibit A: You Press the Button, We Do the Rest.
  • Exhibit B: We’ve taken care of the technology.  All you have to do is find something beautiful and tap the shutter button.

Merchant explains:

Exhibit A comes to us from 1888, when George Eastman, the founder of Kodak, thrust his camera into the mainstream with that simple eight-word slogan.  Eastman had initially hired an ad agency to market his Kodak box camera but fired them after they returned copy he viewed as needlessly complicated.  Extolling the key virtue of his product — that all a consumer had to do was snap the photos and then take the camera into a Kodak shop to get them developed — he launched one of the most famous ad campaigns of the young industry.

Exhibit B is for the iPhone camera.  The two ads are similar in their focus on ease of use and in their targeting of the average consumer.

At first, the 2-megapixel camera included on the iPhone wasn’t remarkable.  But it wasn’t a priority at that point.  By 2016, there were 800 employees dedicated to the camera, an 8-megapixel unit with a Sony sensor, optimal image-stabilization module, and a proprietary image-signal processor.

 

SENSING MOTION

A mass in a rotating system experiences a force perpendicular to the direction of motion and to the axis of rotation.  This is the Coriolis effect.  The Foucault pendulum in the Paris Observatory slowly changes direction over the course of a day due to this effect.

(Coriolis effect, Wikimedia Commons)

Merchant:

The gyroscope in your phone is a vibrating structure gyroscope (VSG).  It is… a gyroscope that uses a vibrating structure to determine the rate at which something is rotating.  Here’s how it works: A vibrating object tends to continue vibrating in the same plane if, when, and as its support rotates.  So the Coriolis effect — the result of the same force that causes Foucault’s pendulum to rotate to the right in Paris — makes the object exert a force on its own support.  By measuring that force, the sensor can determine the rate of rotation.

Another sensor, the accelerometer, measures the acceleration of an object.  If an iPhone is sideways, then it accelerates sideways — towards the ground — due to gravity.  So the iPhone knows to flip the display from portrait to landscape.

Proximity sensors knows to turn off the display when you lift the iPhone to your ear.  They work by emitting tiny bursts of infrared radiation, which hit an object and are reflected back.  If the object is close, then the reflected radiation is more intense.

(Photos of proximity sensor by Hyderabaduser, Wikimedia Commons)

For the iPhone to determine its place relative to everything else, it relies on GPS (Global Positioning System) — a globe-spanning system of satellites.  GPS was developed by the U.S. Naval Research Laboratory in the 1960s and 1970s.

Today, every iPhone has a dedicated GPS chip that trilaterates with Wi-Fi signals and cell towers.  Google Maps uses this technology.

 

STRONG-ARMed

In 1977, Alan Kay and his colleague Adele Goldberg developed the concept of a Dynabook, which was powerful, dynamic, and very easy to use.

The Dynabook, which looks like an iPad with a hard keyboard, was one of the first mobile-computer concepts ever put forward, and perhaps the most influential.  It has since earned the dubious distinction of being the most famous computer that never got built.

(Alan Kay and the prototype of Dynabook, Photo by Marcin Wichary, Wikimedia Commons)

Kay is one of the fathers of personal computing.  He once said that the Mac was the “first computer worth criticizing.”  Kay holds that the Dynabook still has not been built.  The smartphone, shaped in part by marketing departments, simply gives people more of what they already wanted, such as news and social media.

Because Moore’s law has been in effect for fifty years now, computer chips (which include transistors) have gotten dramatically smaller, more powerful, and less energy intensive.  Moore’ law may be slowing down.  But depending upon progress in areas such as quantum computing, there could still be much room for improvement before any limit is reached.

The first iPhone processor had 137,500,000 transistors.  But the iPhone 7, released 9 years after the first iPhone, has 3.3 billion transistors, about 240 times more.  Whatever app you just downloaded has more computing power than the first mission to the moon.

The other part of the story is a breakthrough low-power processor, without which the iPhone battery would drain far too quickly.  The ARM processor is the most popular ever.  95 billion have been sold, with 15 billion shipped in 2015 alone.  ARM chips are in everything: smartphones, computers, wristwatches, cars, coffeemakers, etc.

ARM stands for Acorn RISC Machine.  RISC is reduced instruction set computing.  Berkeley researchers developed RISC after they observed that most computer programs weren’t using the majority of a given processor’s instruction set.

(Acorn RISC PC ARM-710 CPU, Photo by Flibble, Wikimedia Commons)

Sophie Wilson and Steve Furber were star engineers for Acorn, a company founded by Herman Hauser after he met Wilson and saw some of her designs for various machines.  Wilson visited a group in Phoenix that designed the processor for Acorn’s computer.  Wilson was surprised to find “two senior engineers and a bunch of school kids.”  Wilson and Furber realized that they could develop their own RISC CPU for Acorn.  Merchant quotes Wilson:

“It required some luck and happenstance, the papers being published close in time to when we were visiting Phoenix.  It also required Herman.  Herman gave us two things that Intel and Motorola didn’t give their staff: He gave us no resources and no people.  So we had to build a microprocessor the simplest possible way, and that was probably the reason that we were successful.”

Also, Acorn wanted to simplify their designs.  So they developed SoC, or System on a Chip, which integrates all the components of a computer on to one chip.  Acorn didn’t realize how important SoC would become.

Merchant describes the evolution of apps for the iPhone:

The first iPhone shipped with sixteen apps, two of which were made in collaboration with Google.  The four anchor apps were laid out on the bottom: Phone, Mail, Safari, and iPod.  On the home screen, you had Text, Calendar, Photos, Camera, YouTube, Stocks, Google Maps, Weather, Clock, Calculator, Notes, and Settings.  There weren’t any more apps available for download and users couldn’t delete or even rearrange the apps.  The first iPhone was a closed, static device.

Then Jobs, continuously pressured by software developers, decided that they would allow web apps.  Brett Bilbrey, who was senior manager of Apple’s Advanced Technology Group until 2013, observed:

“The thing with Steve was that nine times out of ten, he was brilliant, but one of those times he had a brain fart, and it was like, ‘Who’s going to tell him he’s wrong?'”

If mounting pressure from developers and Apple’s own executives wasn’t enough, there was the fact that the iPhone sold poorly for the first 3 to 6 months.  Scott Forstall finally convinced Jobs to allow apps.  Merchant:

…This was arguably the most important decision Apple made in the iPhone’s post-launch era.  And it was made because developers, hackers, engineers, and insiders pushed and pushed.  It was an anti-executive decision.  And there’s a recent precedent — Apple succeeds when it opens up, even a little.

The iPod took off when Apple made iTunes for Windows.  Before that, the iPod hardly sold.

If an app was approved for the iPhone and if it was monetized, then Apple would take a 30 percent cut.

…And that was when the smartphone era entered the mainstream.  That’s when the iPhone discovered that its killer app wasn’t the phone, but a store for more apps.

(iPhone apps and app store, Photo by Michael Damkier)

There are over 2 million apps in the App Store today.  As of 2014, six years after the launch of the App Store, over 627,000 jobs have been created based on iOS and U.S.-based developers have earned more than $8 billion.

On the other hand, the majority of the app money is going to games and streaming media — services designed to be as addictive as possible.  This is part of Kay’s point.  We have the technology for a Dynabook.  We have the technology to help us engage in productive and creative pursuits.  But consumerism — channeled by marketing departments — has turned mobile computers into consumption devices.

 

ENTER THE iPHONE

In the mid-2000s, top engineers at Apple were regularly disappearing mysteriously.  They ended up doing top secret work on what would become the iPhone.  And they had time for little else.  Everyone on the team was brilliant.  The mission was impossible.  The deadlines were impossible.  Quite a few marriages were ruined.

The iPod didn’t sell its first two years.  Finally Apple introduced iTunes software so that people could manage their iPods from computers running Windows, rather than just from Apple computers.  After Apple’s success with iPod hardware and iTunes software, people both inside and outside Apple were wondering what else the company could do.  Many ideas were mentioned, including a camera, a phone, and an electric car.

One thing everyone at Apple agreed on was that, before the iPhone, cell phones were “terrible.”  Merchant:

“Apple is best when it’s fixing things that people hate,” Greg Christie tells me.  Before the iPod, nobody could figure out how to use a digital music player; as Napster boomed, people took to carting around skip-happy portable CD players loaded with burned albums.  And before the Apple II, computers were considered too complex and unwieldy for the lay person.

It took time to convince Steve Jobs that Apple should do a phone.  Mike Bell, who’d worked at Apple for fifteen years and at Motorola’s wireless division before that, was one of those who helped convince Jobs.  Bell was sure that computers, music players, and cell phones would converge.  Eventually Jobs agreed.

Jobs contacted Bas Ording and Imran Chaudhri of the touchscreen-tablet project.  Jobs said, “We’re gonna do a phone.”  The engineers got to work.  Many features of the iPhone that we now take for granted were the result of persistent tinkering.

(Photo by Sergey Gavrilichev)

But despite compelling multitouch demos, the team still lacked a coherent concept.  Jobs gave the team a 2-week ultimatum in February, 2005.  The team came through.  Jobs was pleased.  This meant a great deal more work, of course.  Then Jobs did a presentation to the Top 100 at Apple.  Another huge success.

Soon there were two separate approaches, code-named P1 and P2.  P1 was the iPod phone.  P2 was an evolving hybrid of multitouch technology and Mac software.  Tony Fadell ran P1, while Scott Forstall managed P2.  It’s not clear whether it was a good idea to have these two teams compete, given how much political conflict later erupted on the iPhone project.

The iPhone’s code name was Purple.  Forstall’s group was viewed as the underdog by many, since Fadell had been responsible for many millions of iPod sales.  But soon the touchscreen approach won out.

The next battle was over the operating system.  Fadell’s group wanted to do it like the iPod, which used a rudimentary operating system.  But Forstall’s team wanted to take Apple’s main operating system, OS X, and shrink it down.  One top engineer, Richard Williamson, said:

“There were some epic battles, philosophical battles about trying to decide what to do.”

Once basic scrolling operations were demonstrated on the stripped-down OS X, the decision was essentially made: OS X.

(Photo by Mohamed Soliman)

 

HEY, SIRI

Merchant:

Siri is really a constellation of features — speech-recognition software, a natural-language user interface, and an artificially intelligent personal assistant.  When you ask Siri a question, here’s what happens: Your voice is digitized and trasmitted to an Apple server in the Cloud while a local voice recognizer scans it right on your iPhone.  Speech-recognition software translates your speech into text.  Natural-language processing parses it.  Siri consults what tech writer Stephen Levy calls the iBrain — around 200 megabytes of data about your preferences, the way you speak, and other details.  If your question can be answered by the phone itself (“Would you set my alarm for eight a.m.?”), the Cloud request is canceled.  If Siri needs to pull data from the web (“Is it going to rain tomorrow?”), to the Cloud it goes, and the request is analyzed by another array of models and tools.

The history of artificial intelligence is quite fascinating.  I wrote about that and related topics here: http://boolefund.com/future-of-the-mind/

(Photo by Christian Lagereek)

One recent divide in AI is whether the computer should learn through symbolic reasoning or through repeated exposure to extensive data sets.  When it comes to perception — computer vision, computer speech, pattern recognition — the data-driven approach works best.  Machine learning is another term for this type of approach.

One problem with machine-learned models, however, is that a human can have a hard time understanding what the computer actually “knows.”

Consider chess.  At some point, computing power will be great enough that a computer will be able to “solve” the game of chess by figuring out every single possible chain of moves.  Perhaps white can always win.  Would we say that such a supercomputer is “intelligent”?  A program like this is similar to an extremely high-powered calculator.  We don’t say that calculators are “intelligent” just because they can quickly and accurately compute using astronomical numbers.

Part of the problem is that we still have much to learn about how the human brain works.

 

DESIGNED IN CALIFORNIA, MADE IN CHINA

Merchant writes about his visit to China:

The vast majority of plants that produce the iPhone’s component parts and carry out the devices’s final assembly are based here, in the People’s Republic, where low labor costs and a massive, highly skilled workforce have made the nation an ideal place to manufacture iPhones (and just about every other gadget).  The country’s vast, unprecedented production capabilities — the U.S. Bureau of Labor Statistics estimated that as of 2009 there were ninety-nine million factory workers in China — has helped the nation become the world’s largest economy.  And since the first iPhone shipped, the company doing the lion’s share of the manufacturing is the Taiwanese Hon Hai Precision Industry Company, Ltd., better known by its trade name, Foxconn.

Foxconn is the single largest employer on mainland China; there are 1.3 million people on its payroll.  Worldwide, among corporations, only Walmart and McDonald’s employ more.  As of 2016, that was more than twice as many people working for the five most valuable tech companies in the United States — Apple (66,000), Alphabet (70,000), Amazon (270,000), Microsoft (64,000), and Facebook (16,000) — combined.

(Wikimedia Commons)

Foxconn was in the news when it was learned that many of its workers were committing suicide.

The epidemic caused a media sensation — suicides and sweatshop conditions in the House of iPhone.  Suicide notes and survivors told of immense stress, long workdays, and harsh managers who were prone to humiliate workers for mistakes; of unfair fines and unkept promises of benefits.

Foxconn CEO Terry Gou installed large nets outside many of the buildings to catch falling bodies.  The company also hired counselors, and made workers sign no-suicide pledges.  Steve Jobs remarked that the suicide rates at Foxconn were within the national averages and were lower than at many U.S. universities.  Perhaps not the best thing to say, although technically accurate.

Merchant continues:

Shenzhen was the first SEZ, or special economic zone, that China opened to foreign companies, beginning in 1980.  At that time, it was a fishing village that was home to some twenty-five thousand people.  In one of the most remarkable urban transformations in history, today, Shenzhen is China’s third-largest city, home to towering skyscrapers, millions of residents, and, of course, sprawling factories.  And it pulled off the feat in part by becoming the world’s gadget factory.  An estimated 90 percent of the world’s consumer electronics pass through Shenzhen.

Many, if not most, Chinese people believe strongly in hard work and constant improvement.  They are driven in part by the memory or knowledge of how poor most Chinese were in the recent past.  They fear that if they don’t work hard and keep improving, they’ll become very poor again.

Merchant spoke with as many people as he could.  But he’s careful to note that he didn’t get a truly representative sample, which would have required a massive canvassing effort and interviewing thousands of employees.

Merchant learned that most workers viewed the pace of work as relentless.  They agreed that most workers only last a year.

Also, many thought that the management culture was cruel.  Managers often used public condemnation if a mistake was made or if quota wasn’t met.  Workers were frequently expected to stay silent.  Even asking to use the restroom was often met with a rebuke.

(Protest in 2011 outside new Apple Store in Hong Kong, Photo by SACOM, Wikimedia Commons)

Many Chinese workers would like to work for Huawei, a Chinese smartphone competitor.  When one worker went to the recruiting office, they told him Huawei was full.  But it wasn’t.  He feels he was tricked into working for Foxconn.  He suspects Foxconn has a deal with the recruiter.

Furthermore, Foxconn often didn’t keep promises.  They offered free housing, but then charged exorbitant prices for electricity and water.  Also, bonuses were often delayed.  Moreover, many workers were told they would get overtime pay, but then received regular pay.  Many workers were promised a raise but never got one.

 

SELLPHONE

Merchant writes:

…Simply put, the iPhone would not be what it is today were it not for Apple’s extraordinary marketing and retail strategies.  It is in a league of its own in creating want, fostering demand, and broadcasting technological cool.  By the time the iPhone was actually announced in 2007, speculation and rumor over the device had reached a fever pitch, generating a hype that few to no marketing departments are capable of ginning up.

Of course, the product itself is impressive, and has to be for these marketing tactics to work so well.

(2010 Photo by Matthew Yohe)

In the late 1990s or early 2000s, Jobs began to use secrecy much more than before.  The “magical” aspect of a new Apple product is heightened by the use of secrecy.

At the same time, Apple uses scarcity.  After launching a new iPhone, Apple deliberately keeps the supplies artificially low for at least a few weeks.  In general, if something humans want is scarce, they tend to want it significantly more.  A well-known psychological fact that Apple carefully exploits.

 

THE BLACK MARKET

Merchant:

Huaqiangbei is a bustling downtown bazaar: crowded streets, neon lights, sidewalk vendors, and chain smokers.  My fixer Wang and I wander into SEG Electronics Plaza, a series of gadget markets surrounding a towering ten-story Best-Buy-on-acid on Huaqiangbei Road.  Drones whir, high-end gaming consoles flash, and customers inspect cases of chips.  Someone bumbles by on a Hoverboard.  A couple shops over, a clustor of kiosks hock knockoff smartphones at deep discount.  One saleswoman tries to sell me an iPhone 6 that’s running Google’s Android operating system.  Another pitches a shiny Huawei phone for about twenty dollars.

(Huaqiangbei electronics market, Photo by Lzf)

Merchant, a bit later:

In downtown Shenzhen, a couple blocks from the famed electronics market, this smoky four-story building the size of a suburban minimall is an emporium for refurbished, reused, and black-market iPhones.  You have to see it to believe it.  I’ve never seen so many iPhones in one place — not at an Apple store, not raised by the crowd at a rock concert, not at CES.  This is just piles and piles of iPhones of every color, model, and stripe.

Some booths are tricked-out repair stalls where young men and women examine iPhones with magnifying glasses and disassemble them with an array of tiny tools.  There are entire stalls filled with what must be thousands of tiny little camera lenses.  Others advertise custom casings… Another table has a huge pile of silver bitten-Apple logos that a man is separating and meting out.  And it’s packed full of shoppers, buyers, repair people, all talking and smoking and poring over iPhone paraphernalia.

Some of the tables don’t sell iPhones to individuals but to wholesale buyers.  Counterfeits are one thing.  But these iPhones are virtually indistinguishable from the real thing.

Obvious counterfeits don’t last long:

In 2015, China shut down a counterfeit iPhone factory in Shenzhen, believed to have made some forty-one thousand phones out of secondhand parts.  And you may have read headlines about counterfeit iPhone rings being busted up in the United States too, from time to time.  In 2016, eleven thousand counterfeit iPhones and Samsung phones worth an estimated eight million dollars were seized in an NYPD raid.  In 2013, border security agents seized two hundred and fifty thousand dollars’ worth of counterfeit iPhones from a Miami shop owner who says he sourced his parts legitimately.

But counterfeits are generally easy to spot because they won’t be compatible with specific software or they’ll have obvious glitches.  So any iPhone that works like an iPhone is an iPhone, notes Merchant.  Those iPhones available on the black market that have been made with iPhone parts are, for all practical purposes, iPhones, right?

Apple discourages customers from getting inside their phones.  It uses proprietary screws.  It issues takedown requests on grounds of copyright to blogs that post repair manuals.  It voids warranties if anyone tries to repair their own phone or hires a thiry-party to do so.  Apple does not sell any replacement parts for iPhones; customers have to pay Apple to do it, often at high prices.

 

THE ONE DEVICE

Merchant:

There’s a reason that all those software engineers had migrated to the interface designers’ home base — the iPhone was built on intense collaboration between the two camps.  Designers could pop over to an engineer to see if a new idea was workable.  The engineer could tell them which elements needed to be adjusted.  It was unusual, even for Apple, for teams to be so tightly integrated.

“One of the important things to note about the iPhone team was there was a spirit of ‘We’re all in this together,'” Richard Williamson says.  “There was a ton of collaboration across the whole stack, all the way from Bas Ording doing innovative UI mock-ups down to the OS team with John Wright doing modifications to the kernel.  And we could do this because we were all actually in this lockdown area.  It was maybe just forty people at the max, but we had this hub right above Jony Ive’s design studio.  In Infinite Loop Two, you had to have a second access key to get in there.  We pretty much lived there for a couple of years.”

(Photo by Rafal Olechowski)

The team was composed of brilliant engineers across the board.  They worked long hours, and constantly collaborated.  They would sit down together and figure it out as they went.  Many ideas that would have been delayed, or even dismissed, under most circumstances became workable in short order.

Williamson credits Steve Jobs with creating essentially a start-up inside a large company.  Put the best engineers together on the most promising project, insulate them from everyone else, push them to meet very high expectations, and give them unlimited resources.

The team was very focused on making the iPhone easy and intuitive to use.  They thought carefully about how people manipulate physical things in their daily life.  They wanted these movements to give users clues about how to use the iPhone.  It goes without saying there would never be a user’s manual — that would be a failure by the team.

Then there was hardware.  Merchant spoke with Tony Fadell:

“We had to get all kinds of experts involved,” he says.  “third-party suppliers to help.  We had to basically make a touchscreen company.”  Apple hired dozens of people to execute the multitouch hardware alone.  “The team itself was forty, fifty people just to do touch,” Fadell says.  The touch sensors they needed to manufacture were not widely available yet.  TPK, the small Taiwanese firm they found to mass-manufacture them, would boom into a multibillion-dollar company, largely on the strength of that one contract.  And that was just touch — they were going to need Wi-Fi modules, multiple sensors, a tailor-made CPU, a suitable screen, and more.

Tony Fadell called the project “a moon shot… like the Apollo project.”

(Apollo program insignia, by NASA, Wikimedia Commons)

There was never enough people and never enough time.  People worked seriously hard.  Vacations and holidays were out of the question.  There were quite a few divorces.

Merchant spoke with Evan Doll, who was on the iPhone team:

The ENRI team created a batch of interaction demos on an experimental touchscreen rig — right before Apple needed a successor to the iPod.  FingerWorks came to market with consumer-friendly multitouch — just in time for the ENRI crew to use it as a foundation.  Computer chips had to shrink.  “So much of it is timing and getting lucky,” Doll says.  “Maybe the ARM chips that powered the iPhone had been in development for a very long time, and maybe fortuitously had reached a happy place in terms of their capabilities.  The stars aligned.”  They also aligned with lithium-ion battery technology, and with the compacting of cameras.  With the accretion of China’s skilled labor force, and the surfeit of cheaper metals around the world.  The list goes on.  “It’s not just a question of waking up one morning in 2006 and deciding that you’re doing to build the iPhone; it’s a matter of making these nonintuitive investments and failed products and crazy experimentation — and being able to operate on this huge timescale,” Doll says. “Most companies aren’t able to do that.  Apple almost wasn’t able to do that.”

While Steve Jobs will always be associated with the iPhone, it’s clear that a great many people contributed to its creation.

Proving the lone-inventor myth inadequate does not diminish Jobs’s role as curator, editor, bar-setter — it elevates the role of everyone else to show he was not alone in making it possible.  I hope my jaunt into the heart of the iPhone has helped demonstrate that the one device is the work of countless inventors and factory workers, miners and recyclers, brilliant thinkers and child laborers, and revolutionary designers and cunning engineers.  Of long-evolving technologies, of collaborative, incremental work, of fledgling startups and massive public-research institutions.

 

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 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  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)

January 28, 2018

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 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Common Stocks and Common Sense

(Image:  Zen Buddha Silence by Marilyn Barbone)

Januuary 21, 2018

It’s crucial in investing to have the proper balance of confidence and humility.  Overconfidence is very deep-seated in human nature.  Nearly all of us tend to believe that we’re above average across a variety of dimensions, such as looks, smarts, academic ability, business aptitude, driving skill, and even luck (!).

Overconfidence is often harmless and it even helps in some areas.  But when it comes to investing, if we’re overconfident about what we know and can do, eventually our results will suffer.

(Image by Wilma64)

The simple truth is that the vast majority of us should invest in broad market low-cost index funds.  Buffett has maintained this argument for a long time: http://boolefund.com/warren-buffett-jack-bogle/

The great thing about investing in index funds is that you can outperform most investors, net of costs, over the course of several decades.  This is purely a function of costs.  A Vanguard S&P 500 index fund costs 2-3% less per year than the average actively managed fund.  This means that, after a few decades, you’ll be ahead of roughly 90% (or more) of all active investors.

You can do better than a broad market index fund if you invest in a solid quantitative value fund.  Such a fund can do at least 1-2% better per year, on average and net of costs, than a broad market index fund.

But you can do even better—at least 5% better per year than the S&P 500 index—by investing in a quantitative value fund focused on microcap stocks.

  • At the Boole Microcap Fund, our mission is to help you do at least 5% better per year, on average, than an S&P 500 index fund.  We achieve this by implementing a quantitative deep value approach focused on cheap micro caps with improving fundamentals.  See: http://boolefund.com/best-performers-microcap-stocks/

 

I recently re-read Common Stocks and Common Sense (Wiley, 2016), by Edgar Wachenheim III.  It’s a wonderful book.  Wachenheim is one of the best value investors.  He and his team at Greenhaven Associates have produced 19% annual returns for over 25 years.

Wachenheim emphasizes that, due to certain behavioral attributes, he has outperformed many other investors who are as smart or smarter.  As Warren Buffett has said:

Success in investing doesn’t correlate with IQ once you’re above the level of 125.  Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

That’s not to say IQ isn’t important.  Most of the finest investors are extremely smart.  Wachenheim was a Baker Scholar at Harvard Business School, meaning that he was in the top 5% of his class.

The point is that—due to behavioral factors such as patience, discipline, and rationality—top investors outperform many other investors who are as smart or smarter.  Buffett again:

We don’t have to be smarter than the rest; we have to be more disciplined than the rest.

Buffett himself has always been extraordinarily patient and disciplined.  There have been several times in Buffett’s career when he went for years on end without making a single investment.

Wachenheim highlights three behavioral factors that have helped him outperform others of equal or greater talent.

The bulk of Wachenheim’s book—chapters 3 through 13—is case studies of specific investments.  Wachenheim includes a good amount of fascinating business history, some of which is mentioned here.

Outline for this blog post:

  • Approach to Investing
  • Being a Contrarian
  • Probable Scenarios
  • Controlling Emotions
  • IBM
  • Interstate Bakeries
  • U.S. Home Corporation
  • Centex
  • Union Pacific
  • American International Group
  • Lowe’s
  • Whirlpool
  • Boeing
  • Southwest Airlines
  • Goldman Sachs

(Photo by Lsaloni)

 

APPROACH TO INVESTING

From 1960 through 2009 in the United States, common stocks have returned about 9 to 10 percent annually (on average).

The U.S. economy grew at roughly a 6 percent annual rate—3 percent from real growth (unit growth) and 3 percent from inflation (price increases).  Corporate revenues—and earnings—have increased at approximately the same 6 percent annual rate.  Share repurchases and acquisitions have added 1 percent a year, while dividends have averaged 2.5 percent a year.  That’s how, on the whole, U.S. stocks have returned 9 to 10 percent annually, notes Wachenheim.

Even if the economy grows more slowly in the future, Wachenheim argues that U.S. investors should still expect 9 to 10 percent per year.  In the case of slower growth, corporations will not need to reinvest as much of their cash flows.  That extra cash can be used for dividends, acquisitions, and share repurchases.

Following Warren Buffett and Charlie Munger, Wachenheim defines risk as the potential for permanent loss.  Risk is not volatility.

Stocks do fluctuate up and down.  But every time the market has declined, it has ultimately recovered and gone on to new highs.  The financial crisis in 2008-2009 is an excellent example of large—but temporary—downward volatility:

The financial crisis during the fall of 2008 and the winter of 2009 is an extreme (and outlier) example of volatility.  During the six months between the end of August 2008 and end of February 2009, the [S&P] 500 Index fell by 42 percent from 1,282.83 to 735.09.  Yet by early 2011 the S&P 500 had recovered to the 1,280 level, and by August 2014 it had appreciated to the 2000 level.  An investor who purchased the S&P 500 Index on August 31, 2008, and then sold the Index six years later, lived through the worst financial crisis and recession since the Great Depression, but still earned a 56 percent profit on his investment before including dividends—and 69 percent including the dividends that he would have received during the six-year period.  Earlier, I mentioned that over a 50-year period, the stock market provided an average annual return of 9 to 10 percent.  During the six-year period August 2008 through August 2014, the stock market provided an average annual return of 11.1 percent—above the range of normalcy in spite of the abnormal horrors and consequences of the financial crisis and resulting deep recession.

(Photo by Terry Mason)

Wachenheim notes that volatility is the friend of the long-term investor.  The more volatility there is, the more opportunity to buy at low prices and sell at high prices.

Because the stock market increases on average 9 to 10 percent per year and always recovers from declines, hedging is a waste of money over the long term:

While many investors believe that they should continually reduce their risks to a possible decline in the stock market, I disagree.  Every time the stock market has declined, it eventually has more than fully recovered.  Hedging the stock market by shorting stocks, or by buying puts on the S&P 500 Index, or any other method usually is expensive, and, in the long run, is a waste of money.

Wachenheim describes his investment strategy as buying deeply undervalued stocks of strong and growing companies that are likely to appreciate significantly due to positive developments not yet discounted by stock prices.

Positive developments can include:

  • a cyclical upturn in an industry
  • an exciting new product or service
  • the sale of a company to another company
  • the replacement of a poor management with a good one
  • a major cost reduction program
  • a substantial share repurchase program

If the positive developments do not occur, Wachenheim still expects the investment to earn a reasonable return, perhaps close to the average market return of 9 to 10 percent annually.  Also, Wachenheim and his associates view undervaluation, growth, and strength as providing a margin of safety—protection against permanent loss.

Wachenheim emphasizes that at Greenhaven, they are value investors not growth investors.  A growth stock investor focuses on the growth rate of a company.  If a company is growing at 15 percent a year and can maintain that rate for many years, then most of the returns for a growth stock investor will come from future growth.  Thus, a growth stock investor can pay a high P/E ratio today if growth persists long enough.

Wachenheim disagrees with growth investing as a strategy:

…I have a problem with growth-stock investing.  Companies tend not to grow at high rates forever.  Businesses change with time.  Markets mature.  Competition can increase.  Good managements can retire and be replaced with poor ones.  Indeed, the market is littered with once highly profitable growth stocks that have become less profitable cyclic stocks as a result of losing their competitive edge.  Kodak is one example.  Xerox is another.  IBM is a third.  And there are hundreds of others.  When growth stocks permanently falter, the price of their shares can fall sharply as their P/E ratios contract and, sometimes, as their earnings fall—and investors in the shares can suffer serious permanent loss.

Many investors claim that they will be able to sell before a growth stock seriously declines.  But very often it’s difficult to determine whether a company is suffering from a temporary or permanent decline.

Wachenheim observes that he’s known many highly intelligent investors—who have similar experiences to him and sensible strategies—but who, nonetheless, haven’t been able to generate results much in excess of the S&P 500 Index.  Wachenheim says that a key point of his book is that there are three behavioral attributes that a successful investor needs:

In particular, I believe that a successful investor must be adept at making contrarian decisions that are counter to the conventional wisdom, must be confident enough to reach conclusions based on probabilistic future developments as opposed to extrapolations of recent trends, and must be able to control his emotions during periods of stress and difficulties.  These three behavioral attributes are so important that they merit further analysis.

 

BEING A CONTRARIAN

(Photo by Marijus Auruskevicius)

Most investors are not contrarians because they nearly always follow the crowd:

Because at any one time the price of a stock is determined by the opinion of the majority of investors, a stock that appears undervalued to us appears appropriately valued to most other investors.  Therefore, by taking the position that the stock is undervalued, we are taking a contrarian position—a position that is unpopular and often is very lonely.  Our experience is that while many investors claim they are contrarians, in practice most find it difficult to buck the conventional wisdom and invest counter to the prevailing opinions and sentiments of other investors, Wall Street analysts, and the media.  Most individuals and most investors simply end up being followers, not leaders.

In fact, I believe that the inability of most individuals to invest counter to prevailing sentiments is habitual and, most likely, a genetic trait.  I cannot prove this scientifically, but I have witnessed many intelligent and experienced investors who shunned undervalued stocks that were under clouds, favored fully valued stocks that were in vogue, and repeated this pattern year after year even though it must have become apparent to them that the pattern led to mediocre results at best.

Wachenheim mentions a fellow investor he knows—Danny.  He notes that Danny has a high IQ, attended an Ivy League university, and has 40 years of experience in the investment business.  Wachenheim often describes to Danny a particular stock that is depressed for reasons that are likely temporary.  Danny will express his agreement, but he never ends up buying before the problem is fixed.

In follow-up conversations, Danny frequently states that he’s waiting for the uncertainty to be resolved.  Value investor Seth Klarman explains why it’s usually better to invest before the uncertainty is resolved:

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain.  Yet high uncertainty is frequently accompanied by low prices.  By the time the uncertainty is resolved, prices are likely to have risen.  Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.  The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

 

PROBABLE SCENARIOS

(Image by Alain Lacroix)

Many (if not most) investors tend to extrapolate recent trends into the future.  This usually leads to underperforming the market.  See:

The successful investor, by contrast, is a contrarian who can reasonably estimate future scenarios and their probabilities of occurrence:

Investment decisions seldom are clear.  The information an investor receives about the fundamentals of a company usually is incomplete and often is conflicting.  Every company has present or potential problems as well as present or future strengths.  One cannot be sure about the future demand for a company’s products or services, about the success of any new products or services introduced by competitors, about future inflationary cost increases, or about dozens of other relevant variables.  So investment outcomes are uncertain.  However, when making decisions, an investor often can assess the probabilities of certain outcomes occurring and then make his decisions based on the probabilities.  Investing is probabilistic.

Because investing is probabilitistic, mistakes are unavoidable.  A good value investor typically will have at least 33% of his or her ideas not work, whether due to an error, bad luck, or an unforeseeable event.  You have to maintain equanimity despite inevitable mistakes:

If I carefully analyze a security and if my analysis is based on sufficiently large quantities of accurate information, I always will be making a correct decision.  Granted, the outcome of the decision might not be as I had wanted, but I know that decisions always are probabilistic and that subsequent unpredictable changes or events can alter outcomes.  Thus, I do my best to make decisions that make sense given everything I know, and I do not worry about the outcomes.  An analogy might be my putting game in golf.  Before putting, I carefully try to assess the contours and speed of the green.  I take a few practice strokes.  I aim the putter to the desired line.  I then putt and hope for the best.  Sometimes the ball goes in the hole…

 

CONTROLLING EMOTION

(Photo by Jacek Dudzinski)

Wachenheim:

I have observed that when the stock market or an individual stock is weak, there is a tendency for many investors to have an emotional response to the poor performance and to lose perspective and patience.  The loss of perspective and patience often is reinforced by negative reports from Wall Street and from the media, who tend to overemphasize the significance of the cause of the weakness.  We have an expression that aiplanes take off and land every day by the tens of thousands, but the only ones you read about in the newspapers are the ones that crash.  Bad news sells.  To the extent that negative news triggers further selling pressures on stocks and further emotional responses, the negativism tends to feed on itself.  Surrounded by negative news, investors tend to make irrational and expensive decisions that are based more on emotions than on fundamentals. This leads to the frequent sale of stocks when the news is bad and vice versa.  Of course, the investor usually sells stocks after they already have materially decreased in price.  Thus, trading the market based on emotional reactions to short-term news usually is expensive—and sometimes very expensive.

Wachenheim agrees with Seth Klarman that, to a large extent, many investors simply cannot help making emotional investment decisions.  It’s part of human nature.  People overreact to recent news.

I have continually seen intelligent and experienced investors repeatedly lose control of their emotions and repeatedly make ill-advised decisions during periods of stress.

That said, it’s possible (for some, at least) to learn to control your emotions.  Whenever there is news, you can learn to step back and look at your investment thesis.  Usually the investment thesis remains intact.

 

IBM

(IBM Watson by Clockready, Wikimedia Commons)

When Greenhaven purchases a stock, it focuses on what the company will be worth in two or three years.  The market is more inefficient over that time frame due to the shorter term focus of many investors.

In 1993, Wachenheim estimated that IBM would earn $1.65 in 1995.  Any estimate of earnings two or three years out is just a best guess based on incomplete information:

…having projections to work with was better than not having any projections at all, and my experience is that a surprisingly large percentage of our earnings and valuation projections eventually are achieved, although often we are far off on the timing.

The positive development Wachenheim expected was that IBM would announce a concrete plan to significantly reduce its costs.  On July 28, 1993, the CEO Lou Gerstner announced such a plan.  When IBM’s shares moved up from $11½ to $16, Wachenheim sold his firm’s shares since he thought the market price was now incorporating the expected positive development.

Selling IBM at $16 was a big mistake based on subsequent developments.  The company generated large amounts of cash, part of which it used to buy back shares.  By 1996, IBM was on track to earn $2.50 per share.  So Wachenheim decided to repurchase shares in IBM at $24½.  Although he was wrong to sell at $16, he was right to see his error and rebuy at $24½.  When IBM ended up doing better than expected, the shares moved to $48 in late 1997, at which point Wachenheim sold.

Over the years, I have learned that we can do well in the stock market if we do enough things right and if we avoid large permanent losses, but that it is impossible to do nearly everything right.  To err is human—and I make plenty of errors.  My judgment to sell IBM’s shares in 1993 at $16 was an expensive mistake.  I try not to fret over mistakes.  If I did fret, the investment process would be less enjoyable and more stressful.  In my opinion, investors do best when they are relaxed and are having fun.

Finding good ideas takes time.  Greenhaven rejects the vast majority of its potential ideas.  Good ideas are rare.

 

INTERSTATE BAKERIES

(Photo of a bakery by Mohylek, Wikimedia Commons)

Wachenheim discovered that Howard Berkowitz bought 12 percent of the outstanding shares of Interstate Bakeries, became chairman of the board, and named a new CEO.  Wachenheim believed that Howard Berkowitz was an experienced and astute investor.  In 1967, Berkowitz was a founding partner of Steinhardt, Fine, Berkowitz & Co., one of the earliest and most successful hedge funds.  Wachenheim started analyzing Interstate in 1985 when the stock was at about $15:

Because of my keen desire to survive by minimizing risks of permanent loss, the balance sheet then becomes a good place to start efforts to understand a company.  When studying a balance sheet, I look for signs of financial and accounting strengths.  Debt-to-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and ‘hidden’ assets and liabilities all are among common considerations, with their relative importance depending on the situation.  If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise.  

Wachenheim looks at management after he is done analyzing the balance sheet.  He admits that he is humble about his ability to assess management.  Also, good or bad results are sometimes due in part to chance.

Next Wachenheim examines the business fundamentals:

We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital.  Because we believe that information reduces uncertainty, we try to gather as much information as possible.  We read and think—and we sometimes speak to customers, competitors, and suppliers.  While we do interview the managements of the companies we analyze, we are wary that their opinions and projections will be biased.

Wachenheim reveals that the actual process of analyzing a company is far messier than you might think based on the above descriptions:

We constantly are faced with incomplete information, conflicting information, negatives that have to be weighed against positives, and important variables (such as technological change or economic growth) that are difficult to assess and predict.  While some of our analysis is quantitative (such as a company’s debt-to-equity ratio or a product’s share of market), much of it is judgmental.  And we need to decide when to cease our analysis and make decisions.  In addition, we constantly need to be open to new information that may cause us to alter previous opinions or decisions.

Wachenheim indicates a couple of lessons learned.  First, it can often pay off when you follow a capable and highly incentivized business person into a situation.  Wachenheim made his bet on Interstate based on his confidence in Howard Berkowitz.  Interstate’s shares were not particularly cheap.

Years later, Interstate went bankrupt because they took on too much debt.  This is a very important lesson.  For any business, there will be problems.  Working through difficulties often takes much longer than expected.  Thus, having low or no debt is essential.

 

U.S. HOME CORPORATION

(Photo by Dwight Burdette, Wikimedia Commons)

Wachenheim describes his use of screens:

I frequently use Bloomberg’s data banks to run screens.  I screen for companies that are selling for low price-to-earnings (PE) ratios, low prices to revenues, low price-to-book values, or low prices relative to other relevant metrics.  Usually the screens produce a number of stocks that merit additional analyses, but almost always the additional analyses conclude that there are valid reasons for the apparent undervaluations. 

Wachenheim came across U.S. Home in mid-1994 based on a discount to book value screen.  The shares appeared cheap at 0.63 times book and 6.8 times earnings:

Very low multiples of book and earnings are adrenaline flows for value investors.  I eagerly decided to investigate further.

Later, although U.S. Home was cheap and produced good earnings, the stock price remained depressed.  But there was a bright side because U.S. Home led to another homebuilder idea…

 

CENTEX CORPORATION

(Photo by Steven Pavlov, Wikimedia Commons)

After doing research and constructing a financial model of Centex Corporation, Wachenheim had a startling realization:  the shares would be worth about $63 a few years in the future, and the current price was $12.  Finally, a good investment idea:

…my research efforts usually are tedious and frustrating.  I have hundreds of thoughts and I study hundreds of companies, but good investment ideas are few and far between.  Maybe only 1 percent or so of the companies we study ends up being part of our portfolios—making it much harder for a stock to enter our portfolio than for a student to enter Harvard.  However, when I do find an exciting idea, excitement fills the air—a blaze of light that more than compensates for the hours and hours of tedium and frustration.

Greenhaven typically aims for 30 percent annual returns on each investment:

Because we make mistakes, to achieve 15 to 20 percent average returns, we usually do not purchase a security unless we believe that it has the potential to provide a 30 percent or so annual return.  Thus, we have very high expectations for each investment.

In late 2005, Wachenheim grew concerned that home prices had gotten very high and might decline.  Many experts, including Ben Bernanke, argued that because home prices had never declined in U.S. history, they were unlikely to decline.  Wachenheim disagreed:

It is dangerous to project past trends into the future.  It is akin to steering a car by looking through the rearview mirror…

 

UNION PACIFIC

(Photo by Slambo, Wikimedia Commons)

After World War II, the construction of the interstate highway system gave trucks a competitive advantage over railroads for many types of cargo.  Furthermore, fewer passengers took trains, partly due to the interstate highway system and partly due to the commercialization of the jet airplane.  Excessive regulation of the railroadsin an effort to help farmersalso caused problems.  In the 1960s and 1970s, many railroads went bankrupt.  Finally, the government realized something had to be done and it passed the Staggers Act in 1980, deregulating the railroads:

The Staggers Act was a breath of fresh air.  Railroads immediately started adjusting their rates to make economic sense.  Unprofitable routes were dropped.  With increased profits and with confidence in their future, railroads started spending more to modernize.  New locomotives, freight cars, tracks, automated control systems, and computers reduced costs and increased reliability.  The efficiencies allowed the railroads to reduce their rates and become more competitive with trucks and barges….

In the 1980s and 1990s, the railroad industry also enjoyed increased efficiencies through consolidating mergers.  In the west, the Burlington Northern merged with the Santa Fe, and the Union Pacific merged with the Southern Pacific.  

Union Pacific reduced costs during the 2001-2002 recession, but later this led to congestion on many of its routes and to the need to hire and train new employees once the economy had picked up again.  Union Pacific experienced an earnings shortfall, leading the shares to decline to $14.86.

Wachenheim thought that Union Pacific’s problems were temporary, and that the company would earn about $1.55 in 2006.  With a conservative multiple of 14 times earnings, the shares would be worth over $22 in 2006.  Also, the company was paying a $0.30 annual dividend.  So the total return over a two-year period from buying the shares at $14½ would be 55 percent.

Wachenheim also thought Union Pacific stock had good downside protection because the book value was $12 a share.

Furthermore, even if Union Pacific stock just matched the expected return from the S&P 500 Index of 9½ percent a year, that would still be much better than cash.

The fact that the S&P 500 Index increases about 9½ percent a year is an important reason why shorting stocks is generally a bad business.  To do better than the market, the short seller has to find stocks that underperform the market by 19 percent a year.  Also, short sellers have limited potential gains and unlimited potential losses.  On the whole, shorting stocks is a terrible business and often even the smartest short sellers struggle.

Greenhaven sold its shares in Union Pacific at $31 in mid-2007, since other investors had recognized the stock’s value.  Including dividends, Greenhaven earned close to a 24 percent annualized return.

Wachenheim asks why most stock analysts are not good investors.  For one, most analysts specialize in one industry or in a few industries.  Moreover, analysts tend to extrapolate known information, rather than define future scenarios and their probabilities of occurrence:

…in my opinion, most individuals, including securities analysts, feel more comfortable projecting current fundamentals into the future than projecting changes that will occur in the future.  Current fundamentals are based on known information.  Future fundamentals are based on unknowns.  Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking one’s neck out—all efforts that human beings too often prefer to avoid.

Also, I believe it is difficult for securities analysts to embrace companies and industries that currently are suffering from poor results and impaired reputations.  Often, securities analysts want to see tangible proof of better results before recommending a stock.  My philosophy is that life is not about waiting for the storm to pass.  It is about dancing in the rain.  One usually can read a weather map and reasonably project when a storm will pass.  If one waits for the moment when the sun breaks out, there is a high probability others already will have reacted to the improved prospects and already will have driven up the price of the stock—and thus the opportunity to earn large profits will have been missed.

Wachenheim then quotes from a New York Times op-ed piece written on October 17, 2008, by Warren Buffett:

A simple rule dictates my buying:  Be fearful when others are greedy, and be greedy when others are fearful.  And most certainly, fear is now widespread, gripping even seasoned investors.  To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions.  But fears regarding the long-term prosperity of the nation’s many sound companies make no sense.  These businesses will indeed suffer earnings hiccups, as they always have.  But most major companies will be setting new profit records 5, 10, and 20 years from now.  Let me be clear on one point:  I can’t predict the short-term movements of the stock market.  I haven’t the faintest idea as to whether stocks will be higher or lower a month—or a year—from now.  What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up.  So if you wait for the robins, spring will be over.

 

AMERICAN INTERNATIONAL GROUP

(AIG Corporate, Photo by AIG, Wikimedia Commons)

Wachenheim is forthright in discussing Greenhaven’s investment in AIG, which turned out to be a huge mistake.  In late 2005, Wachenheim estimated that the intrinsic value of AIG would be about $105 per share in 2008, nearly twice the current price of $55.  Wachenheim also liked the first-class reputation of the company, so he bought shares.

In late April 2007, AIG’s shares had fallen materially below Greenhaven’s cost basis:

When shares of one of our holdings are weak, we usually revisit the company’s longer-term fundamentals.  If the longer-term fundamentals have not changed, we normally will continue to hold the shares, if not purchase more.  In the case of AIG, it appeared to us that the longer-term fundamentals remained intact.

When Lehman filed for Chapter 11 bankruptcy protection on September 15, 2008, all hell broke loose:

The decline in asset values caused financial institutions to mark down the carrying value of their assets, which, in turn, caused sharp reductions in their credit ratings.  Sharp reductions in credit ratings required financial institutions to raise capital and, in the case of AIG, to post collateral on its derivative contracts.  But the near freezing of the financial markets prevented the requisite raising of capital and cash and thus caused a further deterioration in creditworthiness, which further increased the need for new capital and cash, and so on… On Tuesday night, September 16, the U.S. government agreed to provide the requisite cash in return for a lion’s share of the ownership of AIG.  As soon as I read the agreement, it was clear to me that we had a large permanent loss in our holdings of AIG.

Wachenheim defends the U.S. government bailouts.  Much of the problem was liquidity, not solvency.  Also, the bailouts helped restore confidence in the financial system.

Wachenheim asked himself if he would make the same decision today to invest in AIG:

My answer was ‘yes’—and my conclusion was that, in the investment business, relatively unpredictable outlier developments sometimes can quickly derail otherwise attractive investments.  It comes with the territory.  So while we work hard to reduce the risks of large permanent loss, we cannot completely eliminate large risks.  However, we can draw a line on how much risk we are willing to accept—a line that provides sufficient apparent protection and yet prevents us from being so risk averse that we turn down too many attractive opportunities.  One should not invest with the precept that the next 100-year storm is around the corner.

Wachenheim also points out that when Greenhaven learns of a flaw in its investment thesis, usually the firm is able to exit the position with only a modest loss.  If you’re right 2/3 of the time and if you limit losses as much as possible, the results should be good over time.

 

LOWE’S

(Photo by Miosotis Jade, Wikimedia Commons)

In 2011, Wachenheim carefully analyzed the housing market and reached an interesting conclusion:

I was excited that we had a concept about a probable strong upturn in the housing market that was not shared by most others.  I believed that the existing negativism about housing was due to the proclivity of human beings to uncritically project recent trends into the future and to overly dwell on existing problems.  When analyzing companies and industries, I tend to be an optimist by nature and a pragmatist through effort.  In terms of the proverbial glass of water, it is never half empty, but always half full—and, as a pragmatist, it is twice as large as it needs to be.

Next Wachenheim built a model to estimate normalized earnings for Lowe’s three years in the future (in 2014).  He came up with normal earnings of $3 per share.  He thought the appropriate price-to-earnings ratio was 16.  So the stock would be worth $48 in 2014 versus its current price (in 2011) of $24.  It looked like a bargain.

After gathering more information, Wachenheim revised his earnings model:

…I revise models frequently because my initial models rarely are close to being accurate.  Usually, they are no better than directional.  But they usually do lead me in the right direction, and, importantly, the process of constructing a model forces me to consider and weigh the central fundamentals of a company that will determine the company’s future value.

Wachenheim now thought that Lowe’s could earn close to $4.10 in 2015, which would make the shares worth even more than $48.  In August 2013, the shares hit $45.

In late September 2013, after playing tennis, another money manager asked Wachenheim if he was worried that the stock market might decline sharply if the budget impasse in Congress led to a government shutdown:

I answered that I had no idea what the stock market would do in the near term.  I virtually never do.  I strongly believe in Warren Buffett’s dictum that he never has an opinion on the stock market because, if he did, it would not be any good, and it might interfere with opinions that are good.  I have monitored the short-term market predictions of many intelligent and knowledgeable investors and have found that they were correct about half the time.  Thus, one would do just as well by flipping a coin.

I feel the same way about predicting the short-term direction of the economy, interest rates, commodities, or currencies.  There are too many variables that need to be identified and weighed.

As for Lowe’s, the stock hit $67.50 at the end of 2014, up 160 percent from what Greenhaven paid.

 

WHIRLPOOL CORPORATION

(Photo by Steven Pavlov, Wikimedia Commons)

Wachenheim does not believe in the Efficient Market Hypothesis:

It seems to me that the boom-bust of growth stocks in 1968-1974 and the subsequent boom-bust of Internet technology stocks in 1998-2002 serve to disprove the efficient market hypothesis, which states that it is impossible for an investor to beat the stock market because stocks always are efficiently priced based on all the relevant and known information on the fundamentals of the stocks.  I believe that the efficient market hypothesis fails because it ignores human nature, particularly the nature of most individuals to be followers, not leaders.  As followers, humans are prone to embrace that which already has been faring well and to shun that which recently has been faring poorly.  Of course, the act of buying into what already is doing well and shunning what is doing poorly serves to perpetuate a trend.  Other trend followers then uncritically join the trend, causing the trend to feed on itself and causing excesses.

Many investors focus on the shorter term, which generally harms their long-term performance:

…so many investors are too focused on short-term fundamentals and investment returns at the expense of longer-term fundamentals and returns.  Hunter-gatherers needed to be greatly concerned about their immediate survival—about a pride of lions that might be lurking behind the next rock… They did not have the luxury of thinking about longer-term planning… Then and today, humans often flinch when they come upon a sudden apparent danger—and, by definition, a flinch is instinctive as opposed to cognitive.  Thus, over years, the selection process resulted in a subconscious proclivity for humans to be more concerned about the short term than the longer term.

By far the best thing for long-term investors is to do is absolutely nothing.  The investors who end up performing the best over the course of several decades are nearly always those investors who did virtually nothing.  They almost never checked prices.  They never reacted to bad news.

Regarding Whirlpool:

In the spring of 2011, Greenhaven studied Whirlpool’s fundamentals.  We immediately were impressed by management’s ability and willingness to slash costs.  In spite of a materially subnormal demand for appliances in 2010, the company was able to earn operating margins of 5.9 percent.  Often, when a company is suffering from particularly adverse industry conditions, it is unable to earn any profit at all.  But Whirlpool remained moderately profitable.  If the company could earn 5.9 percent margins under adverse circumstances, what could the company earn once the U.S. housing market and the appliance market returned to normal?

Not surprisingly, Wall Street analysts were focused on the short term:

…A report by J. P. Morgan dated April 27, 2011, stated that Whirlpool’s current share price properly reflected the company’s increased costs for raw materials, the company’s inability to increase its prices, and the current soft demand for appliances…

The J. P. Morgan report might have been correct about the near-term outlook for Whirlpool and its shares.  But Greenhaven invests with a two- to four-year time horizon and cares little about the near-term outlook for its holdings.

The bulk of Greenhaven’s returns has been generated by relatively few of its holdings:

If one in five of our holdings triples in value over a three-year period, then the other four holdings only have to achieve 12 percent average annual returns in order for our entire portfolio to achieve its stretch goal of 20 percent.  For this reason, Greenhaven works extra hard trying to identify potential multibaggers.  Whirlpool had the potential to be a multibagger because it was selling at a particularly low multiple of its potential earnings power.  Of course, most of our potential multibaggers do not turn out to be multibaggers.  But one cannot hit a multibagger unless one tries, and sometimes our holdings that initially appear to be less exciting eventually benefit from positive unforeseen events (handsome black swans) and unexpectedly turn out to be a complete winner.  For this reason, we like to remain fully invested as long as our holdings remain reasonably priced and free from large risks of permanent loss.

 

BOEING

(Photo by José A. Montes, Wikimedia Commons)

Wachenheim likes to read about the history of each company that he studies.

On July 4, 1914, a flight took place in Seattle, Washington, that had a major effect on the history of aviation.  On that day, a barnstormer named Terah Maroney was hired to perform a flying demonstration as part of Seattle’s Independence Day celebrations.  After displaying aerobatics in his Curtis floatplane, Maroney landed and offered to give free rides to spectators.  One spectator, William Edward Boeing, a wealthy owner of a lumber company, quickly accepted Maroney’s offer.  Boeing was so exhilarated by the flight that he completely caught the aviation bug—a bug that was to be with him for the rest of his life.

Boeing launched Pacific Aero Products (renamed the Boeing Airplane Company in 1917).  In late 1916, Boeing designed an improved floatplane, the Model C.  The Model C was ready by April 1917, the same month the United States entered the war.  Boeing thought the Navy might need training aircraft.  The Navy bought two.  They performed well, so the Navy ordered 50 more.

Boeing’s business naturally slowed down after the war.  Boeing sold a couple of small floatplanes (B-1’s), then 13 more after Charles Lindberg’s 1927 transatlantic flight.  Still, sales of commercial planes were virtually nonexistent until 1933, when the company started marketing its model 247.

The twin-engine 247 was revolutionary and generally is recognized as the world’s first modern airplane.  It had a capacity to carry 10 passengers and a crew of 3.  It had a cruising speed of 189 mph and could fly about 745 miles before needing to be refueled.

Boeing sold seventy-five 247’s before making the much larger 307 Stratoliner, which would have sold well were it not for the start of World War II.

Boeing helped the Allies defeat Germany.  The Boeing B-17 Flying Fortress bomber and the B-29 Superfortress bomber became legendary.  More than 12,500 B-17s and more than 3,500 B-29s were built (some by Boeing itself and some by other companies that had spare capacity).

Boeing prospered during the war, but business slowed down again after the war.  In mid-1949, the de Havilland Aircraft Company started testing its Comet jetliner, the first use of a jet engine.  The Comet started carrying passengers in 1952.  In response, Boeing started developing its 707 jet.  Commercial flights for the 707 began in 1958.

The 707 was a hit and soon became the leading commercial plane in the world.

Over the next 30 years, Boeing grew into a large and highly successful company.  It introduced many models of popular commercial planes that covered a wide range of capacities, and it became a leader in the production of high-technology military aircraft and systems.  Moreover, in 1996 and 1997, the company materially increased its size and capabilities by acquiring North American Aviation and McDonnell Douglas.

In late 2012, after several years of delays on its new, more fuel-efficient plane—the 787—Wall Street and the media were highly critical of Boeing.  Wachenheim thought that the company could earn at least $7 per share in 2015.  The stock in late 2012 was at $75, or 11 times the $7.  Wachenheim believed that this was way too low for such a strong company.

Wachenheim estimated that two-thirds of Boeing’s business in 2015 would come from commercial aviation.  He figured that this was an excellent business worth 20 times earnings (he used 19 times to be conservative).  He reckoned that defense, one-third of Boeing’s business, was worth 15 times earnings.  Therefore, Wachenheim used 17.7 as the multiple for the whole company, which meant that Boeing would be worth $145 by 2015.

Greenhaven established a position in Boeing at about $75 a share in late 2012 and early 2013.  By the end of 2013, Boeing was at $136.  Because Wall Street now had confidence that the 787 would be a commercial success and that Boeing’s earnings would rise, Wachenheim and his associates concluded that most of the company’s intermediate-term potential was now reflected in the stock price.  So Greenhaven started selling its position.

 

SOUTHWEST AIRLINES

(Photo by Eddie Maloney, Wikimedia Commons)

The airline industry has had terrible fundamentals for a long time.  But Wachenheim was able to be open-minded when, in August 2012, one of his fellow analysts suggested Southwest Airlines as a possible investment.  Over the years, Southwest had developed a low-cost strategy that gave the company a clear competitive advantage.

Greenhaven determined that the stock of Southwest was undervalued, so they took a position.

The price of Southwest’s shares started appreciating sharply soon after we started establishing our position.  Sometimes it takes years before one of our holdings starts to appreciate sharply—and sometimes we are lucky with our timing.

After the shares tripled, Greenhaven sold half its holdings since the expected return from that point forward was not great.  Also, other investors now recognized the positive fundamentals Greenhaven had expected.  Greenhaven sold the rest of its position as the shares continued to increase.

 

GOLDMAN SACHS

(Photo of Marcus Goldman, Wikimedia Commons)

Wachenheim echoes Warren Buffett when it comes to recognizing how much progress the United States has made:

My experience is that analysts and historians often dwell too much on a company’s recent problems and underplay its strengths, progress, and promise.  An analogy might be the progress of the United States during the twentieth century.  At the end of the century, U.S. citizens generally were far wealthier, healthier, safer, and better educated than at the start of the century.  In fact, the century was one of extraordinary progress.  Yet most history books tend to focus on the two tragic world wars, the highly unpopular Vietnam War, the Great Depression, the civil unrest during the Civil Rights movement, and the often poor leadership in Washington.  The century was littered with severe problems and mistakes.  If you only had read the newspapers and the history books, you likely would have concluded that the United States had suffered a century of relative and absolute decline.  But the United States actually exited the century strong and prosperous.  So did Goldman exit 2013 strong and prosperous.

In 2013, Wachenheim learned that Goldman had an opportunity to gain market share in investment banking because some competitors were scaling back in light of new regulations and higher capital requirements.  Moreover, Goldman had recently completed a $1.9 billion cost reduction program.  Compensation as a percentage of sales had declined significantly in the past few years.

Wachenheim discovered that Goldman is a technology company to a large extent, with a quarter of employees working in the technology division.  Furthermore, the company had strong competitive positions in its businesses, and had sold or shut down sub-par business lines.  Wachenheim checked his investment thesis with competitors and former employees.  They confirmed that Goldman is a powerhouse.

Wachenheim points out that it’s crucial for investors to avoid confirmation bias:

I believe that it is important for investors to avoid seeking out information that reinforces their original analyses.  Instead, investors must be prepared and willing to change their analyses and minds when presented with new developments that adversely alter the fundamentals of an industry or company.  Good investors should have open minds and be flexible.

Wachenheim also writes that it’s very important not to invent a new thesis when the original thesis has been invalidated:

We have a straightforward approach.  When we are wrong or when fundamentals turn against us, we readily admit we are wrong and we reverse our course.  We do not seek new theories that will justify our original decision.  We do not let errors fester and consume our attention.  We sell and move on.

Wachenheim loves his job:

I am almost always happy when working as an investment manager.  What a perfect job, spending my days studying the world, economies, industries, and companies;  thinking creatively;  interviewing CEOs of companies… How lucky I am.  How very, very lucky.

 

BOOLE MICROCAP FUND

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

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

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  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.

More Than You Know

(Image: Zen Buddha Silence, by Marilyn Barbone)

January 14, 2018

To boost our productivity—including our ability to think and make decisions—nothing beats continuous learning.  Broad study makes us better people.  See: http://boolefund.com/lifelong-learning/

Michael Mauboussin is a leading expert in the multidisciplinary study of businesses and markets.  His book—More Than You Know: Finding Financial Wisdom in Unconventional Places—has been translated into eight languages.

Each chapter in Mauboussin’s book is meant to stand on its own.  I’ve summarized most of the chapters below.

Here’s an outline:

  • Process and Outcome in Investing
  • Risky Business
  • Are You an Expert?
  • The Hot Hand in Investing
  • Time is on my Side
  • The Low Down on the Top Brass
  • Six Psychological Tendencies
  • Emotion and Intuition in Decision Making
  • Beware of Behavioral Finance
  • Importance of a Decision Journal
  • Right from the Gut
  • Weighted Watcher
  • Why Innovation is Inevitable
  • Accelerating Rate of Industry Change
  • How to Balance the Long Term with the Short Term
  • Fitness Landscapes and Competitive Advantage
  • The Folly of Using Average P/E’s
  • Mean Reversion and Turnarounds
  • Considering Cooperation and Competition Through Game Theory
  • The Wisdom and Whim of the Collective
  • Vox Populi
  • Complex Adaptive Systems
  • The Future of Consilience in Investing

(Photo: Statue of Leonardo da Vinci in Italy, by Raluca Tudor)

 

PROCESS AND OUTCOME IN INVESTING

(Image by Amir Zukanovic)

Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs.  But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

Robert Rubin made this remark in his Harvard Commencement Address in 2001.  Mauboussin points out that the best long-term performers in any probabilistic field—such as investing, bridge, sports-team management, and pari-mutuel betting—all emphasize process over outcome.

Mauboussin also writes:

Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.

If you don’t understand why your view differs from the consensus, and why the consensus is likely to be wrong, then you cannot reasonably expect to beat the market.  Mauboussin quotes horse-race handicapper Steven Crist:

The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory… This may sound elementary, and many players may think that they are following this principle, but few actually do.  Under this mindset, everything but the odds fades from view.  There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price.

Robert Rubin’s four rules for probabilistic decision-making:

  • The only certainty is that there is no certainty.  It’s crucial not to be overconfident, because inevitably that leads to big mistakes.  Many of the biggest hedge fund blowups resulted when people were overconfident about particular bets.
  • Decisions are a matter of weighing probabilities.  Moreover, you also have to consider payoffs.  Probabilities alone are not enough if the payoffs are skewed.  A high probability of winning does not guarantee that it’s a positive expected value bet if the potential loss is far greater than the potential gain.
  • Despite uncertainty, we must act.  Often in investing and in life, we have to make decisions based in imperfect or incomplete information.
  • Judge decisions not only on results, but also on how they were made.  If you’re making decisions under uncertainty—probabilistic decisions—you have to focus on developing the best process you can.  Also, you must accept that some good decisions will have bad outcomes, while some bad decisions will have good outcomes.

Rubin again:

It’s not that results don’t matter.  They do.  But judging solely on results is a serious deterrent to taking risks that may be necessary to making the right decision.  Simply put, the way decisions are evaluated affects the way decisions are made.

 

RISKY BUSINESS

(Photo by Shawn Hempel)

Mauboussin:

So how should we think about risk and uncertainty?  A logical starting place is Frank Knight’s distinction: Risk has an unknown outcome, but we know what the underlying outcome distribution looks like.  Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like.  So games of chance like roulette or blackjack are risky, while the outcome of a war is uncertain.  Knight said that objective probability is the basis for risk, while subjective probability underlies uncertainty.

Mauboussin highlights three ways to get a probability, as suggested by Gerd Gigerenzer in Calculated Risks:

  • Degrees of belief.  Degrees of belief are subjective probabilities and are the most liberal means to translate uncertainty into a probability.  The point here is that investors can translate even onetime events into probabilities provided they satisfy the laws of probability—the exhaustive and exclusive set of alternatives adds up to one.  Also, investors can frequently update probabilities based on degrees of belief when new, relevant information becomes available.
  • Propensities.  Propensity-based probabilities reflect the properties of the object or system.  For example, if a die is symmetrical and balanced, then you have a one-in-six probability of rolling any particular side… This method of probability assessment does not always consider all the factors that may shape an outcome (such as human error).
  • Frequencies.  Here the probability is based on a large number of observations in an appropriate reference class.  Without an appropriate reference class, there can be no frequency-based probability assessment.  So frequency users would not care what someone believes the outcome of a die roll will be, nor would they care about the design of the die.  They would focus only on the yield of repeated die rolls.

When investing in a stock, we try to figure out the expected value by delineating possible scenarios along with a probability for each scenario.  This is the essence of what top value investors like Warren Buffett strive to do.

 

ARE YOU AN EXPERT?

In 1996, Lars Edenbrandt, a Lund University researcher, set up a contest between an expert cardiologist and a computer.  The task was to sort a large number of electrocardiograms (EKGs) into two piles—heart attack and no heart attack.

(Image by Johannes Gerhardus Swanepoel)

The human expert was Dr. Hans Ohlin, a leading Swedish cardiologist who regularly evaluated as many as 10,000 EKGs per year.  Edenbrandt, an artificial intelligence expert, trained his computer by feeding it thousands of EKGs.  Mauboussin describes:

Edenbrandt chose a sample of over 10,000 EKGs, exactly half of which showed confirmed heart attacks, and gave them to machine and man.  Ohlin took his time evaluating the charts, spending a week carefully separating the stack into heart-attack and no-heart-attack piles.  The battle was reminiscent of Garry Kasparov versus Deep Blue, and Ohlin was fully aware of the stakes.

As Edenbrandt tallied the results, a clear-cut winner emerged: the computer correctly identified the heart attacks in 66 percent of the cases, Ohlin only in 55 percent.  The computer proved 20 percent more accurate than a leading cardiologist in a routine task that can mean the difference between life and death.

Mauboussin presents a table illustrating that expert performance depends on the problem type:

Domain Description (Column) Expert Performance Expert Agreement Examples
Rules based: Limited Degrees of Freedom Worse than computers High (70-90%)
  • Credit scoring
  • Simple medical diagnosis
Rules based: High Degrees of Freedom Generally better than computers Moderate (50-60%)
  • Chess
  • Go
Probabilistic: Limited Degrees of Freedom Equal to or worse than collectives Moderate/ Low (30-40%)
  • Admissions officers
  • Poker
Probabilistic: High Degrees of Freedom Collectives outperform experts Low (<20%)
  • Stock market
  • Economy

For rules-based systems with limited degrees of freedom, computers consistently outperform individual humans; humans perform well, but computers are better and often cheaper, says Mauboussin.  Humans underperform computers because humans are influenced by suggestion, recent experience, and how information is framed.  Also, humans fail to weigh variables well.  Thus, while experts tend to agree in this domain, computers outperform experts, as illustrated by the EKG-reading example.

In the next domain—rules-based systems with high degrees of freedom—experts tend to add the most value.  However, as computing power continues to increase, eventually computers will outperform experts even here, as illustrated by Chess and Go.  Eventually, games like Chess and Go are “solvable.”  Once the computer can check every single possible move within a reasonable amount of time—which is inevitable as long as computing power continues to increase—no human will be able to match such a computer.

In probabilistic domains with limited degrees of freedom, experts are equal to or worse than collectives.  Overall, the value of experts declines compared to rules-based domains.

(Image by Marrishuanna)

In probabilistic domains with high degrees of freedom, experts do worse than collectives.  For instance, stock market prices aggregate many guesses from individual investors.  Stock market prices typically are more accurate than experts.

 

THE HOT HAND IN INVESTING

Sports fans and athletes believe in the hot hand in basketball.  A player on a streak is thought to be “hot,” or more likely to make his or her shots.  However, statistical analysis of streaks shows that the hot hand does not exist.

(Illustration by lbreakstock)

Long success streaks happen to the most skillful players in basketball, baseball, and other sports.  To illustrate this, Mauboussin asks us to consider two basketball players, Sally Swish and Allen Airball.  Sally makes 60 percent of her shot attempts, while Allen only makes 30 percent of his shot attempts.

What are the probabilities that Sally and Allen make five shots in a row?  For Sally, the likelihood is (0.6)^5, or 7.8 percent.  Sally will hit five in a row about every thirteen sequences.  For Allen, the likelihood is (0.3)^5, or 0.24 percent.  Allen will hit five straight once every 412 sequences.  Sally will have far more streaks than Allen.

In sum, long streaks in sports or in money management indicate extraordinary luck imposed on great skill.

 

TIME IS ON MY SIDE

The longer you’re willing to hold a stock, the more attractive the investment.  For the average stock, the chance that it will be higher is (almost) 100 percent for one decade, 72 percent for one year, 56 percent for one month, and 51 percent for one day.

(Illustration by Marek)

The problem is loss aversion.  We feel the pain of a loss 2 to 2.5 times more than the pleasure of an equivalent gain.  If we check a stock price daily, there’s nearly a 50 percent chance of seeing a loss.  So checking stock prices daily is a losing proposition.  By contrast, if we only check the price once a year or once every few years, then investing in a stock is much more attractive.

A fund with a high turnover ratio is much more short-term oriented than a fund with a low turnover ratio.  Unfortunately, most institutional investors have a much shorter time horizon than what is needed for the typical good strategy to pay off.  If portfolio managers lag over shorter periods of time, they may lose their jobs even if their strategy works quite well over the long term.

 

THE LOW DOWN ON THE TOP BRASS

(Illustration by Travelling-light)

It’s difficult to judge leadership, but Mauboussin identifies four things worth considering:

  • Learning
  • Teaching
  • Self-awareness
  • Capital allocation

Mauboussin asserts:

A consistent thirst to learn marks a great leader.  On one level, this is about intellectual curiosity—a constant desire to build mental models that can help in decision making.  A quality manager can absorb and weigh contradictory ideas and information as well as think probabilistically…

Another critical facet of learning is a true desire to understand what’s going on in the organization and to confront the facts with brutal honesty.  The only way to understand what’s going on is to get out there, visit employees and customers, and ask questions and listen to responses.  In almost all organizations, there is much more information at the edge of the network—the employees in the trenches dealing with the day-to-day issues—than in the middle of the network, where the CEO sits.  CEOs who surround themselves with managers seeking to please, rather than prod, are unlikely to make great decisions.

A final dimension of learning is creating an environment where everyone in the organization feels they can voice their thoughts and opinions without the risk of being rebuffed, ignored, or humiliated.  The idea here is not that management should entertain all half-baked ideas but rather that management should encourage and reward intellectual risk taking.

Teaching involves communicating a clear vision to the organization.  Mauboussin points out that teaching comes most naturally to those leaders who are passionate.  Passion is a key driver of success.

Self-awareness implies a balance between confidence and humility.  We all have strengths and weaknesses.  Self-aware leaders know their weaknesses and find colleagues who are strong in those areas.

Finally, capital allocation is a vital leadership skill.  Regrettably, many consultants and investment bankers give poor advice on this topic.  Most acquisitions destroy value for the acquirer, regardless of whether they are guided by professional advice.

Mauboussin quotes Warren Buffett:

The heads of many companies are not skilled in capital allocation.  Their inadequacy is not surprising.  Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities.  They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.  To stretch the point, it’s as if the final step for a highly talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.  CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers.  Charlie and I have frequently observed the consequences of such “help.”  On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes place in corporate America.  (That’s why you hear so much about “restructing.”)

 

SIX PSYCHOLOGICAL TENDENCIES

(Image by Andreykuzmin)

The psychologist Robert Cialdini, in his book Influence: The Psychology of Persuasion, mentions six psychological tendencies that cause people to comply with requests:

  • Reciprocation.  There is no human society where people do not feel the obligation to reciprocate favors or gifts.  That’s why charitable organizations send free address labels and why real estate companies offer free house appraisals.  Sam Walton was smart to forbid all of his employees from accepting gifts from suppliers, etc.
  • Commitment and consistency.  Once we’ve made a decision, and especially if we’ve publicly committed to that decision, we’re highly unlikely to change.  Consistency allows us to stop thinking and also to avoid further action.
  • Social validation.  One of the chief ways we make decisions is by observing the decisions of others.  In an experiment by Solomon Asch, eight people in a room are shown three lines of clearly unequal lengths.  Then they are shown a fourth line that has the same length as one of the three lines.  They are asked to match the fourth line to the one with equal length.  The catch is that only one of the eight people in the room is the actual subject of the experiment.  The other seven people are shills who have been instructed to choose an obviously incorrect answer.  About 33 percent of the time, the subject of the experiment ignores the obviously right answer and goes along with the group instead.
  • Liking.  We all prefer to say yes to people we like—people who are similar to us, who compliment us, who cooperate with us, and who we find attractive.
  • Authority.  Stanley Milgram wanted to understand why many seemingly decent people—including believing Lutherans and Catholics—went along with the great evils perpetrated by the Nazis.  Milgram did a famous experiment.  A person in a white lab coat stands behind the subject of the experiment.  The subject is asked to give increasingly severe electric shocks to a “learner” in another room whenever the learner gives an incorrect answer to a question.  (Unknown to the subject, the learner in the other room is an actor and the electric shocks are not really given.)  Roughly 60 percent of the time, the subject of the experiment gives a fatal shock of 450 volts to the learner.  This is a terrifying result.  See: https://en.wikipedia.org/wiki/Milgram_experiment
  • Scarcity.  Items or data that are scarce or perceived to be scarce automatically are viewed as more attractive.  That’s why companies frequently offer services or products for a limited time only.

These innate psychological tendencies are especially powerful when they operate in combination.  Charlie Munger calls this lollapalooza effects.

Mauboussin writes that investors are often influenced by commitment and consistency, social validation, and scarcity.

Psychologists discovered that after bettors at a racetrack put down their money, they are more confident in the prospects of their horses winning than immediately before they placed their bets.  After making a decision, we feel both internal and external pressure to remain consistent to that view even if subsequent evidence questions the validity of the initial decision.

So an investor who has taken a position in a particular stock, recommended it publicly, or encouraged colleagues to participate, will feel the need to stick with the call.  Related to this tendency is the confirmation trap: postdecision openness to confirming data coupled with disavowal or denial of disconfirming data.  One useful technique to mitigate consistency is to think about the world in ranges of values with associated probabilities instead of as a series of single points.  Acknowledging multiple scenarios provides psychological shelter to change views when appropriate.

There is a large body of work about the role of social validation in investing.  Investing is an inherently social activity, and investors periodically act in concert…

Finally, scarcity has an important role in investing (and certainly plays a large role in the minds of corporate executives).  Investors in particular seek informational scarcity.  The challenge is to distinguish between what is truly scarce information and what is not.  One means to do this is to reverse-engineer market expectations—in other words, figure out what the market already thinks.

 

EMOTION AND INTUITION IN DECISION MAKING

(Photo by Marek Uliasz)

Humans need to be able to experience emotions in order to make good decisions.  Mauboussin writes about an experiment conducted by Antonio Damasio:

…In one experiment, he harnessed subjects to a skin-conductance-response machine and asked them to flip over cards from one of four decks; two of the decks generated gains (in play money) and the other two were losers.  As the subjects turned cards, Damasio asked them what they thought was going on.  After about ten turns, the subjects started showing physical reactions when they reached for a losing deck.  About fifty cards into the experiment, the subjects articulated a hunch that two of the four decks were riskier.  And it took another thirty cards for the subjects to explain why their hunch was right.

This experiment provided two remarkable decision-making lessons.  First, the unconscious knew what was going on before the conscious did.  Second, even the subjects who never articulated what was going on had unconscious physical reactions that guided their decisions.

 

BEWARE OF BEHAVIORAL FINANCE

Individual agents can behave irrationally but the market can still be rational.

…Collective behavior addresses the potentially irrational actions of groups.  Individual behavior dwells on the fact that we all consistently fall into psychological traps, including overconfidence, anchoring and adjustment, improper framing, irrational commitment escalation, and the confirmation trap.

Here’s my main point: markets can still be rational when investors are individually irrational.  Sufficient investor diversity is the essential feature in efficient price formation.  Provided the decision rules of investors are diverse—even if they are suboptimal—errors tend to cancel out and markets arrive at appropriate prices.  Similarly, if these decision rules lose diversity, markets become fragile and susceptible to inefficiency.

Mauboussin continues:

In case after case, the collective outperforms the individual.  A full ecology of investors is generally sufficient to assure that there is no systematic way to beat the market.  Diversity is the default assumption, and diversity breakdowns are the notable (and potentially profitable) exceptions.

(Illustration by Trueffelpix)

Mauboussin writes about an interesting example of how the collective can outperform individuals (including experts).

On January 17, 1966, a B-52 bomber and a refueling plane collided in midair while crossing the Spanish coastline.  The bomber was carrying four nuclear bombs.  Three were immediately recovered.  But the fourth was lost and its recovery became a national security priority.

Assistant Security of Defense Jack Howard called a young naval officer, John Craven, to find the bomb.  Craven assembled a diverse group of experts and asked them to place bets on where the bomb was.  Shortly thereafter, using the probabilities that resulted from all the bets, the bomb was located.  The collective intelligence in this example was superior to the intelligence of any individual expert.

 

IMPORTANCE OF A DECISION JOURNAL

In investing and in general, it’s wise to keep a journal of our decisions and the reasoning behind them.

(Photo by Leerobin)

We all suffer from hindsight bias.  We are unable to recall what we actually thought before making a decision or judgment.

  • If we decide to do something and it works out, we tend to underestimate the uncertainty that was present when we made the decision.  “I knew I made the right decision.”
  • If we decide to do something and it doesn’t work, we tend to overestimate the uncertainty that was present when we made the decision.  “I suspected that it wouldn’t work.”
  • If we judge that event X will happen, and then it does, we underestimate the uncertainty that was present when we made the judgment.  “I knew that would happen.”
  • If we judge that event X will happen, and it doesn’t, we overestimate the uncertainty that was present when we made the judgment.  “I was fully aware that it was unlikely.”

See: https://en.wikipedia.org/wiki/Hindsight_bias

As Mauboussin notes, keeping a decision journal gives us a valuable source of objective feedback.  Otherwise, we won’t recall with any accuracy the uncertainty we faced or the reasoning we used.

 

RIGHT FROM THE GUT

Robert Olsen has singled out five conditions that are present in the context of naturalistic decision making.

  • Ill-structured and complex problems.  No obvious best procedure exists to solve a problem.
  • Information is incomplete, ambiguous, and changing.  Because stock picking relates to future financial performance, there is no way to consider all information.
  • Ill-defined, shifting, and competing goals.  Although long-term goals may be clearer, goals can change over shorter horizons.
  • Stress because of time constraints, high stakes, or both.  Stress is clearly a feature of investing.
  • Decisions may involve multiple participants.  

Mauboussin describes three key characteristics of naturalistic decision makers.  First, they rely heavily on mental imagery and simulation in order to assess a situation and possible alternatives.  Second, they excel at pattern matching.  (For instance, chess masters can glance at a board and quickly recognize a pattern.)

(Photo by lbreakstock)

Third, naturalistic decision makers reason through analogy.  They can see how seemingly different situations are in fact similar.

 

WEIGHTED WATCHER

Mauboussin describes how we develop a “degree of belief” in a specific hypothesis:

Our degree of belief in a particular hypothesis typically integrates two kinds of evidence: the strength, or extremeness, of the evidence and the weight, or predictive validity.  For instance, say you want to test the hypothesis that a coin in biased in favor of heads.  The proportion of heads in the sample reflects the strength, while the sample size determines the weight.

Probability theory describes rules for how to combine strength and weight correctly.  But substantial experimental data show that people do not follow the theory.  Specifically, the strength of evidence seems to dominate the weight of evidence in people’s minds.

This bias leads to a distinctive pattern of over- and underconfidence.  When the strength of evidence is high and the weight is low—which accurately describes the outcome of many Wall Street-sponsored surveys—people tend to be overconfident.  In contrast, when the strength is low and the evidence is high, people tend to be underconfident.

(Photo by Michele Lombardo)

Does survey-based research lead to superior stock selection?  Mauboussin responds that the answer is ambiguous.  First, the market adjusts to new information rapidly.  It’s difficult to gain an informational edge, especially when it comes to what is happening now or what will happen in the near future.  In contrast, it’s possible to gain an informational edge if you focus on the longer term.  That’s because many investors don’t focus there.

The second issue is that understanding the fundamentals about a company or industry is very different from understanding the expectations built into a stock price.  The question is not just whether the information is new to you, but whether the information is also new to the market.  In the vast majority of cases, the information is already reflected in the current stock price.

Mauboussin sums it up:

Seeking new information is a worthy goal for an investor.  My fear is that much of what passes as incremental information adds little or no value, because investors don’t properly weight new information, rely on unsound samples, and fail to recognize what the market already knows.  In contrast, I find that thoughtful discussions about a firm’s or an industry’s medium- to long-term competitive outlook extremely rare.

 

WHY INNOVATION IS INEVITABLE

(Image: Innovation concept, by Daniil Peshkov)

Mauboussin quotes Andrew Hargadon’s How Breakthroughs Happen:

All innovations represent some break from the past—the lightbulb replaced the gas lamp, the automobile replaced the horse and cart, the steamship replaced the sailing ship.  By the same token, however, all innovations are built from pieces of the past—Edison’s system drew its organizing principles from the gas industry, the early automobiles were built by cart makers, and the first steam ships added steam engines to existing sailing ships.

Mauboussin adds:

Investors need to appreciate the innovation process for a couple of reasons.  First, our overall level of material well-being relies heavily on innovation.  Second, innovation lies at the root of creative destruction—the process by which new technologies and businesses supersede others.  More rapid innovation means more rapid success and failure for companies.

Mauboussin draws attention to three interrelated factors that continue to drive innovation at an accelerating rate:

  • Scientific advances
  • Information storage capacity
  • Gains in computing power

 

ACCELERATING RATE OF INDUSTRY CHANGE

(Photo: Drosophila Melanogaster, by Tomatito26)

Mauboussin mentions the common fruit fly, Drosophila melanogaster, which geneticists and other scientists like to study because its life cycle is only two weeks.

Why should businesspeople care about Drosophila?  A sound body of evidence now suggests that the average speed of evolution is accelerating in the business world.  Just as scientists have learned a great deal about evolutionary change from fruit flies, investors can benefit from understanding the sources and implications of accelerated business evolution.

The most direct consequence of more rapid business evolution is that the time an average company can sustain a competitive advantage—that is, generate an economic return in excess of its cost of capital—is shorter than it was in the past.  This trend has potentially important implications for investors in areas such as valuation, portfolio turnover, and diversification.

Mauboussin refers to research by Robert Wiggins and Timothy Ruefli on the sustainability of economic returns.  They put forth four hypotheses.  The first three were supported by the data, while the fourth one was not:

  • Periods of persistent superior economic performance are decreasing in duration over time.
  • Hypercompetition is not limited to high-technology industries but will occur through most industries.
  • Over time, firms increasingly seek to sustain competitive advantage by concatenating a series of short-term competitive advantages.
  • Industry concentration, large market share, or both are negatively correlated with chance of loss of persistent superior economic performance in an industry.

Mauboussin points out that faster product and process life cycles means that historical multiples are less useful for comparison.  Also, the terminal valuation in discounted cash-flow models in many cases has to be adjusted to reflect shorter periods of sustainable competitive advantage.

(Image by Marek Uliasz)

Furthermore, while portfolio turnover on average is too high, portfolio turnover could be increased for those investors who have historically had a portfolio turnover of 20 percent (implying a holding period of 5 years).  Similarly, shorter periods of competitive advantage imply that some portfolios should be more diversified.  Lastly, faster business evolution means that investors must spend more time understanding the dynamics of organizational change.

 

HOW TO BALANCE THE LONG TERM WITH THE SHORT TERM

(Photo by Michael Maggs, via Wikimedia Commons)

Mauboussin notes the lessons emphasized by chess master Bruce Pandolfini:

  • Don’t look too far ahead.  Most people believe that great players strategize by thinking far into the future, by thinking 10 or 15 moves ahead.  That’s just not true.  Chess players look only as far into the future as they need to, and that usually means looking just a few moves ahead.  Thinking too far ahead is a waste of time: The information is uncertain.
  • Develop options and continuously revise them based on the changing conditions: Great players consider their next move without playing it.  You should never play the first good move that comes into your head.  Put that move on your list, and then ask yourself if there’s an even better move.  If you see a good idea, look for a better one—that’s my motto.  Good thinking is a matter of making comparisons.
  • Know your competition: Being good chess also requires being good at reading people.  Few people think of chess as an intimate, personal game.  But that’s what it is.  Players learn a lot about their opponents, and exceptional chess players learn to interpret every gesture that their opponents make.
  • Seek small advantages: You play for seemingly insignificant advantages—advantages that your opponent doesn’t notice or that he dismisses, thinking, “Big deal, you can have that.”  It could be slightly better development, or a slightly safer king’s position.  Slightly, slightly, slightly.  None of those “slightlys” mean anything on their own, but add up seven or eight of them, and you have control.

Mauboussin argues that companies should adopt simple, flexible long-term decision rules.  This is the “strategy as simple rules” approach, which helps us from getting caught in the short term versus long term debate.

Moreover, simple decision rules help us to be consistent.  Otherwise we will often reach different conclusions from the same data based on moods, suggestion, recency bias, availability bias, framing effects, etc.

 

FITNESS LANDSCAPES AND COMPETITIVE ADVANTAGE

(Image: Fitness Landscape, by Randy Olsen, via Wikimedia Commons)

Mauboussin:

What does a fitness landscape look like?  Envision a large grid, with each point representing a different strategy that a species (or a company) can pursue.  Further imagine that the height of each point depicts fitness.  Peaks represent high fitness, and valleys represent low fitness.  From a company’s perspective, fitness equals value-creation potential.  Each company operates in a landscape full of high-return peaks and value-destructive valleys.  The topology of the landscape depends on the industry characteristics.

As Darwin noted, improving fitness is not about strength or smarts, but rather about becoming more and more suited to your environment—in a word, adaptability.  Better fitness requires generating options and “choosing” the “best” ones.  In nature, recombination and mutation generate species diversity, and natural selection assures that the most suitable options survive.  For companies, adaptability is about formulating and executing value-creating strategies with a goal of generating the highest possible long-term returns.

Since a fitness landscape can have lots of peaks and valleys, even if a species reaches a peak (a local optimum), it may not be at the highest peak (a global optimum).  To get a higher altitude, a species may have reduce its fitness in the near term to improve its fitness in the long term.  We can say the same about companies…

Mauboussin remarks that there are three types of fitness landscape:

  • Stable.  These are industries where the fitness landscape is reasonably stable.  In many cases, the landscape is relatively flat, and companies generate excess economic returns only when cyclical forces are favorable.  Examples include electric and telephone utilities, commodity producers (energy, paper, metals), capital goods, consumer nondurables, and real estate investment trusts.  Companies within these sectors primarily improve their fitness at the expense of their competitors.  These are businesses that tend to have structural predictability (i.e., you’ll know what they look like in the future) at the expense of limited opportunities for growth and new businesses.
  • Coarse.  The fitness landscape is in flux for these industries, but the changes are not so rapid as to lack predictability.  The landscape here is rougher.  Some companies deliver much better economic performance than do others.  Financial services, retail, health care, and more established parts of technology are illustrations.  These industries run a clear risk of being unseated (losing fitness) by a disruptive technology.
  • Roiling.  This group contains businesses that are very dynamic, with evolving business models, substantial uncertainty, and ever-changing product offerings.  The peaks and valleys are constantly changing, ever spastic.  Included in this type are many software companies, the genomics industry, fashion-related sectors, and most start-ups.  Economic returns in this group can be (or can promise to be) significant but are generally fleeting.

Mauboussin indicates that innovation, deregulation, and globalization are probably causing the global fitness landscape to become even more contorted.

Companies can make short, incremental jumps towards a local maximum.  Or they can make long, discontinuous jumps that may lead to a higher peak or a lower valley.  Long jumps include investing in new potential products or making meaningful acquisitions in unrelated fields.  The proper balance between short jumps and long jumps depends on a company’s fitness landscape.

Mauboussin adds that the financial tool for valuing a given business depends on the fitness landscape that the business is in.  A business in a stable landscape can be valued using discounted cash-flow (DCF).  A business in a course landscape can be valued using DCF plus strategic options.  A business in a roiling landscape can be valued using strategic options.

 

THE FOLLY OF USING AVERAGE P/E’S

Bradford Cornell:

For past averages to be meaningful, the data being averaged have to be drawn from the same population.  If this is not the case—if the data come from populations that are different—the data are said to be nonstationary.  When data are nonstationary, projecting past averages typically produces nonsensical results.

Nonstationarity is a key concept in time-series analysis, such as the study of past data in business and finance.  If the underlying population changes, then the data are nonstationary and you can’t compare past averages to today’s population.

(Image: Time Series, by Mike Toews via Wikimedia Commons)

Mauboussin gives three reasons why past P/E data are nonstationary:

  • Inflation and taxes
  • Changes in the composition of the economy
  • Shifts in the equity-risk premium

Higher taxes mean lower multiples, all else equal.  And higher inflation also means lower multiples.  Similarly, low taxes and low inflation both cause P/E ratios to be higher.

As I write this in January 2018, inflation has been low for many years.  As well, interest rates have been low for many years.  If interest rates stay low enough for long enough, stocks can have an average P/E of 30 or even 50, as Warren Buffett has commented.

The more companies rely on intangible capital rather than tangible capital, the higher the cash-flow-to-net-income ratio.  Overall, the economy is relying increasingly on intangible capital.  Higher cash-flow-to-net-income ratios, and higher returns on capital, mean higher P/E ratios.

 

MEAN REVERSION AND TURNAROUNDS

Growth alone does not create value.  Growth creates value only if the return on invested capital exceeds the cost of capital.  Growth actually destroys value if the return on invested capital is less than the cost of capital.

(Illustration by Teguh Jati Prasetyo)

Over time, a company’s return on capital moves towards its cost of capital.  High returns bring competition and new capital, which drives the return on capital toward the cost of capital.  Similarly, capital exits low-return industries, which lifts the return on capital toward the cost of capital.

Mauboussin reminds us that a good business is not necessarily a good investment, just as a bad business is not necessarily a bad investment.  What matters is the expectations embedded in the current price.  If expectations are overly low for a bad business, it can represent a good investment.  If expectations are too high for a good business, it may be a poor investment.

On the other hand, some cheap stocks deserve to be cheap and aren’t good investments.  And some expensive-looking stocks trading at high multiples may still be good investments if high growth and high return on capital can persist long enough into the future.

 

CONSIDERING COOPERATION AND COMPETITION THROUGH GAME THEORY

(Illustration: Concept of Prisoner’s Dilemma, by CXJ Jensen via Wikimedia Commons)

Mauboussin quotes Robert Axelrod’s The Complexity of Cooperation:

What the Prisoner’s Dilemma captures so well is the tension between the advantages of selfishness in the short run versus the need to elicit cooperation from the other player to be successful over the longer run.  The very simplicity of the Prisoner’s Dilemma is highly valuable in helping us to discover and appreciate the deep consequences of the fundamental processes involved in dealing with this tension.

The Prisoner’s Dilemma shows that the rational response for an individual company  is not necessarily optimal for the industry as a whole.

If the Prisoner’s Dilemma game is going to be repeated many times, then the best strategy is tit-for-tat.  Whatever your competitor’s latest move was, copy that for your next move.  So if your competitor deviates one time and then cooperates, you deviate one time and then cooperate.  Tit-for-tat is both the simplest strategy and also the most effective.

When it comes to market pricing and capacity decisions, competitive markets need not be zero sum.  A tit-for-tat strategy is often optimal, and by definition it includes a policing component if your competitor deviates.

 

THE WISDOM AND WHIM OF THE COLLECTIVE

Mauboussin quotes Robert D. Hanson’s Decision Markets:

[Decision markets] pool the information that is known to diverse individuals into a common resource, and have many advantages over standard institutions for information aggregation, such as news media, peer review, trials, and opinion polls.  Speculative markets are decentralized and relatively egalitarian, and can offer direct, concise, timely, and precise estimates in answer to questions we pose.

Mauboussin then writes about bees and ants, ending with this comment:

What makes the behavior of social insects like bees and ants so amazing is that there is no central authority, no one directing traffic.  Yet the aggregation of simple individuals generates complex, adaptive, and robust results.  Colonies forage efficiently, have life cycles, and change behavior as circumstances warrant.  These decentralized individuals collectively solve very hard problems, and they do it in a way that is very counterintuitive to the human predilection to command-and-control solutions.

(Illustration: Swarm Intelligence, by Farbentek)

Mauboussin again:

Why do decision markets work so well?  First, individuals in these markets think they have some edge, so they self-select to participate.  Second, traders have an incentive to be right—they can take money from less insightful traders.  Third, these markets provide continuous, real-time forecasts—a valuable form of feedback.  The result is that decision markets aggregate information across traders, allowing them to solve hard problems more effectively than any individual can.

 

VOX POPULI

(Painting: Sir Francis Galton, by Charles Wellington Furse, via Wikimedia Commons)

Mauboussin tells of an experiment by Francis Galton:

Victorian polymath Francis Galton was one of the first to thoroughly document this group-aggregation ability.  In a 1907 Nature article, “Vox Populi,” Galton describes a contest to guess the weight of an ox at the West of England Fat Stock and Poultry Exhibition in Plymouth.  He collected 787 participants who each paid a sixpenny fee to participate.  (A small cost to deter practical joking.)  According to Galton, some of the competitors were butchers and farmers, likely expert at guessing the weight.  He surmised that many others, though, were guided by “such information as they might pick up” or “by their own fancies.”

Galton calculated the median estimate—the vox populi—as well as the mean.  He found that the median guess was within 0.8 percent of the correct weight, and that the mean of the guesses was within 0.01 percent.  To give a sense of how the answer emerged, Galton showed the full distribution of answers.  Simply stated, the errors cancel out and the result is distilled information.

Subsequently, we have seen the vox populi results replicated over and over.  Examples include solving a complicated maze, guessing the number of jellybeans in a jar, and finding missing bombs.  In each case, the necessary conditions for information aggregation to work include an aggregation mechanism, an incentive to answer correctly, and group heterogeneity.

 

COMPLEX ADAPTIVE SYSTEMS

(Illustration by Acadac, via Wikimedia Commons)

Complex adaptive systems exhibit a number of essential properties and mechanisms, writes Mauboussin:

  • Aggregation.  Aggregation is the emergence of complex, large-scale behavior from the collective interactions of many less-complex agents.
  • Adaptive decision rules.  Agents within a complex adaptive system take information from the environment, combine it with their own interaction with the environment, and derive decision rules.  In turn, various decision rules compete with one another based on their fitness, with the most effective rules surviving.
  • Nonlinearity.  In a linear model, the whole equals the sum of the parts.  In nonlinear systems, the aggregate behavior is more complicated than would be predicted by totaling the parts.
  • Feedback loops.  A feedback system is one in which the output of one iteration becomes the input of the next iteration.  Feedback loops can amplify or dampen an effect.

Governments, many corporations, and capital markets are all examples of complex adaptive systems.

Humans have a strong drive to invent a cause for every effect.  This has been biologically advantageous for the vast majority of human history.  In the past, if we heard a rustling in the grass, we immediately sought safety.  There was always some cause for the noise.  It virtually never made sense to wait around to see if it was a predator or not.

However, in complex adaptive systems like the stock market, typically there is no simple cause and effect relationship that explains what happens.

For many big moves in the stock market, there is no identifiable cause.  But people have such a strong need identify a cause that they make up causes.  The press delivers to people what they want: explanations for big moves in the stock market.  Usually these explanations are simply made up.  They’re false.

 

THE FUTURE OF CONSILIENCE IN INVESTING

(Painting: Galileo Galilei, by Justus Sustermans, via Wikimedia Commons)

Mauboussin, following Charlie Munger, argues that cross-disciplinary research is likely to produce the deepest insights into the workings of companies and markets.  Here are some examples:

  • Decision making and neuroscience.  Prospect theory—invented by Daniel Kahneman and Amos Tversky—describes how people suffer from cognitive biases when they make decisions under uncertainty.  Prospect theory is extremely well-supported by countless experiments.  But prospect theory still doesn’t explain why people make the decisions they do.  Neuroscience will help with this.
  • Statistical properties of markets—from description to prediction?  Stock price changes are not normally distributed—along a bell-shaped curve—but rather follow a power law.  The statistical distribution has fat tails, which means there are more extreme moves than would occur under a normal distribution.  Once again, a more accurate description is progress.  But the next step involves a greater ability to explain and predict the phenomena in question.
  • Agent-based models.  Individual differences are important in market outcomes.  Feedback mechanisms are also central.
  • Network theory and information flows.  Network research involves epidemiology, psychology, sociology, diffusion theory, and competitive strategy.  Much progress can be made.
  • Growth and size distribution.  There are very few large firms and many small ones.  And all large firms experience significantly slower growth once they reach a certain size.
  • Flight simulator for the mind?  One of the biggest challenges in investing is that long-term investors don’t get nearly enough feedback.  Statistically meaningful feedback for investors typically takes decades.

 

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 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  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)

December 31, 2017

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 in theory 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’Shaugnessy 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’Shaugnessy learned that low EV/EBITDA was the best-performing individual measure of cheapness from 1964 to 2009.
  • But O’Shaugnessy 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’Shaugnessy found that a composite measure led to the best performance from 1964 to 2009.

Carlisle and Gray, as well as O’Shaugnessy, 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’Shaugnessy, 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.

 

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—including net nets—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’Shaugnessy’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.  Generally not as good as net nets, but 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 comment 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—or 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—or 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 rather than 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 plc (NYSE: ESV), an offshore oil driller.  Having just completed its acquisition of Atwood Oceanics (NYSE: ATW), Ensco is now a leading offshore driller with a high-specification, globally diverse fleet.  The company also has one of the lowest cost structures, and relatively low debt levels (with the majority of debt due in 2024 or later).  Ensco—like Atwood—has a long history of operational excellence and safety.  Ensco has been rated #1 for seven consecutive years in the leading independent customer satisfaction survey.

  • At $5.91 recently, Ensco is trading near 20% of tangible book value.  (It purchased Atwood at about the same discount to tangible book.)  If oil prices revert to a mean of $60-70 per barrel (or more), Ensco will probably be worth at least tangible book value.
  • That implies a 400% return (or more)—over the next 3 to 5 years—for an investor who owns shares today.

However, it’s possible oil will never return to $60-70.  It’s possible the seemingly cyclical decline for offshore oil drillers is actually more permanent in nature.  Mihaljevic observes:

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 $60-70, at least in the next 5-10 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 $60+, oil will be needed for many decades.  At least some offshore drilling will still be needed, and Ensco will be a survivor.

Full Disclosure:

  • The Boole Fund had an investment in Atwood Oceanics. With the acquisition of Atwood by Ensco now completed, the Boole Fund currently owns shares in Ensco plc.
  • 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 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 

 

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

My e-mail: jb@boolefund.com

 

 

 

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

The Essays of Warren Buffett

(Image:  Zen Buddha Silence by Marilyn Barbone.)

December 24, 2017

A chief purpose of this blog is to teach others about business and investing.  (My other passion is artificial intelligence.)  For those curious about these and related subjects, I hope this blog is useful.

The other main purpose of this blog is to create awareness for the Boole Microcap Fund, which I manage.

  • Buffett correctly observes that a low-cost index fund is the best long-term investment for most investors: http://boolefund.com/warren-buffett-jack-bogle/
  • A quantitative value strategy – properly implemented – has high odds of beating an index fund.
  • Buffett, Munger, Lynch, and other top investors started in micro caps because there’s far less competition and far more inefficiency.  An equal weighted microcap approach has outperformed every other size category historically: http://boolefund.com/best-performers-microcap-stocks/
  • If you also screen for value and for improving fundamentals, then a microcap value approach is likely to do significantly better (net of all costs) than an S&P 500 index fund over time.

 

This week’s blog post covers The Essays of Warren Buffett: Lessons for Corporate America (4th edition, 2015), selected and arranged by Lawrence A. Cunningham.  The book is based on 50 years of Buffett’s letters to shareholders, organized according to topic.

Not only is Warren Buffett arguably the greatest investor of all time;  but Buffett wants to be remembered as a “Teacher.”  Buffett and Munger have been outstanding “professors” for decades now, carrying on the value investing community’s tradition of generosity.  Munger:

The best thing a human being can do is to help another human being know more.

Every section (but taxation) from The Essays of Warren Buffett is included here:

  • Prologue: Owner-Related Business Principles
  • Corporate Governance
  • Finance and Investing
  • Investment Alternatives
  • Common Stock
  • Mergers and Acquisitions
  • Valuation and Accounting
  • Accounting Shenanigans
  • Berkshire at Fifty and Beyond

 

PROLOGUE: OWNER-RELATED BUSINESS PRINCIPLES

Buffett writes that Berkshire Hathaway shareholders are unusual because nearly all of them focus on long-term compounding of business value.  At the end of a typical year, 98% of those who own shares in Berkshire owned the shares at the beginning of the year.

Buffett remarks that, to a large extent, companies end up with the shareholders they seek and deserve.  Buffett sets forth Berkshire’s fifteen owner-related business principles:

  1. Although our form is corporate, our attitude is partnership.  Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners… We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
  2. In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company.  We eat our own cooking.
  3. Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis.  We do not measure the economic significance or performance of Berkshire by its size;  we measure by per-share progress…
  4. Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital.  Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries…
  5. Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance.  Charlie and I, both as owners and managers, virtually ignore such consolidated numbers.  However, we will also report to you the earnings of each major business we control, numbers we consider of great importance.  These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.
  6. Accounting consequences do not influence our operating or capital-allocation decisions.  When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.  This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rate price of small portions (whose earnings will be largely unreportable).  In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.
  7. We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis.  We will reject interesting opportunities rather than over-leverage our balance sheet.  This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care.  (As one of the Indianapolis ‘500’ winners said:  ‘To finish first, you must first finish.’)
  8. A managerial ‘wish list’ will not be filled at shareholder expense.  We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders.  We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.
  9. We feel noble intentions should be checked periodically against results.  We test the wisdom of retained earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.  To date, this test has been met.  We will continue to apply it on a five-year rolling basis…
  10. We will issue common stock only when we receive as much in business value as we give…
  11. You should be fully aware of one attitude Charlie and I share that hurts our financial performance:  Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns.  We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations…
  12. We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value.  Our guideline is to tell you the business facts that we would want to know if our positions were reversed.  We owe you no less… We also believe candor benefits us as managers:  The CEO who misleads others in public may eventually mislead himself in private.
  13. Despite our policy of candor we will discuss our activities in marketable securities only to the extent legally required.  Good investment ideas are rare, valuable and subject to competitive appropriation…
  14. To the extent possible, we would like each Berkshire shareholder to record a gain or loss in market value during his period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded by the company during that holding period…
  15. We regularly compare the gain in Berkshire’s per-share book value to the performance of the S&P 500…

 

CORPORATE GOVERNANCE

Buffett explains:

At Berkshire, full reporting means giving you the information that we would wish you to give to us if our positions were reversed.  What Charlie and I would want under the circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business.  We would expect both a lot of financial details and a discussion of any significant data we would need to interpret what was presented.  (page 37)

Buffett comments that it is deceptive and dangerous – as he and Charlie see it – for CEOs to predict publicly growth rates for their companies.  Though they are pushed to do so by analysts and their own investor relations departments, such predictions too often lead to trouble.  Having internal targets is fine, of course.  Buffett:

The problem arising from lofty predictions is not just that they spread unwarranted optimism.  Even more troublesome is the fact that they corrode CEO behavior.  Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced.  Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to ‘make the numbers.’  (page 39)

Buffett offers three suggestions for investors.  He says:

  • First, beware of companies displaying weak accounting… When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes.
  • Second, unintelligible footnotes usually indicate untrustworthy management.  If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to…
  • Finally, be suspicious of companies that trumpet earnings projections and growth expectations.  Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).

Buffett writes that when CEOs fall short, it’s quite difficult to remove them.  Part of the problem is that there are no objective standards.

At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands.  (page 41)

A further problem is that the CEO has no immediate superior whose performance is itself being measured.  Buffett describes this and related issues:

But the CEO’s boss is a board of directors that seldom measures itself and is infrequently held to account for substandard corporate performance.  If the Board makes a mistake in hiring, and perpetuates that mistake, so what?  Even if the company is taken over because of the mistake, the deal will probably bestow substantial benefits on the outgoing board members…

Finally, relations between the Board and the CEO are expected to be congenial.  At board meetings, criticisms of the CEO’s performance is often viewed as the social equivalent of belching…

These points should not be interpreted as a blanket condemnation of CEOs or Boards of Directors:  Most are able and hardworking, and a number are truly outstanding.  But the management failings Charlie and I have seen make us thankful that we are linked with the managers of our permanent holdings.  They love their businesses, they think like owners, and they exude integrity and ability.  (pages 41-42)

Buffett wrote more about corporate governance on a different occasion.  He points out that there are three basic manager/owner situations.

The first situation – by far the most common – is that there is no controlling shareholder.  Buffett argues that directors in this case should act as if there is a single absentee owner, whose long-term interest they should try to further.  If a board member sees management going wrong, he should try to convince other board members.  Failing that, he should make his views known to absentee owners, says Buffett.  Also, the board should set standards for CEO performance and regularly meet – without the CEO present – to measure that performance.  Finally, board members should be chosen based on business savvy, interest in the job, and owner-orientation, holds Buffett.

The second situation is that the controlling owner is also the manager.  In this case, if the owner/manager is failing, it’s difficult for board members to improve things.  If the board members agree, they could as a unit convey their concerns.  But this probably won’t achieve much.  On an individual level, a board member who has serious concerns could resign.

The third governance situation is when there is a controlling owner who is not involved in management.  In this case, unhappy directors can go directly to the owner, observes Buffett.

Buffett then remarks:

Logically, the third case should be the most effective in insuring first-class management.  In the second case the owner is not going to fire himself, and in the first case, directors often find it very difficult to deal with mediocrity or mild over-reaching.  Unless the unhappy directors can win over a majority of the board – an awkward social and logistical task, particularly if management’s behavior is merely odious, not egregious – their hands are effectively tied…  (page 44)

Buffett also writes that most directors are decent folks who do a first-class job.  But, nonetheless, being human, some directors will fail to be objective if their director fees are a large part of their annual income.

Buffett says that Berkshire’s policy is only to work with people they like and admire.  Berkshire generally only buys a business when they like and admire the manager and when that manager is willing to stay in place.

…Berkshire’s ownership may make even the best of managers more effective.  First, we eliminate all of the ritualistic and nonproductive activities that normally go with the job of CEO.  Our managers are totally in charge of their personal schedules.  Second, we give each a simple mission:  Just run your business as if:

  • you own 100% of it;
  • it is the only asset in the world that you and your family have or will ever have;  and
  • you can’t sell or merge it for at least a century.

As a corollary, we tell them they should not let any of their decisions be affected even slightly by accounting considerations.  We want our managers to think about what counts, not how it will be counted.  (pages 50-51)

Buffett comments that very few CEOs of public companies can follow such mandates, chiefly because they have owners (shareholders) who focus on short-term prospects and reported earnings.  It’s not that Berkshire ignores current results, says Buffett, but that they should never be achieved at the expense of building ever-greater long-term competitive strengths.

I believe the GEICO story demonstrates the benefits of Berkshire’s approach.  Charlie and I haven’t taught Tony a thing – and never will – but we have created an environment that allows him to apply all of his talents to what’s important.  He does not have to devote his time or energy to board meetings, press interviews, presentations by investment bankers or talks with financial analysts.  Furthermore, he need never spend a minute thinking about financing, credit ratings or ‘Street’ expectations for earnings per share.  Because of our ownership structure, he also knows that this operational framework will endure for decades to come.  In this environment of freedom, both Tony and his company can convert their almost limitless potential into matching achievements.  (page 51)

Buffett discusses the importance of building long-term competitive strengths:

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger.  If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength.  But if we treat customers with indifference or tolerate bloat, our businesses will wither.  On a daily basis, the effects of our actions are imperceptible;  cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as ‘widening the moat.’  And doing that is essential if we are to have the kind of business we want a decade or two from now.  We always, of course, hope to earn more money in the short-term.  But when short-term and long-term conflict, widening the moat must take precedence.

It’s interesting that Berkshire Hathaway itself, a textile operation, is one of Buffett’s biggest investment mistakes.  Furthermore, Buffett owned the textile business from 1965 to 1985, despite generally bad results.  Buffett explains that he held on to this business because management was straightforward and energetic, labor was cooperative and understanding, the company was a large employer, and the business was still earning modest cash returns.

Buffett was able to build today’s Berkshire Hathaway, one of the largest and most successful companies in the world, because he took cash out of the textile operation and reinvested in a series of highly successful businesses.  Buffett did have to close the textile business in 1985 – twenty years after acquiring it – because, by then, the company was losing money each year, with no prospect for improvement.

Buffett tells the story of Burlington, the largest U.S. textile enterprise.  From 1964 to 1985, Burlington spent about $3 billion on improvement and expansion.  This amounted to more than $200-a-share on a $60 stock.  However, after 20 years, the stock had gone nowhere, while the CPI had more than tripled.  Buffett:

This devastating outcome for the shareholders demonstrates what can happen when much brain power and energy are applied to a faulty premise…

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad).  Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.  (pages 55-56)

Buffett also covers the topic of executive pay:

When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement.  You can get the same result personally by operating from your rocking chair.  Just quadruple the capital you commit to a savings account and you will quadruple your earnings.  You would hardly expect hosannas for that particular accomplishment.  Yet, retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign – with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest.

If the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well deserved.  But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld.  A savings account in which interest was reinvested would achieve the same year-by-year increase in earnings – and, at only 8% interest, would quadruple its annual earnings in 18 years.

The power of this simple math is often ignored by companies to the detriment of their shareholders.  Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings – i.e., earnings withheld from owners…  (page 67)

Buffett points out that ten-year, fixed-price options ignore the fact that earnings automatically build value, and that carrying capital has a cost.  Managers in this situation profit just as they would if they had an option on the savings account that automatically was building value.

Buffett repeatedly emphasizes that excellent management performance should be rewarded.  Indeed, says Buffett, exceptional managers nearly always get less than they should.  But that means you have to measure return on capital versus cost of capital.  Buffett does admit, however, that some managers he admires enormously disagree with him regarding fixed-price options.

Buffett designs Berkshire’s employment contracts with managers based on returns on capital employed versus the cost of that capital.  If the return on capital is high, the manager is rewarded.  If return on capital is sub-standard, then the manager is penalized.  Fixed-price options, by contrast, besides not usually being adjustable for the cost of capital, also fall short in that they reward managers on the upside without penalizing them on the downside.  (Buffett does adjust manager contracts based on the economic characteristics of the business, however.  A regulated business will have lower but still acceptable returns, for instance.)

Regarding reputation, Buffett has written for over 30 years:

We can’t be perfect but we can try to be…

We can afford to lose money – even a lot of money.  But we can’t afford to lose reputation – even a shred of reputation.  

Most auditors, observes Buffett, see that the CEO and CFO pay their fees.  So the auditors are more worried about offending the CEO than they are about accurate reporting.  Buffett suggests that audit committees ask the following four questions of auditors:

  1. If the auditor were solely responsible for the preparation of the company’s financial statements, would they in any way have been prepared differently from the manner selected by management?  This question should cover both material and nonmaterial differences.  If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed.  The audit committee should then evaluate the facts.
  2. If the auditor were an investor, would he have received – in plain English – the information essential to his understanding the company’s financial performance during the reporting period?
  3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO?  If not, what are the differences and why?
  4. Is the auditor aware of any actions – either accounting or operational – that have had the purpose and effect of moving revenues or expenses from one reporting period to another?  (page 79)

Buffett remarks that this procedure would save time and expense, in addition to focusing auditors on their duty.

 

FINANCE AND INVESTING

Buffett discusses his purchase of a farm in Nebraska in 1986, a few years after a bubble in Midwest farm prices had popped.  First, he learned from his son how many bushels of corn and of soybeans would be produced, and what the operating expenses would be.  Buffett determined that the normalized return from the farm would be 10%, and that productivity and prices were both likely to increase over time.  Three decades later, the farm had tripled its earnings and Buffett’s investment had grown five times in value.

Buffett also mentions buying some real estate next to NYU shortly after a bubble in commercial real estate had popped.  The unlevered current yield was 10%.  Earnings subsequently tripled and annual distributions soon exceeded 35% of the original equity investment.

Buffett says these two investments illustrate certain fundamentals of investing, which he spells out as follows:

  • You don’t need to be an expert in order to achieve satisfactory investment returns.  But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well.  Keep things simple and don’t swing for the fences.  When promised quick profits, respond with a quick ‘no.’
  • Focus on the future productivity of the asset you are considering.  If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on.  No one has the ability to evaluate every investment possibility.  But omniscience isn’t necessary;  you only need to understand the actions you undertake.
  • If you instead focus on the prospective price change of a contemplated purchase, you are speculating.  There is nothing improper about that.  I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so… And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
  • With my two small investments, I thought only of what the property would produce and cared not at all about their daily valuations.  Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.  If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
  • Forming macro opinions or listening to the macro or market opinions of others is a waste of time.  Indeed, it is dangerous because it may blur your vision of the facts that are truly important…
  • My two purchases were made in 1986 and 1993.  What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments.  I can’t remember what the headlines or pundits were saying at the time.  Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

Many long-term investors make the mistake of feeling good when stock prices rise.  Buffett says that if you’re going to be a long-term investor and regularly add to your investments, you should prefer stock prices to fall rather than rise.  Eventually, stock prices follow business results.  And it’s safe to assume the U.S. economy will continue to grow over the long term.  But between now and then, if you’re a net buyer of stocks, you’re better off if stock prices fall before they rise.  Buffett:

So smile when you read a headline that says ‘Investors lose as market falls.’  Edit it in your mind to ‘Disinvestors lose as market falls – but investors gain.’  (page 89)

Buffett advises most investors to invest in index funds:  http://boolefund.com/warren-buffett-jack-bogle/

But for a handful of investors who can understand some businesses, it’s better to patiently wait for the fattest pitches.  Buffett gives an analogy:

If my universe of business opportunities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business;  second, assess the quality of the people in charge of running it;  and, third, try to buy into a few of the best operations at a sensible price.  I certainly would not wish to own an equal part of every business in town.  Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies?  And since finding great businesses and outstanding managers is so difficult, why should we discard proven products?  (page 102)

Buffett then quotes the economist and investor John Maynard Keynes:

‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.  It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.  One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.’ – J. M. Keynes

Here are details on Keynes as an investor: http://boolefund.com/greatest-economist-defied-convention-got-rich/

Buffett explains Berkshire’s equity investment strategy by quoting its 1977 annual report:

We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety.  We want the business to be one (a) that we can understand;  (b) with favorable long-term prospects;  (c) operated by honest and competent people;  and (d) available at a very attractive price.  (page 106)

Buffett then notes that, due to Berkshire’s much larger size as well as market conditions, they would now substitute ‘an attractive price’ for ‘a very attractive price.’  How do you decide what’s ‘attractive’?  Buffett quotes The Theory of Investment Value, by John Burr Williams:

‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’

Buffett comments:

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value…

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.  The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.  Unfortunately, the first type of business is very hard to find…

Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future ‘coupons.’  At Berkshire, we attempt to deal with this problem in two ways.  First, we try to stick to businesses we believe we understand.  That means they must be relatively simple and stable in character.  If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.  Incidentally, that shortcoming doesn’t bother us.  What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.  An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price.  If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying.  We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.  (pages 107-108)

At another point, Buffett explains concentrated, buy-and-hold investing:

Inactivity strikes us as intelligent behavior.  Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market.  Why, then, should we behave differently with our minority positions in wonderful businesses?  The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries.  In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management.  Thereafter, you need only monitor whether these qualities are being preserved.

When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio.  This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars.  A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream.  To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate this portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.  (page 111)

Buffett reiterates that he and Charlie, when buying subsidiaries or common stocks, focus on businesses and industries unlikely to change much over time:

…The reason for that is simple:  Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now.  A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.

I should emphasize that, as citizens, Charlie and I welcome change:  Fresh ideas, new products, innovative processes and the like cause our country’s standard of living to rise, and that’s clearly good.  As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration:  We applaud the endeavor but prefer to skip the ride.

Obviously all businesses change to some extent.  Today, See’s is different in many ways from what it was in 1972 when we bought it:  It offers a different assortment of candy, employs different machinery and sells through different distribution channels.  But the reasons why people today buy boxed chocolates, and why they buy them from us rather than from someone else, are virtually unchanged from what they were in the 1920s when the See family was building the business.  Moreover, these motivations are not likely to change over the next 20 years, or even 50.

Buffett goes on to discuss Coca-Cola and Gillette, labeling companies like Coca-Cola ‘The Inevitables.’  Buffett points out that he’s not downplaying the important work these companies must continue to do in order to maximize their results over time.  He’s merely saying that all sensible observers agree that Coke will dominate worldwide over an investment lifetime.  This degree of brand strength – reflected in sustainably high returns on capital – is very rare.  Buffett:

Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables.  But I would rather be certain of a good result than hopeful of a great one.  (page 112)

The main danger for a great company is getting sidetracked from its wonderful core business while acquiring other businesses that are mediocre or worse.

Unfortunately, that is exactly what transpired years ago at Coke.  (Would you believe that a few decades back they were growing shrimp at Coke?)  Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding.  All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.  (page 113)

***

Buffett (again) recommends index funds for most investors:

Most investors, both individual and institutional, will find that the best way to own common stocks is through an index fund that charges minimal fees.  Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

For those investors seeking to pick individual stocks, the notion of circle of competence is crucial.  Buffett and Munger are well aware of which companies they can evaluate and which they can’t.  Buffett:

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter.  Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.  If others claim predictive skill in those industries – and seem to have their claims validated by the behavior of the stock market – we neither envy nor emulate them.  Instead, we just stick with what we understand.  (page 115)

Mistakes of the First 25 Years

Buffett first notes that the lessons of experience are not always helpful.  But it’s still good to review past mistakes ‘before committing new ones.’  To that end, Buffett lists mistakes of the twenty-five years up until 1989:

** My first mistake, of course, was in buying control of Berkshire.  Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap.  Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

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…

** That leads right into a related lesson:  Good jockeys will do well on good horses, but not on broken-down nags…

I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact…

** A further related lesson:  Easy does it.  After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems.  What we have learned is to avoid them.  To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.  On occasion, tough problems must be tackled.  In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO…

** My most surprising discovery:  the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’  In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world.  I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions.  But I learned over time that isn’t so.  Instead, rationality frequently wilts when the institutional imperative comes into play.

For example:  (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction;  (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds;  (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops;  and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

** After some mistakes, I learned to go into business only with people I like, trust, and admire… We’ve never succeeded in making a good deal with a bad person.

** Some of my worst mistakes were not publicly visible.  These were stock and business purchases whose virtues I understood and yet didn’t make… For Berkshire’s shareholders, myself included, the cost of this thumb-sucking has been huge.

** Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not.  In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged.  Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good.  Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.

We wouldn’t have liked those 99:1 odds – and never will.  A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.  If your actions are sensible, you are certain to get good results;  in most such cases, leverage just moves things along faster.  Charlie and I have never been in a big hurry:  We enjoy the process far more than the proceeds – though we have learned to live with those also.  (pages 117-120)

 

INVESTMENT ALTERNATIVES

Buffett in 2011:

Investment possibilities are both many and varied.  There are three major categories, however, and it’s important to understand the characteristics of each.  So let’s survey the field.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments.  Most of these currency-based investments are thought of as ‘safe.’  In truth they are among the most dangerous of assets.  Their beta may be zero but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal.  This ugly result, moreover, will forever recur.  Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation.  From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire.  It takes no less than $7 today to buy what $1 did at that time.  Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power.  Its managers would have been kidding themselves if they thought of any portion of that interest as income.  (pages 123-124)

Buffett then notes that it’s even worse for tax-paying investors, who would have needed 5.7% annually to hold their ground.  In other words, an invisible ‘inflation tax’ has consumed 4.3% per year.  Given that interest rates today (mid-2017) are very low, currency-based investments are not attractive for the long term (decades).

The second major category of investments involves assets that will never produce anything, but that are purchased in the hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future.  Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further.  Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful).  Gold, however, has two significant shortcomings, being neither of much use nor procreative.  True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production.  Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce of gold at its end.

Today, the world’s gold stock is about 170,000 metric tons.  If all of this gold were melded together, it would form a cube of about 68 feet per side.  (Picture it sitting comfortably within a baseball infield.)  At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion.  Call this cube pile A.

Let’s now create a pile B costing an equal amount.  For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus sixteen Exxon Mobiles (the world’s most profitable company, one earning more than $40 billion annually).  After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).  Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be.  Exxon Mobile will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons).  The 170,000 tons of gold will be unchanged in size and still incapable of producing anything.  You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold.  I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Our first two categories enjoy maximum popularity at peaks of fear:  Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse drives investors to sterile assets such as gold.  We heard ‘cash is king’ in late 2008, just when cash should have been deployed rather than held…

My own preference – and you knew this was coming – is our third category:  investment in productive assets, whether businesses, farms, or real estate.  Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.  Farms, real estate, and many businesses such as Coca-Cola, IBM, and our own See’s Candy meet that double-barreled test.  Certain other companies – think of our regulated utilities for example – fail it because inflation places heavy capital requirements on them.  To earn more, their owners must invest more.  Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle.  In the future the U.S. population will move more goods, consume more food, and require more living space than it does now.  People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens… I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined.  More important, it will be by far the safest.  (pages 125-127)

***

Pessimism creates low prices.  But you cannot be a contrarian blindly:

The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry.  We want to do business in such an environment, not because we like pessimism but because we like the prices it produces.  It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular;  a contrarian approach is just as foolish as a follow-the-crowd strategy.  What’s required is thinking rather than polling.  Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world:  ‘Most men would rather die than think.  Many do.’  (page 130)

 

COMMON STOCK

Transaction costs eat up an astonishing degree of corporate earnings every year.  Buffett writes at length – in the 2005 letter – about how this works:

The explanation of how this is happening begins with a fundamental truth: …the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn.  True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B.  And, yes, all investors feel richer when stocks soar.  But an owner can exit only by having someone take his place.  If one investor sells high, another must buy high.  For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of ‘frictional’ costs.  And that’s my point:  These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family.  We’ll call them the Gotrocks.  After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies.  Today that amount is about $700 billion annually.  Naturally, the family spends some of these dollars.  But the portion it saves steadily compounds for its benefit.  In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others.  The Helpers – for a fee, of course – obligingly agree to handle these transactions.  The Gotrocks still own all of corporate America;  the trades just rearrange who owns what.  So the family’s annual gain in wealth dimishes, equalling the earnings of American business minus commissions paid.  The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers.  This fact is not lost upon these broker-Helpers:  Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new ‘beat-my-brother’ game.  Enter another set of Helpers.  These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family.  The suggested cure:  ‘Hire a manager – yes, us – and get the job done professionally.’  These manager-Helpers continue to use the broker-Helpers to execute trades;  the managers may even increase their activity so as to permit the brokers to prosper still more.  Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family’s disappointment grows.  Each of its members is now employing professionals.  Yet overall, the group’s finances have taken a turn for the worse.  The solution?  More help, of course.

It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers.  The befuddled family welcomes this assistance.  By now its members know they can pick neither the right stocks nor the right stock-pickers.  Why, one might ask, should they expect success in picking the right consultant?  But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair.  But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers –  appears.  These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions…

The new arrivals offer a breathtakingly simple solution:  Pay more money.  Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY.  The new Helpers, however, assure the Gotrocks that this change of clothing is all-important… Calmed by this explanation, the family decides to pay up.

And that’s where we are today:  A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers.  Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).

A sufficient number of the arrangements like this – heads, the Helper takes much of the winnings;  tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.  Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business.  In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius.  But Sir Isaac’s talents didn’t extend to investing:  He lost a bundle in the South Sea Bubble explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’  If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion:  For investors as a whole, returns decrease as motion increases.  (pages 169-172)

For more details, see:  http://berkshirehathaway.com/letters/2005ltr.pdf

 

MERGERS AND ACQUISITIONS

The Oracle of Omaha says:

Of all our activities at Berkshire, the most exhilarating for Charlie and me is the acquisition of a business with excellent economic characteristics and a management that we like, trust, and admire.  Such acquisitions are not easy to make, but we look for them constantly…

In the past, I’ve observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess.  Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations.  Initially, disappointing results only deepen their desire to round up new toads… Ultimately, even the most optimistic manager must face reality.  Standing knee-deep in unresponsive toads, he then announces an enormous ‘restructuring’ charge.  In this corporate equivalent of a Head Start program, the CEO receives the education but the stockholders pay the tuition.  (page 199)

Not only do most acquisitions fail to create value for the acquirer;  many actually destroy value.  However, a few do create value.  Buffett writes:

…many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads.  In fairness, we should acknowledge that some acquisition records have been dazzling.  Two major categories stand out.

The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment.  Such favored business must have two characteristics:  (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accomodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.  Managers of ordinary ability, focusing only on acquisition possibilities meeting these tests, have achieved excellent results in recent decades.  However, very few enterprises possess both characteristics, and competition for those that do has now become fierce to the point of being self-defeating.

The second category involves the managerial superstars – who can recognize the rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise.  (page 201)

Capital allocation decisions, including value-destroying acquisitions, add up over the long term.  Buffett:

Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.  Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally.  The company could, of course, distribute the money to shareholders by way of dividends or share repurchases.  But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense.  That’s like asking your interior decorator whether you need a $50,000 rug.

The acquisition problem is often compounded by a biological bias:  Many CEOs obtain their positions in part because they possess an abundance of animal spirits and ego.  If an executive is heavily endowed with these qualities – which, it should be acknowledged, sometimes have their advantages – they won’t disappear when he reaches the top…

At Berkshire, our managers will continue to earn extraordinary returns from what appear to be ordinary businesses.  As a first step, these managers will look for ways to deploy their earnings advantageously in their businesses.  What’s left, they will send to Charlie and me.  We then will try to use those funds in ways that build per-share intrinsic value.  Our goal will be to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust.  (pages 209-210)

Over the years, Berkshire Hathaway has become the buyer of choice for many private business owners.  Buffett remarks:

Our long-avowed goal is to be the ‘buyer of choice’ for businesses – particularly those built and owned by families.  The way to achieve this goal is to deserve it.  That means we must keep our promises;  avoid leveraging up acquired businesses;  grant unusual autonomy to our managers;  and hold the purchased companies through think and thin (though we prefer thick and thicker).

Our record matches our rhetoric.  Most buyers competing against us, however, follow a different path.  For them, acquisitions are ‘merchandise.’  Before the ink dries on their purchase contracts, these operators are contemplating ‘exit strategies.’  We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.  (pages 221-222)

 

VALUATION AND ACCOUNTING

Buffett writes about Aesop and the Inefficient Bush Theory:

The formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop, and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’  To flesh out this principle, you must answer only three questions.  How certain are you that there are indeed birds in the bush?  When will they emerge and how many will there be?  What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?  If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it.  And, of course, don’t literally think birds.  Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable.  It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants.  And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet.  Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.  Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years…

Alas, though Aesop’s proposition and the third variable – that is, interest rates – are simple, plugging in numbers for the other two variables is a difficult task.  Using precise numbers is, in fact, foolish;  working with a range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached.  Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startingly low in relation to value.  (Let’s call this phenomenon the IBT – Inefficient Bush Theory.)  To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion.  But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed.  This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination.  In cases of this sort, any capital commitment must be labeled speculative.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.  Nothing sedates rationality like large doses of effortless money.  (pages 223-224)

Here Buffett is talking about the bubble in internet stocks in 1999.  He acknowledges that, overall, much value had been created and there was much more to come.  However, many individual internet companies destroyed value rather than creating it.

As noted earlier, Buffett and Munger love technological progress.  But they generally don’t invest in tech companies because it doesn’t fit their buy-and-hold approach.  It’s just not their game.  Some venture capitalists have excelled at it, but it usually takes a statistical investment approach whereby a few big winners eventually outweigh a large number of losses.

Buffett again:

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises.  We’re not smart enough to do that, and we know it.  Instead, we try to apply Aesop’s 2600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to ‘A girl in the convertible is worth five in the phone book.’)  Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount.  We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.  Even so, we make many mistakes:  I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.  (page 226)

Buffett writes about how to evaluate management:

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.  In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.  (page 237)

This leads to a discussion of economic Goodwill:

…businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.  The capitalized value of this excess return is economic Goodwill.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage.  It was not the fair market value of inventories, receivables or fixed assets that produced the premium rates of return.  Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price.  Consumer franchises are a prime source of economic Goodwill.  Other sources include governmental franchises not subject to profit regulation… and an enduring position as the low cost producer in an industry.  (page 239)

Buffett compares economic Goodwill with accounting Goodwill.  As mentioned, economic Goodwill is when the net tangible assets produce earnings in excess of market rates of return.  By contrast, accounting Goodwill is when company A buys company B, and the price paid is above the fair market value of net tangible assets.  The difference between price paid and net tangible asset value is accounting Goodwill.

In the past, companies would amortize accounting Goodwill, typically over a 40-year period.  But the current rule is that companies periodically test the value of the assets acquired.  If it is determined that the acquired assets have less value than when acquired, then the accounting Goodwill is written down based on an impairment charge.  This new way of measuring accounting Goodwill is what Buffett and Munger suggested (see page 247).

Earlier we saw that the net present value of any business is the discounted value of its future cash flows.  However, when we estimate future cash flows, it’s important to distinguish between earnings and free cash flow.  Buffett uses the the term owner earnings instead of free cash flow.  Buffett on owner earnings:

…These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

Buffett then observes that item (c), capital expenditures, usually requires a guess.  So owner earnings, or free cash flow, must also be an estimate.  Nonetheless, free cash flow is what matters when estimating the intrinsic value of a business.

If a business requires heavy capital expenditures to maintain its competitive position, that’s worth less to an owner.  By the same logic, if a business requires very little capital investment to maintain its competitive position, that’s clearly worth much more.  The capital-light business will generally earn much higher returns on capital.

So, generally speaking, as Buffett points out, when capital expenditure requirements exceed depreciation, GAAP earnings overstate owner earnings.  When capital expenditure requirements are less than depreciation, GAAP earnings understate owner earnings.

Moreover, Buffett offers a warning.  Often marketers of businesses and securities present ‘cash flow’ as simply (a) plus (b), without subtracting (c).  However, looking at cash flows without subtracting capital expenditures can give you a very misleading notion of what the business is worth.  Every business must make some capital expenditures over time to maintain its competitive position.

Buffett sums up the discussion of owner earnings – or free cash flow – with a note on accounting:

Accounting numbers of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress.  Charlie and I would be lost without these numbers:  they invariably are the starting point for us in evaluating our own businesses and those of others.  Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.  (page 254)

 

ACCOUNTING SHENANIGANS

Buffett observes that managers should try to report the essential information that investors need:

What needs to be reported is data – whether GAAP, non-GAAP, or extra-GAAP – that helps financially literate readers answer three key questions:  (1) Approximately how much is this company worth?  (2) What is the likelihood that it can meet its future obligations?  and (3) How good a job are its managers doing, given the hand they have been dealt?  (page 259)

In 1998, Buffett observed that it had become common to manipulate accounting statements:

In recent years, probity has eroded.  Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers – CEOs you would be happy to have as spouses for your children or as trustees under your will – have come to the view that it’s OK to manipulate earnings to satisfy what they believe are Wall Street’s desires.  Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.

These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree).  To pump the price, they strive, admirably, for operational excellence.  But when operations don’t produce the result hoped for, these CEOs result to unadmirable accounting strategems.  These either manufacture the desired ‘earnings’ or set the stage for them in the future.

Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals – that is, their stock – is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does.  Once such an everybody’s-doing-it attitude takes hold, ethical misgivings vanish.  Call this behavior Son of Gresham:  Bad accounting drives out good.

The distortion du jour is the ‘restructuring charge,’ an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings.  In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors.  In some case, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations.  In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share.

This dump-everything-into-one-quarter behavior suggests a corresponding ‘bold, imaginative’ approach to – golf scores.  In his first round of the season, a golfer should ignore his actual performance and simply fill his card with atrocious numbers – double, triple, quadruple bogeys – and then turn in a score of, say, 140.  Having established this ‘reserve,’ he should go to the golf shop and tell his pro that he wishes to ‘restructure’ his imperfect swing.  Next, as he takes his new swing onto the course, he should count his good holes, but not his bad ones.  These remnants from his old swing should be charged instead to the reserve established earlier.  At the end of five rounds, then, his record will be 140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92.  On Wall Street, they will ignore the 140 – which, after all, came from a ‘discontinued’ swing – and will classify our hero as an 80 shooter (and one who never disappoints).

For those who prefer to cheat up front, there would be a variant of this strategy.  The golfer, playing alone with a cooperative caddy-auditor, should defer the recording of bad holes, take four 80s, accept the plaudits he gets for such athleticism and consistency, and then turn in a fifth card carrying a 140 score.  After rectifying his earlier scorekeeping sins with this ‘big bath,’ he may mumble a few apologies but will refrain from returning the sums he has previously collected from comparing scorecards in the clubhouse.  (The caddy, need we add, will have acquired a loyal patron.)

Unfortunately, CEOs who use variations of these scoring schemes in real life tend to become addicted to the games they’re playing – after all, it’s easier to fiddle with the scorecard than to spend hours on the practice tee – and never muster the will to give them up.  (pages 272-273)

***

In discussing pension estimates, Buffett explains why index fund investors will do better  – net of all costs – than active investors:

Naturally, everyone expects to be above average.  And those helpers – bless their hearts – will certainly encourage their clients in this belief.  But, as a class, the helper-aided group must be below average.  The reason is simple:  (1)  Investors, overall, will necessarily earn an average return, minus costs they incur;  (2)  Passive and index investors, through their very inactivity, will earn that average minus costs that are very low;  (3)  With that group earning average returns, so must the remaining group – the active investors.  But this group will incur high transaction, management, and advisory costs.  Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren.  That means that the passive group – the ‘know-nothings’ – must win.  (page 276)

 

BERKSHIRE AT FIFTY AND BEYOND

Remarks by Buffett (in early 2015) on Berkshire’s fiftieth anniversary:

At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise.  Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo.  That’s important:  If horses had controlled investment decisions, there would have been no auto industry.

Another major advantage we possess is an ability to buy pieces of wonderful business – a.k.a. common stocks.  That’s not a course of action open to most managements.  Over our history, this strategic alternative has proved to be very helpful;  a broad range of options sharpens decision-making.  The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety.  Additionally, the gains we’ve realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.

In effect, the world is Berkshire’s oyster – a world offering us a range of opportunities far beyond those realistically open to most companies.  We are limited, of course, to businesses whose economic prospects we can evaluate.  And that’s a serious limitation:  Charlie and I have no idea what a great many companies will look like ten years from now.  But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry.  On top of that, we can profitably scale to a far larger size than many businesses that are constrained by the limited potential of the single industry in which they operate.

Berkshire has one further advantage that has become increasingly important over the years:  We are now the home of choice for the owners and managers of many outstanding businesses.  Families that own successful businesses have multiple options when they contemplate sale.  Frequently, the best decision is to do nothing.  There are worse things in life than having a prosperous business that one understands well.  But sitting tight is seldom recommended by Wall Street.  (Don’t ask the barber whether you need a haircut.)

When one part of a family wishes to sell while others wish to continue, a public offering often makes sense.  But, when owners wish to cash out entirely, they usually consider one of two paths.  The first is sale to a competitor who is salivating at the possibility of wringing ‘synergies’ from the combining of the two companies.  The buyer invariably contemplates getting rid of large numbers of the seller’s associates, the very people who have helped the owner build his business.  A caring owner, however – and there are plenty of them – usually does not want to leave his long-time associates sadly singing the old country song:  ‘She got the goldmine, I got the shaft.’

The second choice for sellers is the Wall Street buyer.  For some years, these purchasers accurately called themselves ‘leveraged buyout firms.’  When that term got a bad name in the early 1990s – remember RJR and Barbarians at the Gate? – these buyers hastily relabeled themselves ‘private-equity.’  The name may have changed but that was all:  Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases.  Indeed, the amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company.

Later, if things go well and equity begins to build, leveraged buy-out shops will often seek to re-leverage with new borrowings.  They then typically use part of the proceeds to pay a huge dividend that drives equity sharply downward, sometimes even to a negative figure.  In truth, ‘equity’ is a dirty word for many private-equity buyers;  what they love is debt.  And, these buyers can frequently pay top dollar.  Later the business will be resold, often to another leveraged buyer.  In effect, the business becomes a piece of merchandise.

Berkshire offers a third choice to the business owner who wishes to sell:  a permanent home, in which the company’s people and culture will be retained (though, occasionally, management changes will be needed).  Beyond that, any business we acquire dramatically increases its financial strength and ability to grow.  Its days of dealing with banks and Wall Street analysts are also forever ended.  Some sellers don’t care about these matters.  But, when sellers do, Berkshire does not have a lot of competition.  (pages 289-291)

Buffett also observes that companies are worth more as a part of Berkshire than they would be separately.  Berkshire can move funds between businesses or to new ventures instantly and without tax.  Also, some costs would be duplicated if the businesses were independent entities.  This includes regulatory and administrative expenses.  Moreover, there are tax efficiencies, says Buffett:  Certain tax credits available to Berkshire’s utilities are realizable because Berkshire generates large taxable income in other operations.

Buffett sums it up:

Today Berkshire possesses (1) an unmatched collection of businesses, most of them now enjoying favorable economic prospects;  (2) a cadre of outstanding managers who, with few exceptions, are unusually devoted to both the subsidiary they operate and to Berkshire;  (3) an extraordinary diversity of earnings, premier financial strength and oceans of liquidity that we will maintain under all circumstances;  (4) a first-choice ranking among many owners and managers who are contemplating sale of their businesses;  and (5) in a point related to the preceding item, a culture, distinctive in many ways from that of most large companies, that we have worked 50 years to develop and that is now rock-solid.  These strengths provide us a wonderful foundation on which to build.  (page 292)

For the rest of Buffett’s comments, as well as observations by Charles T. Munger on the history and evolution of Berkshire Hathaway, see pages 34-43 of the 2014 letter: http://berkshirehathaway.com/letters/2014ltr.pdf

 

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 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 

 

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

My e-mail: jb@boolefund.com

 

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

The Art of Value Investing

(Image:  Zen Buddha Silence by Marilyn Barbone.)

December 17, 2017

The Art of Value Investing (Wiley, 2013) is an excellent book by John Heins and Whitney Tilson.  Heins and Tilson have been running the monthly newsletter, Value Investor Insight, for a decade now.  Over that time, they have interviewed many of the best value investors in the world.  The Art of Value Investing is a collection of quotations carefully culled from those interviews.

I’ve selected and discussed the best quotes from the following areas:

  • Margin of Safety
  • Humility, Flexibility, and Patience
  • Courage
  • Cigar-Butt’s
  • Opportunities in Micro Caps
  • Predictable Human Irrationality
  • Long-Term Time Horizon
  • Screening and Quantitative Models

 

MARGIN OF SAFETY

(Ben Graham, by Equim43)

Ben Graham, the father of value investing, stressed having a margin of safety by buying well below the probable intrinsic value of a stock.  This is essential because the future is uncertain.  Also, mistakes are inevitable.  (Good value investors tend to be right 60 percent of the time and wrong 40 percent of the time.)  Jean-Marie Eveillard:

Whenever Ben Graham was asked what he thought would happen to the economy or to company X’s or Y’s profits, he always used to deadpan, ‘The future is uncertain.’  That’s precisely why there’s a need for a margin of safety in investing, which is more relevant today than ever.

Value investing legend Seth Klarman:

People should be highly skeptical of anyone’s, including their own, ability to predict the future, and instead pursue strategies that can survive whatever may occur.  

The central idea in value investing is to figure out what a business is worth (approximately), and then pay a lot less to acquire part ownership of that business via stock.  Howard Marks:

If I had to identify a single key to consistently successful investing, I’d say it’s ‘cheapness.’  Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses.  It’s not the only thing that matters—obviously—but it’s something for which there is no substitute.

 

HUMILITY, FLEXIBILITY, AND PATIENCE

(Image by Wilma64)

Successful value investing, to a large extent, is about having the right mindset.  Matthew McLennan identifies humility, flexibility, and patience as key traits:

Starting with the first recorded and reliable history that we can find—a history of the Peloponnesian war by a Greek author named Thucydides—and following through a broad array of key historical global crises, you see recurring aspects of human nature that have gotten people into trouble:  hubris, dogma, and haste.  The keys to our investing approach are the symmetrical opposite of that:  humility, flexibility, and patience.

On the humility side, one of the things that Jean-Marie Eveillard firmly ingrained in the culture here is that the future is uncertain.  That results in investing with not only a price margin of safety, but in companies with conservative balance sheets and prudent and proven management teams….

In terms of flexibility, we’ve been willing to be out of the biggest sectors of the market…

The third thing in terms of temperament we think we value more than most other investors is patience.  We have a five-year average holding period….We like to plant seeds and then watch the trees grow, and our portfolio is often kind of a portrait of inactivity.

It’s hard to overstate the importance of humility in investing.  Many of the biggest investing mistakes have occurred when intelligent investors who have succeeded in the past have developed high conviction in an idea that happens to be wrong.  Kyle Bass explains this point clearly:

You obviously need to develop strong opinions and to have the conviction to stick with them when you believe you’re right, even when everybody else may think you’re an idiot.  But where I’ve seen ego get in the way is by not always being open to questions and to input that could change your mind.  If you can’t ever admit you’re wrong, you’re more likely to hang on to your losers and sell your winners, which is not a recipe for success.

It often happens in investing that ideas that seem obvious or even irrefutable turn out to be wrong.  The very best investors—such as Warren Buffett, Charlie Munger, Seth Klarman, Howard Marks, Jeremy Grantham, George Soros, and Ray Dalio—have developed enough humility to admit when they’re wrong, even when all the evidence seems to indicate that they’re right.

Here are two great examples of how seemingly irrefutable ideas can turn out to be wrong:

  • shorting the U.S. stock market;
  • shorting the Japanese yen.

(Illustration by Eti Swinford)

Professor Russell Napier is the author of Anatomy of the Bear (Harriman House, 4th edition, 2016).  Napier was a top-rated analyst for many years and has been studying and writing about global macro strategy for institutional investors since 1995.

Napier has maintained (at least since 2012) that the U.S. stock market is significantly overvalued based on the Q-ratio and also the CAPE (cyclically adjusted P/E).  Moreover, Napier points out that every major U.S. secular bear market bottom in the last 100 years or so has seen the CAPE approach single digits.  The catalyst for the major drop has always been either inflation or deflation, states Napier.

Napier continues to argue (mid-2017) that U.S. stocks are overvalued and that deflation will cause the U.S. stock market to drop significantly, similar to previous secular bear markets.

Many highly intelligent value investors—at least since 2012 or 2013—have maintained high cash balances and/or short positions because they essentially agree with Napier’s argument.

However, Napier is probably wrong.  Here’s why:  U.S. interest rates are quite low, while profit margins are high compared to history.  And these conditions are likely to continue.

Low interest rates cause stocks to be much higher than otherwise.  At the extreme, as Buffett has noted, if rates stayed low enough for long enough, the stock market could have a P/E of 50 or more.

Also, U.S. profit margins are considerably higher than they have been in the last 100 years.  This situation will probably persist because software and related technology keep becoming more important in the U.S. and global economy.  The five largest U.S. companies are Google, Apple, Microsoft, Facebook, and Amazon, all technology companies.

One of the most astute value investors who tracks fair value of the S&P 500 Index is Jeremy Grantham of GMO.  Grantham used to think, back in 2012-2013, that the U.S. secular bear market was not over.  Then he partially revised his view and predicted that the S&P 500 Index was likely to exceed 2250-2300.  This level would have made the S&P 500’s value two standard deviations above the historical mean, indicating that it was back in bubble territory according to GMO’s definition.

Recently, in the GMO Quarterly Letter (Q2 2017), Grantham has revised his view again.  See: https://www.gmo.com/docs/default-source/public-commentary/gmo-quarterly-letter.pdf

Grantham now says that without a crash in profit margins, or without a dramatic sustained rise in inflation, there’s no reason to expect a market crash.  Furthermore, Grantham believes it’s unlikely for either of those things to happen, especially in the near term.  The fact that Grantham has been able to take in new information and noticeably revise his strongest convictions illustrates why he is a top value investor.

(Image by joshandandreaphotography)

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

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

There are some very smart value investors—such as Frank Martin and John Hussman—who still basically agree with Russell Napier’s views.  They may eventually be right.

But no one has ever been able to predict the stock market.  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 sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

In 1963, Graham gave a lecture, “Securities in an Insecure World.”  Link: https://www8.gsb.columbia.edu/rtfiles/Heilbrunn/Schloss%20Archives%20for%20Value%20Investing/Articles%20by%20Benjamin%20Graham/DOC005.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.  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.

Jeremy Grantham, in the GMO Q2 2017 Letter mentioned earlier, actually quotes these two sentences (among others).  But I first discovered Graham’s 1963 lecture several years ago.

Graham goes on to note that, in the 1962 edition of Security Analysis, Graham and Dodd addressed this issue.  Because of the U.S. government’s more aggressive policy with respect to preventing a depression, Graham and Dodd concluded that the U.S. stock market should have a fair value 50 percent higher.

Similar logic can be applied to the S&P 500 Index today—at just over 2675.  If interest rates remain relatively low for many years—in part based on a more aggressive Fed policy (designed to avoid deflation and create inflation)—and if profit margins are at a permanently higher level, then fair value for the S&P 500 has arguably increased significantly.  Whereas the CAPE (cyclically adjusted P/E)—the modern form of the original Graham P/E—put fair value of the S&P 500 Index at around 1100-1200 back in 2011-2013, that’s way too low if interest rates remain low and if profit margins are permanently higher.

In brief, previous methods—very well-established based on nearly a century—put fair value for the S&P 500 Index around 1100-1200.  But actual fair value could easily be closer to 2000.  And fair value grows each year as the economy grows.  The U.S. economy is still growing steadily.  So 2675 for the S&P 500 may be quite far from “bubble” territory.  In fact, the market may be fairly valued—if not now, then in 5-10 years.

Furthermore, always bear in mind that no one can predict the stock market.  This has not only been observed by Graham.  But it’s also been pointed out by Peter Lynch, Seth Klarman, Henry Singleton, and Warren Buffett.  Peter Lynch is one of the best investors.  Klarman is even better.  Buffett is arguably the best.  And Singleton was even smarter than Buffett.

In a word, history strongly demonstrates that no one has ever been able to predict the stock market with any sort of reliability.

(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.

Seth Klarman:

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.

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 (Sept. 2017) 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.  With only a few months left until the conclusion of the bet, Buffett’s investment in a Vanguard S&P 500 index fund has roughly quadrupled the performance of the hedge funds: http://boolefund.com/warren-buffett-jack-bogle/

Some very able investors have stayed largely in cash since 2011-2012.  The S&P 500 Index has more than doubled since then.  Moreover, many have tried to short the U.S. stock market since 2011-2012.  Some are down 50 percent, while the S&P 500 Index has more than doubled.  The net result of that combination is to be at only 20-25% of the S&P 500’s current value.

Henry Singleton, a business genius (100 points from being a chess grandmaster) who was easily one of the best capital allocators in American business history, never relied on financial forecasts—despite operating in a secular bear market from 1968 to 1982:

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.

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.

Another good example of a “can’t lose” investment idea that has turned out not to be right:  shorting the Japanese yen.  Many macro experts have been quite certain that the Japanese yen versus the U.S. dollar would eventually exceed 200.  They thought this would have happened years ago.  Some called it the “trade of the decade.”  But the yen versus U.S. dollar is still around 110.  A simple S&P 500 index fund appears to be doing far better than the “trade of the decade.”

(Illustration by Shalom3)

Some have tried to short Japanese government bonds (JGB’s), rather than shorting the yen currency.  But that hasn’t worked for decades.  In fact, shorting JGB’s has become known as the widowmaker trade.

Seth Klarman on humility:

In investing, certainty can be a serious problem, because it causes one not to reassess flawed conclusions.  Nobody can know all the facts.  Instead, one must rely on shreds of evidence, kernels of truth, and what one suspects to be true but cannot prove.

Klarman on the vital importance of doubt:

It is much harder psychologically to be unsure than to be sure;  certainty builds confidence, and confidence reinforces certainty.  Yet being overly certain in an uncertain, protean, and ultimately unknowable world is hazardous for investors.  To be sure, uncertainty breeds doubt, which can be paralyzing.  But uncertainty also motivates diligence, as one pursues the unattainable goal of eliminating all doubt.  Unlike premature or false certainty, which induces flawed analysis and failed judgments, a healthy uncertainty drives the quest for justifiable conviction.

My own painful experiences:  shorting the U.S. stock market and shorting the Japanese yen.  In each case, I believed that the evidence was overwhelming.  By far the biggest mistake I’ve ever made was shorting the U.S. stock market in 2011-2013.  At the time, I agreed with Russell Napier’s arguments.  I was completely wrong.

After that, I shorted the Japanese yen because I was convinced the argument was virtually irrefutable.  Wrong.  Perhaps the yen will collapse some day, but if it’s 10-20 years in the future—or even later—then an index fund or a quantitative value fund would be a far better and safer investment.

Spencer Davidson:

Over a long career you learn a certain humility and are quicker to attribute success to luck rather than your own brilliance.  I think that makes you a better investor, because you’re less apt to make the big mistake and you’re probably quicker to capitalize on good fortune when it shines upon you.

Jeffrey Bronchick:

It’s important not to get carried away with yourself when times are good, and to be able to admit your mistakes and move on when they’re not so good.  If you are intellectually honest—and not afraid to be visibly and sometimes painfully judged by your peers—investing is not work, it’s fun.

Patiently waiting for pessimism or temporary bad news to create low stock prices (some place), and then buying stocks well below probable intrinsic value, does not require genius in general.  But it does require the humility to focus only on areas where you can do well.  As Warren Buffett has remarked:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.

 

COURAGE

(Courage concept by Travelling-light)

Humility is essential for success in investing.  But you also need the courage to think and act independently.  You have to be able to develop an investment thesis based on the facts and good reasoning without worrying if many others disagree.  Most of the best value investments are contrarian, meaning that your view differs from the consensus.  Ben Graham:

In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.

Graham again:

You’re neither right nor wrong because the crowd disagrees with you.  You’re right because your data and reasoning are right.

Or as Carlo Cannell says:

Going against the grain is clearly not for everyone—and it doesn’t tend to help you in your social life—but to make the really large money in investing, you have to have the guts to make the bets that everyone else is afraid to make.

Joel Greenblatt identifies two chief reasons why contrarian value investing is hard:

Value investing strategies have worked for years and everyone’s known about them.  They continue to work because it’s hard for people to do, for two main reasons.  First, the companies that show up on the screens can be scary and not doing so well, so people find them difficult to buy.  Second, there can be one-, two- or three-year periods when a strategy like this doesn’t work.  Most people aren’t capable of sticking it out through that.

Contrarian value investing requires buying what is out-of-favor, neglected, or hated.  It also requires the ability to endure multi-year periods of trailing the market, which most investors just can’t do.  Furthermore, while you’re buying what everyone hates and while you’re trailing the market, you also have to put up with people calling you an idiot.  In a word, you must have the ability to suffer.  Eveillard:

If you are a value investor, you’re a long-term investor.  If you are a long-term investor, you’re not trying to keep up with a benchmark on a short-term basis.  To do that, you accept in advance that every now and then you will lag behind, which is another way of saying you will suffer.  That’s very hard to accept in advance because, the truth is, human nature shrinks from pain.  That’s why not so many people invest this way.  But if you believe as strongly as I do that value investing not only makes sense, but that it works, there’s really no credible alternative.

 

CIGAR-BUTT’S

(Photo by Leung Cho Pan)

Warren Buffett has remarked that buying baskets of statistically cheap cigar-butt’s—50-cent dollars—is a more dependable way to generate good returns than buying high-quality businesses.  Rich Pzena perhaps expressed it best:

When I talk about the companies I invest in, you’ll be able to rattle off hundreds of bad things about them—but that’s why they’re cheap!  The most common comment I get is ‘Don’t you read the paper?’  Because if you read the paper, there’s no way you’d buy these stocks.

They’re priced where they are for good reason, but I invest when I believe the conditions that are causing them to be priced that way are probably not permanent.  By nature, you can’t be short-term oriented with this investment philosophy.  If you’re going to worry about short-term volatility, you’re just not going to be able to buy the cheapest stocks.  With the cheapest stocks, the outlooks are uncertain.

Many investors incorrectly assume that high growth in the past will continue into the future, or that a high-quality company is automatically a good investment.  Behavioral finance expert and value investor James Montier:

There’s a great chapter [in Dan Ariely’s Predictably Irrational] about the ways in which we tend to misjudge price and use it as an indicator of something or other.  That links back to my whole thesis that the most common error we as investors make is overpaying for the hope of growth.  Dan did an experiment involving wine, in which he told people, ‘Here’s a $10 bottle of wine and here’s a $90 bottle of wine.  Please rate them and tell me which tastes better.’  Not surprisingly, nearly everyone thought the $90 wine tasted much better than the $10 wine.  The only snag was that the $90 wine and the $10 wine were actually the same $10 wine.

 

OPPORTUNITIES IN MICRO CAPS

(Illustration by Mopic)

Micro-cap stocks are the most inefficiently priced.  That’s because, for most professional investors, assets under management are too large.  These investors cannot even consider micro caps.  The Boole Microcap Fund is designed to take advantage of this inefficiency: http://boolefund.com/best-performers-microcap-stocks/

James Vanasek on the opportunity in micro caps:

We’ll invest in companies with up to $1 billion or so in market cap, but have been most successful in ideas that start out in the $50 million to $300 million range.  Fewer people are looking at them and the industries the companies are in can be quite stable.  Given that, if you find a company doing well, it’s more likely it can sustain that advantage over time.

Because very few professional investors can even contemplate investing in micro caps, there’s far less competition.  Carlo Cannell:

My basic premise is that the efficient markets hypothesis breaks down when there is inconsistent, imperfect dissemination of information.  Therefore it makes sense to direct our attention to the 14,000 or so publicly traded companies in the U.S. for which there is little or no investment sponsorship by Wall Street, meaning three or fewer sell-side analysts who publish research…

You’d be amazed how little competition we have in this neglected universe.  It is just not in the best interest of the vast majority of the investing ecosphere to spend 10 minutes on the companies we spend our lives looking at.

Robert Robotti adds:

We focus on smaller-cap companies that are largely ignored by Wall Street and face some sort of distress, of their own making or due to an industry cycle.  These companies are more likely to be inefficiently priced and if you have conviction and a long-term view they can produce not 20 to 30 percent returns, but multiples of that.

 

PREDICTABLE HUMAN IRRATIONALITY

Value investors recognize that the stock market is not always efficient, largely because humans are often less than fully rational.  As Seth Klarman explains:

Markets are inefficient because of human nature—innate, deep-rooted, permanent.  People don’t consciously choose to invest with emotion—they simply can’t help it.

Quantitative value investor James O’Shaugnessy:

Because of all the foibles of human nature that are well documented by behavioral research—people are always going to overshoot and undershoot when pricing securities.  A review of financial markets all the way back to the South Sea Company nearly 300 years ago proves this out.

Bryan Jacoboski:

The very reason price and value diverge in predictable and exploitable ways is because people are emotional beings.  That’s why the distinguishing attribute among successful investors is temperament rather than brainpower, experience, or classroom training.  They have the ability to be rational when others are not.

Overconfidence is extremely deep-rooted in human psychology.  When asked, the vast majority of us rate ourselves as above average across a wide variety of dimensions such as looks, smarts, driving skill, academic ability, future well-being, and even luck (!).

In a field such as investing, it’s vital to become aware of our natural overconfidence.  Charlie Munger likes this quote from Demosthenes:

Nothing is easier than self-deceit.  For what each man wishes, that also he believes to be true.

But becoming aware of our overconfidence is usually not enough.  We also have to develop systems—such as checklists – that can automatically reduce both the frequency and the severity of mistakes.

(Image by Aleksey Vanin)

Charlie Munger reminds value investors not only to develop and use a checklist, but also to follow the advice of mathematician Carl Jacobi:

Invert, always invert.

In other words, instead of thinking about how to succeed, Munger advises value investors to figure out all the ways you can fail.  This is a powerful concept in a field like investing, where overconfidence frequently causes failure.  Munger:

It is occasionally possible for a tortoise, content to assimilate proven insights of his best predecessors, to outrun hares which seek originality or don’t wish to be left out of some crowd folly which ignores the best work of the past.  This happens as the tortoise stumbles on some particularly effective way to apply the best previous work, or simply avoids the standard calamities.  We try more to profit by always remembering the obvious than from grasping the esoteric.  It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.

When it comes to checklists, it’s helpful to have a list of cognitive biases.  Here’s my list: http://boolefund.com/cognitive-biases/

Munger’s list is more comprehensive: http://boolefund.com/the-psychology-of-misjudgment/

Recency bias is one of the most important biases to be aware of as an investor.  Jed Nussdorf:

It is very hard to avoid recency bias, when what just happened inordinately informs your expectation of what will happen next.  One of the best things I’ve read on that is The Icarus Syndrome, by Peter Beinart.  It’s not about investing, but describes American hubris in foreign policy, in many cases resulting from doing what seemed to work in the previous 10 years even if the setting was materially different or conditions had changed.  One big problem is that all the people who succeed in the recent past become the ones in charge going forward, and they think they have it all figured out based on what they did before.  It’s all quite natural, but can result in some really bad decisions if you don’t constantly challenge your core beliefs.

Availability bias is closely related to recency bias and vividness bias.  You’re at least 15-20 times more likely to be hit by lightning in the United States than to be bitten by shark.  But often people don’t realize this because shark attacks tend to be much more vivid in people’s minds.  Similarly, your odds of dying in a car accident are 1 in 5,000, while your odds of dying in a plane crash are 1 in 11 million.  Nonetheless, many people view flying as more dangerous.

John Dorfman on investors overreacting to recent news:

Investors overreact to the latest news, which has always been the case, but I think it’s especially true today with the Internet.  Information spreads so quickly that decisions get made without particularly deep knowledge about the companies involved.  People also overemphasize dramatic events, often without checking the facts.

 

LONG-TERM TIME HORIZON

(Illustration by Marek)

Because so many investors worry and think about the shorter term, value investors continue to gain a large advantage by focusing on the longer term (especially three to five years).  In a year or less, a given stock can do almost anything.  But over a five-year period, a stock tracks intrinsic business value to a large extent.  Jeffrey Ubben:

It’s still true that the biggest players in the public markets—particularly mutual funds and hedge funds—are not good at taking short-term pain for long-term gain.  The money’s very quick to move if performance falls off over short periods of time.  We don’t worry about headline risk—once we believe in an asset, we’re buying more on any dips because we’re focused on the end game three or four years out.

Mario Cibelli:

One of the last great arbitrages left is to be long-term-oriented when there is a large class of shareholders who have no tolerance for short-term setbacks.  So it’s interesting when stocks get beaten-up because a company misses earnings or the market reacts to a short-term business development.  It’s crazy to me when someone says something is cheap but doesn’t buy it because they think it won’t go anywhere for the next 6 to 12 months.  We have a pretty high tolerance for taking that pain if we see glory longer term.

Whitney Tilson wrote about a great story that value investor Bill Miller told.  Miller recalled that, early in his career, he was visiting an institutional money manager, to whom he was pitching R.J. Reynolds, then trading at four times earnings.  Miller:

“When I finished, the chief investment officer said: ‘That’s a really compelling case but we can’t own that.  You didn’t tell me why it’s going to outperform the market in the next nine months.’  I said I didn’t know if it was going to do that or not but that there was a very high probability it would do well over the next three to five years.

“He said: ‘How long have you been in this business?  There’s a lot of performance pressure, and performing three to five years down the road doesn’t cut it.  You won’t be in business then.  Clients expect you to perform right now.’

“So I said: ‘Let me ask you, how’s your performance?’

“He said: ‘It’s terrible, that’s why we’re under a lot of performance pressure.’

“I said: ‘If you bought stocks like this three years ago, your performance would be good right now and you’d be buying RJR to help your performance over the next three years.’”

Link: http://www.tilsonfunds.com/Patience%20can%20find%20a%20virtue%20in%20market%20inefficiency-FT-6-9-06.pdf

Many investors are so focused on shorter periods of time (a year or less).  They forget that the value of any business is ALL of its (discounted) future free cash flow, which often means 10-20 years or more.  David Herro:

I would assert the biggest reason quality companies sell at discounts to intrinsic value is time horizon.  Without short-term visibility, most investors don’t have the conviction or courage to hold a stock that’s facing some sort of challenge, either internally or externally generated.  It seems kind of ridiculous, but what most people in the market miss is that intrinsic value is the sum of ALL future cash flows discounted back to the present.  It’s not just the next six months’ earnings or the next year’s earnings.  To truly invest for the long term, you have to be able to withstand underperformance in the short term, and the fact of the matter is that most people can’t.

As Mason Hawkins observes, a company may be lagging now precisely because it’s making longer-term investments that will probably increase business value in the future:

Classic opportunities for us get back to time horizon.  A company reports a bad quarter, which disappoints Wall Street with its 90-day focus, but that might be for explainable temporary reasons or even because the company is making very positive long-term investments in the business.  Many times that investment increases the likely value of the company five years from now, but disappoints people who want the stock up tomorrow.

Whitney George:

We evaluate businesses over a full business cycle and probably our biggest advantage is an ability to buy things when most people can’t because the short-term outlook is lousy or very hard to judge.  It’s a good deal easier to know what’s likely to happen than to know precisely when it’s going to happen.

In general, humans are impatient and often discount multi-year investment gains far too much.  John Maynard Keynes: 

Human nature desires quick results, there is a particular zest in making money quickly, and remoter gains are discounted by the average man at a very high rate.

 

SCREENING AND QUANTITATIVE MODELS

(Word cloud by Arloofs)

Automating of the investment process, including screening, is often more straightforward now than it has been, thanks to enormous advances in computing in the past two decades.

Will Browne:

We often start with screens on all aspects of valuation.  There are characteristics that have been proven over long periods to be associated with above-average rates of return:  low P/Es, discounts to book value, low debt/equity ratios, stocks with recent significant price declines, companies with patterns of insider buying and—something we’re paying a lot more attention to—stocks with high dividend yields.

Stephen Goddard:

Our basic screening process weights three factors equally:  return on tangible capital, the multiple of EBIT to enterprise value, and free cash flow yield.  We rank the universe we’ve defined on each factor individually from most attractive to least, and then combine the rankings and focus on the top 10%.

Carlo Cannell:

[We] basically spend our time trying to uncover the assorted investment misfits in the market’s underbrush that are largely neglected by the investment community.  One of the key metrics we assign to our companies is an analyst ratio, which is simply the number of analysts who follow the company.  The lower the better—as of the end of last year, about 65 percent of the companies in our portfolio had virtually no analyst coverage.

For some time now, it has been clear that simple quant models outperform experts in a wide variety of areas: http://boolefund.com/simple-quant-models-beat-experts-in-a-wide-variety-of-areas/

Quantitative value investor James O’Shaugnessy:

Models beat human forecasters because they reliably and consistently apply the same criteria time after time.  Models never vary.  They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored.  They don’t favor vivid, interesting stories over reams of statistical data.  They never take anything personally.  They don’t have egos.  They’re not out to prove anything.  If they were people, they’d be the death of any party.

People on the other hand, are far more interesting.  It’s far more natural to react emotionally or to personalize a problem than it is to dispassionately review broad statistical occurrences—and so much more fun!  It’s much more natural for us to look at the limited set of our personal experiences and then generalize from this small sample to create a rule-of-thumb heuristic.  We are a bundle of inconsistencies, and although this tends to make us interesting, it plays havoc with our ability to successfully invest.

Buffett maintains (correctly) that the vast majority of investors, large or small, should invest in low-cost broad market index funds: http://boolefund.com/quantitative-microcap-value/

If you invest in a quantitative value fund focused on cheap micro caps with improving fundamentals, then you can reasonably expect to do about 7% (+/- 3%) better than the S&P 500 Index over time: http://boolefund.com/best-performers-microcap-stocks/

Will Browne:

When you have a model you believe in, that you’ve used for a long time and which is more empirical than intuitive, sticking with it takes the emotion away when markets are good or bad.  That’s been a central element of our success.  It’s the emotional dimension that drives people to make lousy, irrational decisions.

 

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 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  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.

Shoe Dog

(Image:  Zen Buddha Silence by Marilyn Barbone.)

December 10, 2017

As you may know, I try to read virtually everything recommended by Warren Buffett, Charlie Munger, and Bill Gates.  All three are “learning machines,” and their combined knowledge includes not only business, investing, and history (especially biographies), but many other subjects such as psychology, physics, renewable energy, and computer science.

Gates said recently, in his advice to the class of 2017, that he was lucky to be involved in the digital revolution when he was young.  He noted if he were starting out again today and looking to make a big impact, he would choose artificial intelligence, renewable energy, or biosciences.

Shoe Dog is the autobiography of Phil Knight, the creator of Nike.  Gates mentioned this book as one of his favorites in 2016, saying it was “a refreshingly honest reminder of what the path to business success really looks like:  messy, precarious, and riddled with mistakes.”

 

DAWN

Knight introduces his story:

On paper, I thought, I’m an adult.  Graduated from a good college – University of Oregon.  Earned a master’s from a top business school – Stanford.  Survived a yearlong hitch in the U.S. Army – Fort Lewis and Fort Eustis.  My resume said I was a learned, accomplished soldier, a twenty-four-year-old man in full… So why, I wondered, why do I still feel like a kid?

Worse, like the same shy, pale, rail-thin kid I’d always been.

Maybe because I still hadn’t experienced anything of life.  Least of all its many temptations and excitements.  I hadn’t smoked a cigarette, hadn’t tried a drug.  I hadn’t broken a rule, let alone a law.  The 1960s were just underway, the age of rebellion, and I was the only person in America who hadn’t yet rebelled.  I couldn’t think of one time I’d cut loose, done the unexpected.

I’d never even been with a girl.

If I tended to dwell on all the things I wasn’t, the reason was simple.  Those were the things I knew best.  I’d have found it difficult to see who or what exactly I was, or might become.  Like all my friends I wanted to be successful.  Unlike my friends I didn’t know what that meant.  Money?  Maybe.  Wife?  Kids?  House?  Sure, if I was lucky.  These were the goals I was taught to aspire to, and part of me did aspire to them, instinctively.  But deep down I was searching for something else, something more.  I had an aching sense that our time is short, shorter than we ever know, short as a morning run, and I wanted mine to be meaningful.  And purposeful.  And creative.  And important.  Above all… different.

I wanted to leave a mark on the world…

And then it happened.  As my young heart began to thump, as my pink lungs expanded like the wings of a bird, as the trees turned to greenish blurs, I saw it all before me, exactly what I wanted my life to be.  Play.

Yes, I thought.  That’s it.  That’s the word.  The secret of happiness, I’d always suspected, the essence of beauty or truth, or all we ever need to know of either, lay somewhere in that moment when the ball is in midair, when both boxers sense that approach of the bell, when the runners near the finish line and the crowd rises as one.  There’s a kind of exuberant clarity in that pulsing half second before winning and losing are decided.  I wanted that, whatever that was, to be my life, my daily life.

At different times, I’d fantasized about becoming a great novelist, a great journalist, a great statesman.  But the ultimate dream was always to be a great athlete.  Sadly, fate had made me good, not great.  At twenty-four, I was finally resigned to that fact.  I’d run track at Oregon, and I’d distinguished myself, lettering three of four years.  But that was that, the end.  Now, as I began to clip off one brisk six-minute mile after another, as the rising sun set fire to the lowest needles of the pines, I asked myself:  What if there were a way, without being an athlete, to feel what athletes feel?  To play all the time, instead of working?  Or else to enjoy work so much that it becomes essentially the same thing.

I was suddenly smiling.  Almost laughing.  Drenched in sweat, moving as gracefully and effortlessly as I ever did, I saw my Crazy Idea shining up ahead, and it didn’t look all that crazy.  It didn’t even look like an idea.  It looked like a place.  It looked like a person, or some life force that existed long before I did, separate from me, but also part of me.  Waiting for me, but also hiding from me.  That might sound a little high-flown, a little crazy.  But that’s how I felt back then.

…At twenty-four, I did have a crazy idea, and somehow, despite being dizzy with existential angst, and fears about the future, and doubts about myself, as all young men and women in their midtwenties are, I did decide that the world is made up of crazy ideas.  History is one long processional of crazy ideas.  The things I loved most – books, sports, democracy, free enterprise – started as crazy ideas.

For that matter, few ideas are as crazy as my favorite thing, running.  It’s hard.  It’s painful.  It’s risky.  The rewards are few and far from guaranteed… Whatever pleasures or gains you drive from the act of running, you must find them within.  It’s all in how you frame it, how you sell it to yourself.

So that morning in 1962 I told myself:  Let everyone else call your idea crazy… just keep going.  Don’t stop.  Don’t even think about stopping until you get there, and don’t give much thought to where ‘there’ is.  Whatever comes, just don’t stop.

That’s the precocious, prescient, urgent advice I managed to give myself, out of the blue, and somehow managed to take.  Half a century later, I believe it’s the best advice – maybe the only advice – any of us should ever give.  (pages 2-5)

 

1962

Knight explains that his crazy idea started as a research paper for a seminar on entrepreneurship at Stanford.  He became obsessed with the project.  As a runner, he knew about shoes.  He also knew that some Japanese products, such as cameras, had recently gained much market share.  Perhaps Japanese running shoes might do the same thing.

When Knight presented his idea to his classmates, everyone was bored.  No one asked any questions.  But Knight held on to his idea.  He imagined pitching it to a Japanese shoe company.  Knight also conceived of the idea of seeing the world on his way to Japan.  He wanted to see “the world’s most beautiful and wondrous places.”

And its most sacred.  Of course I wanted to taste other foods, hear other languages, dive into other cultures, but what I really craved was connection with a capital C.  I wanted to experience what the Chinese call Tao, the Greeks call Logos, the Hindus call Jnana, the Buddhists call Dharma.  What the Christians call Spirit.  Before setting out on my own personal life voyage, I thought, let me first understand the greater voyage of humankind.  Let me explore the grandest temples and churches and shrines, the holiest rivers and mountaintops.  Let me feel the presence of… God?

Yes, I told myself, yes.  For lack of a better word, God.  (page 10)

But Knight needed his father’s blessing and cash in order to make the trip around the world.

At the time, most people had never been on an airplane.  Also, Knight’s father’s father had died in an air crash.  As for the shoe company idea, Knight was keenly aware that twenty-six out of twenty-seven new companies failed.  Knight then notes that his father, besides being a conventional Episcopalian, also liked respectability.  Traveling around the world just wasn’t done except by beatniks and hipsters.

Knight then adds:

Possibly, the main reason for my father’s respectability fixation was a fear of his inner chaos.  I felt this, viscerally, because every now and then that chaos would burst forth.  (page 12)

Knight tells about having to pick his father up from his club.  On these evenings, Knight’s father had had too much to drink.  But father and son would pretend nothing was wrong.  They would talk sports.

Knight’s mom’s mom, “Mom Hatfield” – from Roseburg, Oregon – warned “Buck” (Knight’s nickname) that the Japanese would take him prisoner and gouge out his eyeballs.  Knight’s sisters, four years younger (twins), Jeanne and Joanne, had no reaction.  His mom didn’t say anything, as usual, but seemed proud of his decision.

Knight asked a Stanford classmate, Carter, a college hoops star, to come with him.  Carter loved to read good books.  And he liked Buck’s idea.

The first stop was Honolulu.  After seeing Hawaiian girls, then diving into the warm ocean, Buck told Carter they should stay.  What about the plan?  Plans change.  Carter liked the new idea and grinned.

They got jobs selling Encyclopedias door-to-door.  But their main mission was learning how to surf.  “Life was heaven.”  Except that Buck couldn’t sell encyclopedias.  He thought he was getting shier as he got older.

So he tried a job selling securities.  Specifically, Dreyfus funds for Investors Overseas Services, Bernard Cornfeld’s firm.  Knight had better luck with this.

Eventually, the time came for Buck and Carter to continue on their trip around the world.  However, Carter wasn’t sure.

He’d met a girl.  A beautiful Hawaiian teenager with long brown legs and jet-black eyes, the kind of girl who’d greeted our airplane, the kind I dreamed of having and never would.  He wanted to stick around, and how could I argue?  (page 20)

Buck hesitated, not sure he wanted to continue on alone.  But he decided not to stop his journey.  He bought a plane ticket that was good for one year on any airline going anywhere.

When Knight got to Tokyo, much of the city was black because it still hadn’t been rebuilt after the bombing.

American B-29s.  Superfortresses.  Over a span of several nights in the summer of 1944, waves of them dropped 750,000 pounds of bombs, most filled with gasoline and flammable jelly.  One of the world’s oldest cities, Tokyo was made largely of wood, so the bombs set off a hurricane of fire.  Some three hundred thousand people were burned alive, instantly, four times the number who died in Hiroshima.  More than a million were gruesomely injured.  And nearly 80 percent of the buildings were vaporized.  For long, solemn stretches the cab driver and I said nothing.  There was nothing to say.  (page 21)

Fortunately, Buck’s father knew some people in Tokyo at United Press International.  They advised Buck to talk to two ex-GI’s who ran a monthly magazine, the Importer.

First, Knight spent long periods of time in walled gardens reading about Buddhism and Shinto.  He liked the concept of kensho, or sartori – a flash of enlightenment.

But according to Zen, reality is nonlinear.  No past, no present.  All is now.  That required Knight to change his thinking.  There is no self.  Even in competition, all is one.

Knight decided to mix it up and visited the Tokyo Stock Exchange – Tosho.  All was madness and yelling.  Is this what it’s all about?

Knight sought peace and enlightenment again.  He visited the garden of the nineteenth century emperor Meiji and his empress.  This particular place was thought to possess great spiritual power.  Buck sat beneath the ginkgo trees, beside the gorgeous torii gate, which was thought of as a portal to the sacred.

Next it was Tsukiji, the world’s largest fish market.  Tosho all over again.

Then to the lakes region in the Northern Hakone mountains.  An area that inspired many of the great Zen poets.

Knight went to see the two ex-GI’s.  They told him how they’d fallen in love with Japan during the Occupation.  So they stayed.  They had managed to keep the import magazine going for seventeen years thus far.

Knight told them he liked the Tiger shoes produced by Onitsuka Co. in Kobe, Japan.  The ex-GI’s gave him tips on negotiating with the Japanese:

‘No one ever turns you down, flat.  No one ever says, straight out, no.  But they don’t say yes, either.  They speak in circles, sentences with no clear subject or object.  Don’t be discouraged, but don’t be cocky.  You might leave a man’s office thinking you’ve blown it, when in fact he’s ready to do a deal.  You might leave thinking you’ve closed a deal, when in fact you’ve just been rejected.  You never know.  (pages 25-26)

Knight decided to visit Onitsuka right away, with the advice fresh in his mind.  He managed to get an appointment, but got lost and arrived late.

When he did arrive, several executives met him.  Ken Miyazaki showed him the factory.  Then they went to a conference room.

Knight had rehearsed this scene his head, just like he used to visualize his races.  But one thing he hadn’t prepared for was the recent history of World War II hanging over everything.  The Japanese had heroically rebuilt, putting the war behind them.  And these Japanese executives were young.  Still, Knight thought, their fathers and uncles had tried to kill his.  In brief, Knight hesitated and coughed, then finally said, “Gentlemen.”

Mr. Miyazaki interrupted, “Mr. Knight.  What company are you with?”

Knight replied, “Ah, yes.  Good question.”  Knight experienced fight or flight for a moment.  A random jumble of thoughts flickered in his mind until he visualized his wall of blue ribbons from track.  “Blue Ribbon… Gentleman, I represent Blue Ribbon Sports of Portland, Oregon.”

Knight presented his basic argument, which was that the American shoe market was huge and largely untapped.  If Onitsuka could produce good shoes and price them below Adidas, it could be highly profitable.  Knight had spent so much time on his research paper at Stanford that he could simply quote it and come across as eloquent.

The Japanese executives started talking excitedly together, then suddenly stood up and left the room.  Knight didn’t know if he had been rejected.  Perhaps he should leave.  He waited.

Then they came back into the room with sketches of different Tiger shoes.  They told him they had been thinking about the American market for some time.  They asked Knight how big he thought the market could be.  Knight tossed out, “$1 billion.”  He doesn’t know where the number came from.

They asked him if Blue Ribbon would be interested in selling Tigers in the United States.  Yes, please send samples to this address, Knight said, and I’ll send a money order for fifty dollars.

Knight considered returning home to get a jump on the new business.  But then he decided to finish his trek around the world.

Hong Kong, then the Phillipines.

I was fascinated by all the great generals, from Alexander the Great to George Patton.  I hated war, but I loved the warrior spirit.  I hated the sword, but loved the samurai.  And of all the great fighting men in history I found MacArthur the most compelling.  Those Ray-Bans, that corncob pipe – the man didn’t lack for confidence.  Brilliant tactician, master motivator, he also went on to head the U.S. Olympic Committee.  How could I not love him?

Of course, he was deeply flawed.  But he knew that… (pages 31-32)

Bangkok.  He made his way to Wat Phra Kaew, a huge 600-year-old Buddha carved from one hunk of jade.  One of the most sacred statues in Asia.

Vietnam, where U.S. soldiers filled the streets.  Everyone knew a very ugly and different war was coming.

Calcutta.  Knight got sick immediately.  He thinks food poisoning.  He was sure, for one whole day, that he was going to die.  He rallied.  He ended up at the Ganges.  There was a funeral.  Others were bathing.  Others were drinking the same water.

“The Upanishads say, Let me from the unreal to the real.”  So Knight went to Kathmandu and hiked up the Himalayas.

Back to India.  Bombay.

Kenya.  Giant ostriches tried to outrun the bus, records Knight.  When Masai warriors boarded the bus, a baboon or two would also try to board.

Cairo.  The Giza plateau.  Standing besides desert nomads with their silk-draped camels.  At the foot of the Great Sphinx.

…The sun hammered down on my head, the same sun that hammered down on the thousands of men who built these pyramids, and the millions of visitors who came after.  Not one of them was remembered, I thought.  All is vanity, says the Bible.  All is now, says Zen.  All is dust, says the desert.  (pages 33-34)

Jerusalem.

…the first century rabbi Eleazar ben Azariah said our work is the holiest part of us.  All are proud of their craft.  God speaks of his work;  how much more should man.

Istanbul.  Turkish coffee.  Lost on the confusing streets of the Bosphorus.  Glowing minarets.  Then the golden labyrinths of Topkapi Palace.

Rome.  Tons of pasta.  And the most beautiful women and shoes he’d ever seen, says Knight.  The Coliseum.  The Vatican.  The Sistine Chapel.

Florence.  Reading Dante.  Milan.  Da Vinci:  One of his obsessions was the human foot, which he called a masterpiece of engineering.

Venice.  Marco Polo.  The palazzo of Robert Browning:  “If you get simply beauty and naught else, you get about the best thing God invents.”

Paris.  The Pantheon.  Rousseau.  Voltaire:  “Love truth, but pardon error.”  Praying at Notre Dame.  Lost in the Louvre.  Where Joyce slept, and F. Scott Fitzgerald.  Walking down the Seine, and stopping where Hemingway and Dos Passos read the New Testament aloud to each other.

Then up the Champs-Elysees, along the liberators’ path, thinking of Patton:  “Don’t tell people how to do things, tell them what to do and let them surprise you with their results.”

Munich.  Berlin.  East Berlin:

…I looked around, all directions.  Nothing.  No trees, no stores, no life.  I thought of all the poverty I’d seen in every corner of Asia.  This was a different kind of poverty, more willful, somehow, more preventable.  I saw three children playing in the street.  I walked over, took their picture.  Two boys and a girl, eight years old.  The girl – red wool hat, pink coat – smiled directly at me.  Will I ever forget her?  Or her shoes?  They were made of cardboard.  (page 36)

Vienna.  Stalin, Trotsky, Tito, Hitler, Jung, Freud.  All at the same location in the same time period.  A “coffee-scented crossroads.”  Where Mozart walked.  Crossing the Danube.  The spires of St. Stephen’s Church, where Beethoven realized he was deaf.

London.  Buckingham Palace, Speakers’ Corner, Harrods.

Knight asked himself what the highlight of his trip was.

Greece, I thought.  No question.  Greece.

…I meditated on that moment, looking up at those astonishing columns, experiencing that bracing shock, the kind you receive from all great beauty, but mixed with a powerful sense of – recognition?

Was it only my imagination?  After all, I was standing at the birthplace of Western civilization.  Maybe I merely wanted it to be familiar.  But I don’t think so.  I had the clearest thought:  I’ve been here before.

Then, walking up those bleached steps, another thought:  This is where it all begins.

On my left was the Parthenon, which Plato had watched the teams of architects and workmen build.  On my right was the Temple of Athena Nike.  Twenty-five centuries ago, per my guidebook, it had housed a beautiful frieze of the goddess Athena, thought to be the bringer of “nike,” or victory.

It was one of many blessings Athena bestowed.  She also rewarded the dealmakers.  In the Oresteia she says:  ‘I admire… the eyes of persuasion.’  She was, in a sense, the patron saint of negotiators.  (page 37)

 

1963

When Buck got home, his hair was to his shoulders and his beard three inches long.  It had been four months since meeting with Onitsuka.  But they hadn’t sent the sample shoes.  Knight wrote to them to ask why.  They wrote back, “Shoes coming… In a little more days.”

Knight got a haircut and shaved.  He was back.  His father suggested he speak with his old friend, Don Frisbee, CEO of Pacific Power & Light.  Frisbee had an MBA from Harvard.  Frisbee told Buck to get his CPA while he was young, a relatively conservative way to put a floor under his earnings.  Knight liked that idea.  He had to take three more courses in accounting, first, which he promptly did at Portland State.

Then Knight worked at Lybrand, Ross Bros. & Montgomery.  It was a Big Eight national firm, but its Portland office was small.  $500 a month and some solid experience.  But pretty boring.

 

1964

Finally, twelve pairs of shoes arrived from Onitsuka.  They were beautiful, writes Knight.  He sent two pairs immediately to his old track coach at Oregon, Bill Bowerman.

Bowerman was a genius coach, a master motivator, a natural leader of young men, and there was one piece of gear he deemed crucial to their development.  Shoes.  (page 43)

Bowerman was obsessed with shoes.  He constantly took his runners’ shoes and experimented on them.  He especially wanted to make the shoes lighter.  One ounce over a mile is fifty pounds.

Bowerman would try anything.  Kangaroo.  Cod.  Knight says four or five runners on the team were Bowerman’s guinea pigs.  But Knight was his “pet project.”

It’s possible that everything I did in those days was motivated by some deep yearning to impress, to please, Bowerman.  Besides my father there was no man whose approval I craved more, and besides my father there was no man who gave it less often.  Frugality carried over to every part of the coach’s makeup.  He weighed and hoarded words of praise, like uncut diamonds.

After you’d won a race, if you were lucky, Bowerman might say:  ‘Nice race.’  (In fact, that’s precisely what he said to one of his milers after the young man became one of the very first to crack the mythical four-minute mark in the United States.)  More likely Bowerman would say nothing.  He’d stand before you in his tweed blazer and ratty sweater vest, his string tie blowing in the wind, his battered ball cap pulled low, and nod once.  Maybe stare.  Those ice-blue eyes, which missed nothing, gave nothing.  Everyone talked about Bowerman’s dashing good looks, his retro crew cut, his ramrod posture and planed jawline, but what always got me was that gaze of pure violet blue.  (page 45)

For his service in World War II, Bowerman received the Silver Star and four Bronze Stars.  Bowerman eventually became the most famous track coach in America.  But he hated being called “coach,” writes Knight.  He called himself, “Professor of Competitive Responses” because he viewed himself as preparing his athletes for the many struggles and competitions that lay ahead in life.

Knight did his best to please Bowerman.  Even so, Bowerman would often lose patience with Knight.  On one occasion, Knight told Bowerman he was coming down with the flu and wouldn’t be able to practice.  Bowerman told him to get his ass out there.  The team had a time trial that day.  Knight was close to tears.  But he kept his composure and ran one of his best times of the year.  Bowerman gave him a nod afterward.

Bowerman suggested meeting for lunch shortly after seeing the Tiger shoes from Onitsuka.  At lunch, Bowerman told Knight the shoes were pretty good and suggested they become business partners.  Knight was shocked.

Had God himself spoken from the whirlwind and asked to be my partner, I wouldn’t have been more surprised.  (page 48)

Knight and Bowerman signed an agreement soon thereafter.  Knight found himself thinking again about his coach’s eccentricities.

…He always went against the grain.  Always.  For example, he was the first college coach in America to emphasize rest, to place as much value on recovery as on work.  But when he worked you, brother, he worked you.  Bowerman’s strategy for running the mile was simple.  Set a fast pace for the first two laps, run the third as hard as you can, then triple your speed on the fourth.  There was a Zen-like quality to this strategy because it was impossible.  And yet it worked.  Bowerman coached more sub-four-minute milers than anybody, ever.  (page 50)

Knight wrote Onitsuka and ordered three hundred pairs of shoes, which would cost $1,ooo.  Buck had to ask his dad for another loan, who asked him, “Buck, how long do you think you’re going to keep jackassing around with these shoes?”  His father told him he didn’t send him to Oregon and Stanford to be a door-to-door shoe salesman.

At this point, Knight’s mother told him she wanted to purchase a pair of Tigers.  This helped convince Knight’s father to give him another loan.

In April 1964, Knight got the shipment of Tigers.  Also, Mr. Miyazaki told him he could be the distributor for Onitsuka in the West.  Knight quit his accounting job to focus on selling shoes that spring.  His dad was horrified, his mom happy, remarks Knight.

After being rejected by a couple of sporting goods stores, Knight decided to travel around to various track meets in the Pacific Northwest.  Between races, he’d talk with the coaches, the runners, the fans.  He couldn’t write the orders fast enough.  Knight wondered how this was possible, given his inability to sell encyclopedias.

…So why was selling shoes so different?  Because, I realized, it wasn’t selling.  I believed in running.  I believed that if people got out and ran a few miles every day, the world would be a better place, and I believed these shoes were better to run in.  People, sensing my belief, wanted some of that belief for themselves.

Belief, I decided.  Belief is irresistable.  (pages 55-56)

Knight started the mail order business because he started getting letters from folks wanting Tigers.  To help the process along, he mailed some handouts with big type:

‘Best news in flats!  Japan challenges European track shoe domination!  Low Japanese labor costs make it possible for an exciting new firm to offer these shoes at the low, low price of $6.95.’  [Note:  This is close to $54 in 2017 dollars, due to inflation.]

Knight had sold out his first shipment by July 4, 1964.  So he ordered 900 more.  This would cost $3,000.  His dad grudgingly gave him a letter of guarantee, which Buck took to the First National Bank of Oregon.  They approved the loan.

Knight wondered how to sell in California.  He couldn’t afford airfare.  So every other weekend, he’d stuff a duffel bag with Tigers.  He’d don his army uniform and head to the local air base.  The MPs would wave him on to the next military transport to San Francisco or Los Angeles.

When in Los Angeles, he’d save more money by staying with a friend from Stanford, Chuck Cale.  At a meet at Occidental College, a handsome guy approached Knight, introducing himself as Jeff Johnson.  He was a fellow runner whom Knight had run with and against while at Stanford.  At this point, Johnson was studying anthropology and planning on becoming a social worker.  But he was selling shoes – Adidas then – on weekends.  Knight tried to recruit him to sell Tigers instead.  No, because he was getting married and needed stability, responded Johnson.

Then Knight got a letter from a high school wrestling coach in Manhasset, New York, claiming that Onitsuka had named him the exclusive distributor for Tigers in the United States.  He ordered Knight to stop selling Tigers.

Knight contacted his cousin, Doug Houser, who’d recently graduated from Stanford Law School.  Houser found out Mr. Manhasset was a bit of a celebrity, a model who was one of the original Marlboro Men.  Knight:  “Just what I need.  A pissing match with some mythic American cowboy.”

Knight went into a funk for awhile.  Then he decided to go visit Onitsuka in Japan.  Knight bought a new suit and also a book, How to Do Business with the Japanese.

Knight realized he had to remain cool.  Emotion could be fatal.

The art of competition, I’d learned from track, was the art of forgetting, and now I reminded myself of that fact.  You must forget your limits.  You must forget your doubts, your pain, your past.  You must forget that internal voice screaming, begging, ‘Not one more step!’  And when it’s not possible to forget it, you must negotiate with it.  I thought over all the races in which my mind wanted one thing, and my body wanted another, those laps in which I’d had to tell my body, ‘Yes, you raise some excellent points, but let’s keep going anyway…’  (page 61)

After finding a place to stay in Kobe, Knight called Onitsuka and requested a meeting.  He got a call back saying Mr. Miyazaki no longer worked there.  Mr. Morimoto had replaced him, and didn’t want Knight to visit headquarters.  Mr. Morimoto would meet him for tea.  None of this was good.

At the meeting, Knight layed out the arguments.  They had had an agreement.  He also pointed out the very robust sales Blue Ribbon had had thus far.  He dropped the name of his business partner.  Mr. Morimoto, who was about Knight’s age, said he’d get back to him.

Knight thought it was over.  But then he got a call from Morimoto saying, “Mr. Onitsuka… himself… wishes to see you.”

At this meeting, Knight first presented his arguments again to those who were initially present.  Then Mr. Onitsuka arrived.

Dressed in a dark blue Italian suit, with a head of black hair as thick as shag carpet, he filled every man in the conference room with fear.  He seemed oblivious, however.  For all his power, for all his wealth, his movements were deferential… Morimoto tried to summarize my reasons for being there.  Mr. Onitsuka raised a hand, cut him off.

Without preamble, he launched into a long, passionate monologue.  Some time ago, he’d said, he’d had a vision.  A wondrous glimpse of the future.  ‘Everyone in the world wear athletic shoes all the time,’ he said.  ‘I know this day will come.’  He paused, looking around the table at each person, to see if they also knew.  His gaze rested on me.  He smiled.  I smiled.  He blinked twice.  ‘You remind me of myself when I am young,’ he said softly.  His stared into my eyes.  One second.  Two.  Now he turned his gaze to Morimoto.  ‘This about those thirteen western states?’ he said.  ‘Yes,’ Morimoto said.  ‘Hm,’ Onitsuka said.  ‘Hmmmm.’  He narrowed his eyes, looked down.  He seemed to be meditating.  Again he looked up at me.  ‘Yes,’ he said.  ‘Alright.  You have western states.’  (pages 63-64)

Knight ordered $3,400 worth of shoes [about $26,000 in 2017 dollars].

To celebrate, Knight decided to climb to the top of Mount Fuji.  Buck met a girl on the wap up, Sarah, who was studying philosophy at Connecticut College for Women.  It went well for a time.  Many letters back and forth.  A couple of visits.  But she decided Knight wasn’t “sophisticated” enough.  Jeanne, one of Buck’s younger sisters, found the letters, read them, and told Buck, “You’re better off without her.”  Buck then asked his sister – given her interest in mail – if she’d like to help with the mail order business for $1.50 an hour.  Sure.  Blue Ribbon Employee Number One.

 

1965

Buck got a letter from Johnson.  He’d bought some Tigers and loved them.  Could he become a commissioned salesman for Blue Ribbon?  Sure.  $1.75 for each pair of running shoes, $2 for spikes, were the commissions.

Then the letters from Johnson kept coming:

I liked his energy, of course.  And it was hard to fault his enthusiasm.  But I began to worry he might have too much of each.  With the twentieth letter, or the twenty-fifth, I began to worry that the man might be unhinged.  I wondered why everything was so breathless.  I wondered if he was ever going to run out of things he urgently needed to tell me, or ask me…

…He wrote to say that he wanted to expand his sales territory beyond California, to include Arizona, and possibly New Mexico.  He wrote to suggest that we open a retail store in Los Angeles.  He wrote to tell me that he was considering placing ads in running magazines and what did I think?  He wrote to inform me that he’d placed those ads in running magazines and the response was good.  He wrote to ask why I hadn’t answered any of his previous letters.  He wrote to plead for encouragement.  He wrote to complain that I hadn’t responded to his previous plea for encouragement.

I’d always considered myself a conscientious correspondent… And I always meant to answer Johnson’s letters.  But before I got around to it, there was always another one, waiting.  Something about the sheer volume of his correspondence stopped me… (pages 73-73)

Eventually Johnson realized he loved shoes and running more than anthropology or social work.

In his heart of hearts Johnson believed that runners are God’s chosen, that running, done right, in the correct spirit and with the proper form, is a mystical exercise, no less than meditation or prayer, and thus he felt called to help runners reach their nirvana.  I’d been around runners much of my life, but this kind of dewy romanticism was something I’d never encountered.  Not even the Yahweh of running, Bowerman, was as pious about the sport as Blue Ribbon’s Part-Time Employee Number Two.

In fact, in 1965, running wasn’t even a sport.  It wasn’t popular, it wan’t unpopular, it just was.  To go out for a three-mile run was something weirdos did, presumably to burn off manic energy.  Running for exercise, running for pleasure, running for endorphins, running to live better and longer – these things were unheard of.

People often went out of their way to mock runners.  Drivers would slow down and honk their horns.  ‘Get a horse!,’ they’d yell, throwing a beer or soda at the runner’s head.  Johnson had been drenched by many a Pepsi.  He wanted to change all this…

Above all, he wanted to make a living doing it, which was next to impossible in 1965.  In me, in Blue Ribbon, he thought he saw a way.

I did everything I could to discourage Johnson from thinking like this.  At every turn, I tried to dampen his enthusiasm for me and my company.  Besides not writing back, I never phoned, never visited, never invited him to Oregon.  I also never missed an opportunity to tell him the unvarnished truth.  I put it flatly:  ‘Though our growth has been good, I owe First National Bank of Oregon $11,000… Cash flow is negative.’

He wrote back immediately, asking if he could work for me full-time… (pages 75-76)

Knight just shook his head.  Finally in last summer of 1965, Knight accepted Johnson’s offer.  Johnson had been making $460 as a social worker, so he proposed $400 a month [over $3,000 a month in 2017 dollars].  Knight very reluctantly agreed.  It seemed like a huge sum.  Knight writes:

As ever, the accountant in me saw the risk, the entrepreneur the possibility.  So I split the difference and kept moving forward.  (page 77)

Knight then forgot about Johnson because he had bigger issues.  Blue Ribbon had doubled its sales in one year.  But Knight’s banker said they were growing too fast for their equity.  Knight asked how doubling sales – profitably – can be a bad thing.

In those days, however, commercial banks were quite different from investment banks.  Commercial banks never wanted you to outgrow your cash balance.  Knight tried to explain that growing sales as much as possible – profitably – was essential to convince Onitsuka to stick with Blue Ribbon.  And then there’s the monster, Adidas.  But his banker kept repeating:

‘Mr. Knight, you need to slow down.  You don’t have enough equity for this kind of growth.’

Knight kept hearing the word “equity” in his head over and over.  “Cash,” that’s what it meant.  But he was deliberately reinvesting every dollar – on a profitable basis.  What was the problem?

Every meeting with his banker, Knight managed to hold his tongue and say nothing, basically agreeing.  Then he’d keep doubling his orders from Onitsuka.

Knight’s banker, Harry White, had essentially inherited the account.  Previously, Ken Curry was Knight’s banker, but Curry bailed when Knight’s father wouldn’t guarantee the account in the case of business failure.

Furthermore, the fixation on equity didn’t come from White, but from White’s boss, Bob Wallace.  Wallace wanted to be the next president of the bank.  Credit risks were the main roadblock to that goal.

Oregon was smaller back then.  First National and U.S. Bank were the only banks, and the second one had already turned Blue Ribbon down.  So Knight didn’t have a choice.  Also, there as no such thing as venture capital in 1965.

To make matters worse, Onitsuka was always late in its shipments, no matter how much Knight pleaded with them.

By this point, Knight had passed the four parts of the CPA exam.  So he decided to get a job as an accountant.  He invested a good chunk of his paycheck into Blue Ribbon.

In analyzing companies as an accountant, Knight learned how they sold things or didn’t, how they survived or didn’t.  He learned how companies got into trouble and how they got out.

It was while working for the Portland branch of Price Waterhouse that he met Delbert J. Hayes, who was the best accountant in the office.  Knight describes Hayes as a man with “great talent, great wit, great passions – and great appetites.”  Hayes was six-foot-two and three hundred pounds.  He loved food and alcohol.  And he smoked two packs a day.

Hayes looked at numbers the way a poet looks at clouds or a geologist looks at rocks, says Knight.  He could see the beauty of numbers.  Numbers were a secret code.

Every evening, Hayes would insist on taking junior accountants out for a drink.  Hayes would talk nonstop, like he drank.  But while other accountants dismissed Hayes’ stories, Knight always paid careful attention.  In every tale told by Hayes was some piece of wisdom about business.  So Knight would match Hayes, shot for shot, in order to learn as much as he could.

The following morning, Knight was always sick.  But he willed himself to do the work.  Being in the Army Reserves at the same time wasn’t easy.  Meanwhile, the conflict in Vietnam was heating up.  Knight:

I had grown to hate that war.  Not simply because I felt it was wrong.  I also felt it was stupid, wasteful.  I hated stupidity.  I hated waste.  Above all, that war, more than other wars, seemed to be run along the same principles of my bank.  Fight not to win, but to avoid losing.  A surefire losing strategy.  (page 84)

Hayes came to appreciate Knight.  Hayes thought it was a tough time to launch a new company with zero cash balance.  But he did acknowledge that having Bowerman as a partner was a valuable, intangible asset.

Recently, Bowerman and Mrs. Bowerman had visited Onitsuka and charmed everyone.  Mr. Onitsuka told Bowerman about founding his shoe company in the rubble after World War II.

He’d built his first lasts, for a line of basketball shoes, by pouring hot wax from Buddhist candles over his own feet.  Though the basketball shoes didn’t sell, Mr. Onitsuka didn’t give up.  He simply switched to running shoes, and the rest is shoe history.  Every Japanese runner in the 1964 Games, Bowerman told me, was wearing Tigers.

Mr. Onitsuka also told Bowerman that the inspiration for the unique soles on Tigers had come to him while eating sushi.  Looking down at his wooden platter, at the underside of an octopus’s leg, he thought a similar suction cup might work on the sole of a runner’s flat.  Bowerman filed that away.  Inspiration, he learned, can come from quotidian things.  Things you might eat.  Or find lying around the house.  (page 86)

Bowerman started corresponding not only with Mr. Onitsuka, but with the entire production team at the Onitsuka factory.  Bowerman realized that Americans tend to be longer and heavier than the Japanese.  He thought the Tigers could be modified to fit Americans better.  Most of Bowerman’s letters went unanswered, but like Johnson Bowerman just kept writing more.

Eventually he broke through.  Onitsuka made prototypes that conformed to Bowerman’s vision of a more American shoe.  Soft inner sole, more arch support, heel wedge to reduce stress on the Achilles tendon – they sent the prototype to Bowerman and he went wild for it.  He asked for more.  (page 87)

Bowerman also experimented with drinks to help his runners recover.  He invented an early version of Gatorade.  As well, he conducted experiments to make the track softer.  He invented an early version of polyurethane.

 

1966

Johnson kept inundating Knight with long letters, including a boatload of parenthetical comments and a list of PS’s.  Knight felt he didn’t have time to send the requested words of encouragement.  Also, it wasn’t his style.

I look back now and wonder if I was truly being myself, or if I was emulating Bowerman, or my father, or both.  Was I adopting their man-of-few-words demeanor?  Was I maybe modeling all the men I admired?  At the time I was reading everything I could get my hands on about generals, samurai, shoguns, along with biographies of my three main heroes – Churchill, Kennedy, and Tolstoi.  I had no love of violence, but I was fascinated by leadership, or lack thereof, under extreme conditions…

I wasn’t that unique.  Throughout history men have looked to the warrior for a model of Hemingway’s cardinal virtue, pressurized grace… One lesson I took from all my home-schooling about heroes was that they didn’t say much.  None was a blabbermouth.  None micromanaged.  “Don’t tell people how to do things, tell them what to do and let them surprise you with their results.”  (page 90)

Johnson never let Knight’s lack of communication discourage him.  Johnson was full of energy, passion, and creativity.  He was going all-out, seven days a week, to sell Blue Ribbon shoes.  Johnson had an index card for each customer including their shoe sizes and preferences.  He sent all of them birthday cards and Christmas cards.  Johnson developed extensive correspondence with hundreds of customers.

Johnson began aggregating customer feedback on the shoes.

…One man, for instance, complained that Tiger flats didn’t have enough cushion.  He wanted to run the Boston Marathon but didn’t think the Tigers would last the twenty-six miles.  So Johnson hired a local cobbler to graft rubber soles from a pair of shower shoes into a pair of Tiger flats.  Voila.  Johnsn’s Frankenstein flat had space-age, full-length, midsole cushioning.  (Today it’s standard in all training shoes for runners.)  The jerry-rigged Johnson sole was so dynamic, so soft, so new, Johnson’s customer posted a personal best in the Boston.  Johnson forwarded me the results and urged me to pass them along to Tiger.  Bowerman had just asked me to do the same with his batch of notes a few weeks earlier.  Good grief, I thought, one mad genius at a time.  (page 92)

Johnson had customers in thirty-seven states.  Knight meant to warn him about encroaching on Malboro Man’s territory.  But he never got around to it.

Knight did write to tell Johnson that if he could sell 3,250 shoes by the end of June 1966, then he could open the retail outlet he’d been asking about.  Knight calculated that 3,250 was impossible, so he wasn’t too worried.

Somehow Johnson hit 3,250.  So Blue Ribbon opened its first retail store in Santa Monica.

He then set about turning the store into a mecca, a holy of holies for runners.  He bought the most comfortable chairs he could find, and afford (yard sales), and he created a beautiful space for runners to hang out and talk.  He built shelves and filled them with books that every runner should read, many of them first editions from his own library.  He covered the walls with photos of Tiger-shod runners, and laid in a supply of silk-screened T-shirts with Tiger across the front, which he handed out to his best customers.  He also stuck Tigers to a black lacquered wall and illuminated them with a strip of can lights – very hip.  Very mod.  In all the world, there had never been a sanctuary for runners, a place that didn’t just sell them shoes but celebrated them and their shoes.  Johnson, the aspiring cult leader of runners, finally had his church.  Services were Monday through Saturday, nine to six.

When he first wrote me about the store, I thought of the temples and shrines I’d seen in Asia, and I was anxious to see how Johnson’s compared.  But there just wasn’t time... (page 95)

Knight got a heads up that the Marlboro man had just launched an advertising campaign which involved poaching customers of Blue Ribbon.  So Knight flew down to see Johnson.  Johnson’s apartment with one giant running shoe.  There were running shoes seemingly everywhere.  And there were many books – mostly thick volumes on philosophy, religion, sociology, anthropology, and classics in Western literature.  Knight had thought he liked to read.  This was a new level, says Knight.

Johnson told Knight he had to go visit Onitsuka again.  Johnson started typing notes, ideas, lists, which would become a manifesto for Knight to take to Onitsuka.  Knight wired Onitsuka.  They got back to him, but it wasn’t Morimoto.  It was a new guy, Kitami.

Knight told Kitami and other executives about the performance of Blue Ribbon thus far, virtually doubling sales each year and projecting more of the same.  Kitami said they wanted someone more established, with offices on the East Coast.  Knight replied that Blue Ribbon had offices on the East Coast and could handle national distribution.  “Well,” said Kitami, “this changes things.”

The next morning, Kitami awarded Blue Ribbon exclusive distribution rights for the United States.  A three-year contract.  Knight promptly placed an order for 5,000 more shoes, which would cost $20,000 – more than $150,000 in 2017 dollars – that he didn’t have.  Kitami said he would ship them to Blue Ribbon’s East Coast office.

There was only one person crazy enough to move to the East Coast on a moment’s notice….

 

1967

Knight delayed telling Johnson.  Then he hired John Bork, a high school track coach and a friend of a friend, to run the Santa Monica store.  Bork showed up at the store and told Johnson that he, Bork, was the new boss so that Johnson could go back east.

Johnson called Knight.  Knight told him he’d had to tell Onitsuka that Blue Ribbon had an east coast office.  A huge shipment was due to arrive at this office.  Johnson was the only one who could manage the east coast store.  The fate of the company was on his shoulders.  Johnson was shocked, then mad, then freaked out.  Knight flew down to visit him.

Johnson talked himself into going to the east coast.

The forgiveness Johnson showed me, the overall good nature he demonstrated, filled me with gratitude, and a new fondness for the man.  And perhaps a deeper loyalty.  I regretted my treatment of him.  All those unanswered letters.  There are team players, I thought, and then there are team players, and then there’s Johnson.  (page 105)

Soon thereafter, Bowerman called asking Knight to add a new employee – Geoff Hollister.  A former track guy.  Full-time Employee Number Three.

Then Bowerman called again with yet another employee – Bob Woodell.

I knew the name, of course.  Everyone in Oregon knew the name.  Woodell had been a standout on Bowerman’s 1965 team.  Not quite a star, but a gritty and inspiring competitor.  With Oregon defending its second national championship in three years, Woodell had come out of nowhere and won the long jump against vaunted UCLA.  I’d been there, I’d watched him do it, and I’d come away mighty impressed.  (page 108)

The very next day, during a celebration, there had been an accident.  The float twenty guys were carrying collapsed after someone lost their footing.  It landed on Woodell and crushed one of his vertebra, paralyzing his legs.

Knight called Woodell.  Knight realized it was best to keep it strictly business.  So he told Woodell that Bowerman had recommended him.  Would he like to grab lunch to discuss the possibility of working for Blue Ribbon?  Sure thing, he said.

Woodell had already mastered a special car, a Mercury Cougar with hand controls.  At lunch, they hit it off and Woodell impressed Knight.

I wasn’t certain what Blue Ribbon was, or if it would ever become a thing at all, but whatever it was or might become, I hoped it would have something of this man’s spirit.  (page 110)

Knight offered Woodell a job opening a second retail store, in Eugene, for a monthly salary of $400.  Woodell immediately agreed.  They shook hands.  “He still hand the strong grip of an athlete.”

Bowerman’s latest experiment was with the Spring Up.  He noticed the outer sole melted, whereas the midsole remained solid.  He convinced Onitsuka to fuse the outer sole to the midsole.  The result looked like the ultimate distance training shoe.  Onitsuka also accepted Bowerman’s suggestion of a name for the shoe, the “Aztec,” in homage to the upcoming 1968 Olympics in Mexico City.  Unfortunately, Adidas had a similar name for one of its shoes and threatened to sue.  So Bowerman changed the name to “Cortez.”

The situation with Adidas reminded Knight of when he had been a runner in high school.  The fastest runner in the state was Jim Grelle (pronounced “Grella”) and Knight had been second-fastest.  So Knight spent many races staring at Grelle’s back.  Then they both went to Oregon, so Knight spent more years staring at Grelle’s back.

Adidas made Knight think of Grelle.  Knight felt super motivated.

Once again, in my quixotic effort to overtake a superior opponent, I had Bowerman as my coach.  Once again he was doing everything he could to put me in position to win.  I often drew on the memory of his old prerace pep talks, especially when we were up against our blood rivals, Oregon State.  I would replay Bowerman’s epic speeches… Nearly sixty years later it gives me chills to recall his words, his tone.  No one could get your blood going like Bowerman, though he never raised his voice.  (page 112)

Thanks to the Cortez, Blue Ribbon finished the year strong.  They had nearly doubled their sales again, to $84,000.  Knight rented an office for $50 a month.  And he transferring Woodell to the “home office.”  Woodell had shown himself to be highly skilled and energetic, and in particular, he was excellent at organizing.

The office was cold and the floor was warped.  But it was cheap.  Knight built a corkboard wall, pinning up different Tiger models and borrowing some of Johnson’s ideas from the Santa Monica store.

Knight thought perhaps he could save even more money by living at his office.  Then he reflected that living at your office was what a crazy person does.  Then he got a letter from Johnson saying he was living at his office.  Johnson had set up shop in Wellesley, a suburb of Boston.

Johnson told Knight how he had chosen the location.  He’d seen people running along country roads, many of them women.  Ali MacGraw look-alikes.  Sold.

 

1968

Knight:

I wanted to dedicate every minute of every day to Blue Ribbon… I wanted to be present, always.  I wanted to focus constantly on the one task that really mattered.  If my life was to be all work and no play, I wanted my work to be play.  I wanted to quit Price Waterhouse.  Not that I hated it;  it just wasn’t me.

I wanted what everyone wants.  To be me, full-time.  (page 117)

Even though Blue Ribbon was on track to double sales again, there was never enough cash, certainly not to pay Knight.  Knight found another job he thought might fit better with his desire to focus as much as possible on blue Ribbon.  Assistant Professor of Accounting at Portland State University.

Knight, a CPA who had worked for two accounting firms, knew accounting pretty well at this point.  But he was restless and twitchy, with several nervous tics – including wrapping rubber banks around his wrist and snapping them.  One of his students was named Penelope Parks.  Knight was captivated by her.

Knight decided to use the Socratic method to teach accounting.  Miss Parks turned out to be the best student in the class.  Soon thereafter, Miss Parks asked if Knight would be her advisor.  Knight then asked her if she’d like a job for Blue Ribbon to help with bookkeeping.  “Okay.”

On Miss Parks’ first day at Blue Ribbon, Woodell gave her a list of things – typing, bookkeeping, scheduling, stocking, filing invoices – and told her to pick two.  Hours later, she’d done every thing on the list.  Within a week, Woodell and Knight couldn’t remember how they’d gotten by without her, recalls Knight.

Furthermore, Miss Parks was “all-in” with respect to the mission of Blue Ribbon.  She was good with people, too.  She had a healing effect on Woodell, who was still struggling to adjust to his legs being paralyzed.

Knight often volunteered to go get lunch for the three of them.  But his head was usually so full of business matters that he would invariably get the orders mixed up.  “Can’t wait to see what I’m eating for lunch today,” Woodell might say quietly.  Miss Parks would hide a smile.

Later on, Knight found out that Miss Parks and Woodell weren’t cashing any of their paychecks.  They truly believed in Blue Ribbon.  It was more than just a job for them.

Knight and Penny started dating.  They were good at communicating nonverbally since they were both shy people.  They were a good match and eventually decided to get married.  Knight felt like she was a partner in life.

Knight made another trip to Onitsuka.  Kitami was very friendly this time, inviting him to the company’s annual picnic.

…I was doing business with a country I’d come to love.  Gone was the initial fear.  I connected with the shyness of the Japanese people, with the simplicity of their culture and products and arts.  I liked that they tried to add beauty to every part of life, from the tea ceremony to the commode.  I liked that the radio announced each day which cherry trees, on which corner, were blossoming, and how much.  (page 132)

Knight met a man named Fujimoto at the picnic.  It turned out to be another life-altering partnership.

 

1969

Knight was able to hire more ex-runners on commission.  Sales in 1968 had been $150,000 and now they were on track for $300,000 for 1969.

Knight was finally able to pay himself a salary.  But before leaving Portland State, he happened to see a starving artist in the hallway and asked if she’d do advertising art part-time.  Her name was Carolyn Davidson, and she said OK.

Bowerman and Knight were losing trust in Kitami.  Bowerman thought he didn’t know much about shoes and was full of himself.  Knight hired Fujimoto to be a spy.  Knight pondered again that when it came to business in Japan, you never knew what a competitor or a partner would do.

Knight was absentminded.  He couldn’t go to the store and return with the one thing Penny asked for.  He misplaced wallets and keys frequently.  And he was constantly bumping into trees, poles, and fenders while driving.

Knight got in the habit of calling his father in the evening.  His father would be in his recliner, while Buck would be in his.  They’d hash things over.

Woodell and Knight began looking for a new office.  They started enjoying hanging out together.  Before parting, Knight would time Woodell on how fast he could fold up his wheelchair and get it and himself into his car.

Woodell was super positive and super energetic, a constant reminder of the importance of good spirits and a great attitude.

Buck and Penny would have Woodell over for dinner.  Those were fun times.  They would take turns describing that the company was and might be, and what it must never be.  Woodell was always dressed carefully and always had on a pair of Tigers.

Knight asked Woodell to become operations manager.  He’d demonstrated already that he was exceptionally good at managing day-to-day tasks.  Woodell was delighted.

 

1970

Knight visited Onitsuka again.  He discovered that Kitami was being promoted to operations manager.  Onitsuka and Blue Ribbon signed another 3-year agreement.  Knight looked into Kitami’s eyes and noticed something very cold.  Knight never forgot that cold look.

Knight pondered the fact that the shipments from Onitsuka were always late, and sometimes had the wrong sizes or even the wrong models.  Woodell and Knight discovered that Onitsuka always filled its orders from Japanese companies first, and then sent its foreign exports.

Meanwhile, Wallace at the bank kept making things difficult.  Knight concluded that a small public offerings could create the extra cash Blue Ribbon needed.  At the time, in 1970, a few venture capital firms had been launched.  But they were in California and mostly invested in high-tech.  So Knight formed Sports-Tek, Inc., as a holding company for Blue Ribbon.  They tried a small public offering.  It didn’t work.

Friends and family chipped in.  Woodell’s parents were particularly generous.

On June 15, 1970, Knight was shocked to see a Man of Oregon on the cover of Sports Illustrated.  His name was Steve Prefontaine.  He’d already set a national record in high school at the two-mile (8:41).  In 1970, he’d run three miles in 13:12.8, the fastest time on the planet.

Knight learned from a Fortune magazine about Japan’s hyper-aggressive sosa shoga, “trading companies.”  It was hard to see what these trading companies were exactly.  Sometimes they were importers.  Sometimes they were exporters.  Sometimes they were banks.  Sometimes they were an arm of the government.

After being harangued by Wallace at First National about cash balances again, Knight walked out and saw a sign for the Bank of Tokyo.  He was escorted to a back room, where a man appeared after a couple of minutes.  Knight showed the man his financials and said he needed credit.  The man said that Japan’s sixth-largest trading company had an office at the top floor of this same building.  Nissho Iwai was a $100-billion dollar company.

Knight met a man named Cam Murakami, who offered Knight a deal on the spot.  Knight said he had to check with Onitsuka first.  Knight wired Kitami, but heard nothing back at all for weeks.

Then Knight got a call from a guy on the east coast who told him that Onitsuka had approached him about becoming its new U.S. distributor.  Knight check with Fujimoto, his spy.  Yes, it was true.  Onitsuka was considering a clean break with Blue Ribbon.

Knight invited Kitami to visit Blue Ribbon.

 

1971

March 1971.  Kitami was on his way.  Blue Ribbon vowed to give him the time of his life.

Kitami arrived with a personal assistant, Hiraku Iwano, who was just a kid.  At one point, Kitami told Knight that Blue Ribbon’s sales were disappointing.  Knight said sales were doubling every year.  “Should be triple some people say,” Kitami replied.  “What people?”, asked Knight.  “Never mind,” answered Kitami.

Kitami took a folder from his briefcase and repeated the charge.  Knight tried to defend Blue Ribbon.  Back and forth.  Kitami had to use the restroom.  When he left the meeting room, Knight looked into Kitami’s briefcase and tried to snag the folder that he thought Kitami had been referring to.

Kitami went back to his hotel.  Knight still had the folder.  He and Woodell opened it up.  They found a list of eighteen U.S. athletic shoe distributors.  These were the “some people” who told Kitami that Blue Ribbon wasn’t performing well enough.

I was outraged, of course.  But mostly hurt.  For seven years we’d devoted ourselves to Tiger shoes.  We’d introduced them to America, we’d reinvented the line.  Bowerman and Johnson had shown Onitsuka how to make a better shoe, and their designs were now foundational, setting sales records, changing the face of the industry – and this was how we were repaid?  (pages 170-171)

At the end of Kitami’s visit, as planned, there was dinner with Bowerman, Mrs. Bowerman, and his friend (and lawyer), Jaqua.  Mrs. Bowerman usually didn’t allow alcohol, but she was making an exception.  Knight and Kitami both liked mai tais, which were being served.

Unfortunately, Bowerman had a few too many mai tais.  It appeared things might get out of hand.  Knight looked at Jaqua, remembering that he’d been a fighter pilot in World World II, and that his wingman, one of his closest friends, had been shot out of the sky by a Japanese Zero.  Knight thought he sensed something starting to erupt in Jaqua.

Kitami, however, was having a great time.  Then he found a guiter.  He started playing it and singing a country Western.  Suddenly, he sang “O Sole Mio.”

A Japanese businessman, strumming a Western guitar, singing an Italian ballad, in the voice of an Irish tenor.  It was surreal, then a few miles past surreal, and it didn’t stop.  I’d never know there were so many verses to “O Sole Mio.”  I’d never known a roomful of active, restless Oregonians could sit still and quite for so long.  When he set down the guitar, we all tried not to make eye contact with each other as we gave him a big hand.  I clapped and clapped and it all made sense.  For Kitami, this trip to the United States – the visit to the bank, the meetings with me, the dinner with the Bowermans – wasn’t about Blue Ribbon.  Nor was it about Onitsuka.  Like everything else, it was all about Kitami.  (page 174)

At a meeting soon thereafter, however, Kitami told Knight that Onitsuka wanted to buy Blue Ribbon.  If Blue Ribbon did not accept, Onitsuka would have to work with other distributors.  Knight knew he still needed Onitsuka, at least for awhile.  So he thought of a stall.  He told Kitami he’d have to talk with Bowerman.  Kitami said OK and left.

Knight sent the budget and forecast to First National.  White informed Knight at a meeting that First National would no longer be Blue Ribbon’s bank.  White was sick about it, the bank officers were divided, but it had been Wallace’s call.  Knight strove straight to U.S. Bank.  Sorry.  No.

Blue Ribbon was finishing 1971 with $1.3 million in sales, but it was in danger of failing.  Fortunately, Bank of Cal gave Blue Ribbon a small line of credit.

Knight went back to Nissho and met Tom Sumeragi.  Sumeragi told Knight that Nissho was willing to take a second position to their banks.  Also, Nissho had sent a delegation to Onitsuka to try to work out a deal on financing.  Onitsuka had tossed them out.  Nissho was embarrased that a $25 million company had thrown out a $100 billion company.  Sumeragi told Knight that Nissho could introduce him to other shoe manufacturers in Japan.

Knight knew he had to find a new shoe factory somewhere.  He found one in Gaudalajara, Mexico.  Knight placed an order for three thousand soccer shoes.  It’s at this point that Knight asked his part-time artist, Carolyn Davidson, to try to design a logo.  “Something that evokes a sense of motion.”  She came back two weeks later and her sketches had a theme.  But Knight was wondering what the theme was, “…fat lightning bolts?  Chubby check marks?  Morbidly obese squiggles?…”

Davidson returned later.  Same theme, but better.  Woodell, Johnson, and a few others liked it, saying it looked like a wing or a whoosh of air.  Knight wasn’t thrilled about it, but went along because they were out of time and had to send it to the factory in Mexico.

They also needed a name.  Falcon.  Dimension Six.  These were possibilities they’d come up with.  Knight liked Dimension Six mostly because he’d come up with it.  Everyone told him it was awful.  It didn’t mean anything.  Bengal.  Condor.  They debated possibilities.

It was time to decide.  Knight still didn’t know.  Then Woodell told him that Johnson had had a dream and then woke up with the name clearly in mind:  “Nike.”

Knight reminisced…  “The Greek goddess of victory.  The Acropolis.  The Parthenon.  The Temple…”

Knight had to decide.  He hated having to decide under time pressure.  He’s not sure if it was luck or spirit or something else, but he chose “Nike.”  Woodell said, “Hm.”  Knight replied, “Yeah, I know.  Maybe it’ll grow on us.”

Meanwhile, Nissho was infusing Blue Ribbon with cash.  But Knight wanted a more permanent solution.  He conceived of a public offering of convertible debentures.  People bought them, including Knight’s friend Cale.

The factory in Mexico didn’t produce good shoes.  Knight talked with Sumeragi, who knew a great deal about shoe factories around the world.  Sumeragi also offered to introduce Knight to Jonas Senter, “a shoe dog.”

Shoe dogs were people who devoted themselves wholly to the making, selling, buying, or designing of shoes.  Lifers used the phrase cheerfully to describe other lifers, men and women who had toiled so long and hard in the shoe trade, they thought and talked about nothing else.  It was an all-consuming mania… But I understood.  The average person take seventy-five hundred steps a day, 274 million steps over the course of a long life, the equivalent of six times around the globe – shoe dogs, it seemed to me, simply wanted to be part of that journey.  Shoes were their way of connecting with humanity… (page 186)

Senter was the “knockoff king.”  He’d been behind a recent flood of knockoff Adidas.  Senter’s protege was a guy named Sole.

Knight wasn’t sure partnering with Nissho was the best move.  Jaqua suggested Knight meet with his brother-in-law, Chuck Robinson, CEO of Marcona Mining, which had many joint ventures.  Each of the big eight Japanese trading firms was a partner in at least one of Marcona’s mines, records Knight.  Chuck to Buck:  “If the Japanese trading company understands the rules from the first day, they will be the best partners you’ll ever have.”

Knight went to Sumeragi and said:  “No equity in my company.  Ever.”  Sumeragi consulted a few folks, came back and said:  “No problem.  But here’s our deal.  We take four percent off the top, as a markup on product.  And market interest rates on top of that.”  Done.

Knight met Sole, who mentioned five factories in Japan.

A bit later, Bowerman was eating breakfast when he noticed the waffle iron’s gridded pattern.  This gave him an idea and he started experimenting.

…he took a sheet of stainless steel and punched it with holes, creating a waffle-like surface, and brought this back to the rubber company.  The mold they made from that steel sheet was pliable, workable, and Bowerman now had two foot-sized squares of hard rubber nubs, which he brought home and sewed to the sole of a pair of running shoes.  He gave these to one of his runners.  The runner laced them on and ran like a rabbit.

Bowerman phoned me, excited, and told me about his experiment.  He wanted me to send a sample of his waffle-soled shoes to one of my new factories.  Of course, I said.  I’d send it right away – to Nippon Rubber.

I look back over decades and see him toiling in his workshop, Mrs. Bowerman carefully helping, and I get goosebumps.  He was Edison in Menlo Park, Da Vinci in Florence, Tesla in Wardenclyffe.  Divinely inspired.  I wonder if he knew, if he had any clue, that he was the Daedalus of sneakers, that he was making history, remaking an industry, transforming the way athletes would run and stop and jump for generations.  I wonder if he could conceive in that moment all he’d done.  All that would follow.  (pages 196-197)

 

1972

The National Sporting Goods Association Show in Chicago in 1972 was extremely important for Blue Ribbon because they were going to introduce the world to Nike shoes.  If sales reps liked Nike shoes, Blue Ribbon had a chance to flourish.  If not, Blue Ribbon wouldn’t be back in 1973.

Right before the show, Onitsuka announced its “acquisition” of Blue Ribbon.  Knight had to reassure Sumeragi that there was no acquisition.  At the same time, Knight couldn’t break from Onitsuka just yet.

As Woodell and Johnson prepared the booth – with stacks of Tigers and also with stacks of Nikes – they realized the Nikes from Nippon Rubber weren’t as high-quality as the Tigers.  The swooshes were crooked, too.

Darn it, this was no time to be introducing flawed shoes.  Worse, we had to push these flawed shoes on to people who weren’t our kind of people.  They were salesmen.  They talked like salesmen, walked like salesmen, and they dressed like salesmen – tight polyester shirts, Sansabelt slacks.  They were extroverts, we were introverts.  They didn’t get us, we didn’t get them, and yet our future depended on them.  And now we’d have to persuade them, somehow, that this Nike thing was worth their time and trust – and money.

I was on the verge of losing it, right on the verge.  Then I saw Johnson and Woodell were already losing it, and I realized that I couldn’t afford to… ‘Look fellas, this is the worst the shoes will ever be.  They’ll get better.  So if we can just sell these… we’ll be on our way.’  (pages 201-202)

The salesmen were skeptical and full of questions about the Nikes.  But by the end of the day, Blue Ribbon had exceeded its highest expectations.  Nikes had been the smash hit of the show.

Johnson was so perplexed that he demanded an answer from the representative of one his biggest accounts.  The rep explained:

‘We’ve been doing business with you Blue Ribbon guys for years and we know that you guys tell the truth.  Everyone else bullshits, you guys always shoot straight.  So if you say this new shoe, this Nike, is worth a shot, we believe.’  (page 203)

Johnson came back to the booth and said, “Telling the truth.  Who knew?”  Woodell laughed.  Johnson laughed.  Knight laughed.

Two weeks later, Kitami showed up without warning in Knight’s office, asking about “this… NEE-kay.”  Knight had been rehearsing for this situation.  He replied simply that it was a side project just in case Onitsuka drops Blue Ribbon.  Kitami seemed placated.

Kitami asked if the Nikes were in stores.  No, said Knight.  Kitami asked when Blue Ribbon was going to sell to Onitsuka.  Knight answered that he still needed to talk with Bowerman.  Kitami then said he had business in California, but would be back.

Knight called Bork in Los Angeles and told him to hide the Nikes.  Bork hid them in the back of the store.  But Kitami, when visiting the store, told Bork he had to use the bathroom.  While in the back, Kitami found stacks of Nikes.

Bork called Knight and told him, “Jig’s up… It’s over.”  Bork ended up quitting.  Knight discovered later that Bork had a new job… working for Kitami.

Kitami demanded a meeting.  Bowerman, Jaqua, and Knight were in attendance.  Jaqua told Knight to say nothing no matter what.  Jaqua told Kitami that he hoped something could still be worked out, since a lawsuit would be damaging to both companies.

Knight called a company-wide meeting to explain that Onitsuka had cut them off.  Many people felt resigned, says Knight, in part because there was a recession in the United States.  Gas lines, political gridlock, rising unemployment, Vietnam.  Knight saw the discouragement in the faces of Blue Ribbon employees, so he told them:

‘…This is the moment we’ve been waiting for.  One moment.  No more selling someone else’s brand.  No more working for someone else.  Onitsuka has been holding us down for years.  Their late deliveries, their mixed-up orders, their refusal to hear and implement our design ideas – who among us isn’t sick of dealing with all that?  It’s time we faced facts:  If we’re going to succeed, or fail, we should do so on our own terms, with our own ideas – our own brand.  We posted two million in sales last year… none of which had anything to do with Onitsuka.  That number was a testament to our ingenuity and hard work.  Let’s not look at this as a crisis.  Let’s look at this as our liberation.  Our Independence Day.’  (page 208)

Johnson told Knight, “Your finest hour.”  Knight replied he was just telling the truth.

The Olympic track-and-field trials in 1972 were going to be in Eugene.  Blue Ribbon gave Nikes to anyone who would take them.  And they handed out Nike T-shirts left and right.

The main event was on the final day, a race between Steve Prefontaine – known as “Pre” – and the great Olympian George Young.  Pre was the biggest thing to hit American track and field since Jesse Owens.  Knight tried to figure out why.  It was hard to say, exactly.  Knight:

Sometimes I thought the secret to Pre’s appeal was his passion.  He didn’t care if he died crossing the finish line, so long as he crossed first.  No matter what Bowerman told him, no matter what his body told him, Pre refused to slow down, ease off.  He pushed himself to the brink and beyond.  This was often a counterproductive strategy, and sometimes it was plainly stupid, and occasionally it was suicidal.  But it was always uplifting for the crowd.  No matter the sport – no matter the human endeavor, really – total effort will win people’s hearts.  (page 210)

Gerry Lindgren was also in this race with Pre and Young.  Lindgren may have been the best distance runner in the world at that time.  Lindgren had beaten Pre when Lindgren was a senior and Pre a freshman.

Pre took the lead right away.  Young tucked in behind him.  In no time they pulled way ahead of the field and it became a two-man affair… Each man’s strategy was clear.  Young meant to stay with Pre until the final lap, then use his superior sprint to go by and win.  Pre, meanwhile, intended to set such a fast pace at the outset that by the time they got to that final lap, Young’s legs would be gone.

For eleven laps they ran a half stride apart.  With the crowd now roaring, frothing, shrieking, the two men entered the final lap.  It felt like a boxing match.  It felt like a joust… Pre reached down, found another level – we saw him do it.  He opened up a yard lead, then two, then five.  We saw Young grimacing and we knew that he would not, could not, catch Pre.  I told myself, Don’t forget this.  Do not forget.  I told myself there was much to be learned from such a display of passion, whether you were running a mile or a company.  (pages 211-212)

Both men had broken the American record.  Pre had broken it by a little bit more.

…What followed was one of the greatest ovations I’ve ever heard, and I’ve spent my life in stadiums.

I’d never witnessed anything quite like that race.  And yet I didn’t just witness it.  I took part in it.  Days later I felt sore in the hams and quads.  This, I decided, this is what sports are, what they can do.  Like books, sports give people a sense of having lived other lives, of taking part in other people’s victories.  And defeats.  When sports are at their best, the spirit of the fan merges with the spirit of the athlete, and in that convergence, in that transference, is the oneness that mystics talk about.  (page 212)

 

1973

Bowerman had retired from coaching, partly because of the sadness of the terrorist attacks at the 1972 Olympics in Munich.  Bowerman had been able to help hide one Israeli athlete.  Bowerman had immediately called the U.S. consul and shouted, “Send the marines!”  Eleven Israeli athletes had been captured and later killed.  An unspeakable tragedy.  Knight thought of the deaths of the two Kennedys, and Dr. King, and the students at Kent State.

Ours was a difficult, death-drenched age, and at least once every day you were forced to ask yourself:  What’s the point?  (page 213)

Although Bowerman had retired from coaching, he was still coaching Pre.  Pre had finished a disappointing fourth at the Olympics.  He could have gotten silver if he’d allowed another runner to be the front runner and if he’d coasted in his wake.  But, of course, Pre couldn’t do that.

It took Pre six months to re-emerge.  He won the NCAA three-mile for a fourth straight year, with a time of 13:05.3.  He also won in the 5,000 by a good margin with a time of 13:22.4, a new American record.  And Bowerman had finally convinced Pre to wear Nikes.

At that time, Olympic athletes couldn’t receive endorsement money.  So Pre sometimes tended bar and occasionally ran in Europe in exchange for illicit cash from promoters.

Knight decided to hire Pre, partly to keep him from injuring himself by racing too much.  Pre’s title was National Director of Public Affairs.  People often asked Knight what that meant.  Knight would say, “It means he can run fast.”  Pre wore Nikes everywhere and he preached Nike as gospel, says Knight.

Around this time, Knight realized that Johnson was becoming an excellent designer.  The East Coast was running smoothly, but needed reorganization.  So Knight asked Johnson to switch places with Woodell.  Woodell excelled at operations and thus would be a great fit for the East Coast situation.

Although Johnson and Woodell irritated one another, they both denied it.  When Knight asked them to switch places, the two exchanged house keys without the slightest complaint.

In the spring of 1973, Knight held his second meeting with the debenture holders.  He had to tell them that despite $3.2 million in sales, the company had lost $57,000.  The reaction was negative.  Knight tried to explain that sales continue to explode higher.  But the investors were not happy.

Knight left the meeting thinking he would never, ever take the company public.  He didn’t want to deal with that much negativity and rejection ever again.

Onitsuka filed suit against Blue Ribbon in Japan.  So Blue Ribbon had to file against them in the United States.

Knight asked his Cousin Houser to be in charge of the case.  Houser was a fine lawyer who carried himself with confidence.

Better yet, he was a tenacious competitor.  When we were kids Cousin Houser and I used to play vicious, marathon games of badminton in his backyard.  One summer we played exactly 116 games.  Why 116?  Because Cousin Houser beat me 115 straight times.  I refused to quit until I’d won.  And he had no trouble understanding my position.  (page 227)

More importantly, Cousin Houser was able to talk his firm into taking the Blue Ribbon case on contingency.

Knight continued his evening conversations with this father, who believed strongly in Blue Ribbon’s cause.  Knight’s father, who had been trained as a lawyer, spent time studying law books.  He reassured Buck, “we” are going to win.  This support from his father boosted Buck’s spirits at a challenging time.

Cousin Houser told Knight one day that he was bringing on a new member of the team, a young lawyer from UC Berkeley School of Law, Rob Strasser.  Not only was Strasser brilliant.  He also believed in the rightness of Blue Ribbon’s case, viewing it as a “holy crusade.”

Strasser was a fellow Oregonian who felt looked down on by folks north and south.  Moreover, he felt like an outcast.  Knight could relate.  Strasser often downplayed his intelligence for fear of alienating people.  Knight could relate to that, too.

Intelligence like Strasser’s, however, couldn’t be hidden for long.  He was one of the greatest thinkers I ever met.  Debator, negotiator, talker, seeker – his mind was always whirring, trying to understand.  (page 231)

When he wasn’t preparing for the trial, Knight was exclusively focused on sales.  It was essential that they sell out every pair of shoes in each order.  The company was still growing fast and cash was always short.

Whenever there was a delay, Woodell always knew what the problem was and could quickly let Knight know.  Knight on Woodell:

He had a superb talent for underplaying the bad, and underplaying the good, for simply being in the moment… throughout the day a steady rain of pigeon poop would fall on Woodell’s hair, shoulders, desktop.  But Woodell would simply dust himself off, casually clear his desk with the side of his hand, and continue with his work.

…I tried often to emulate Woodell’s Zen monk demeanor.  Most days, however, it was beyond me… (page 233)

Blue Ribbon couldn’t meet demand.  This frustrated Knight.  Supplies were arriving on time.  But in 1973, it seemed that the whole world, all at once, wanted running shoes.  And there were never enough.  This made things precarious, to say the least, for Blue Ribbon:

…We were leveraged to the hilt, and like most people who live from paycheck to paycheck, we were walking the edge of a precipice.  When a shipment of shoes was late, our pair count plummeted.  When our pair count plummeted, we weren’t able to generate enough revenue to repay Nissho and the Bank of California on time.  When we couldn’t repay Nissho and the Bank of California on time, we couldn’t borrow more.  When we couldn’t borrow more we were late placing our next order.  (page 234)

Sales for 1973 hit $4.8 million, up 50 percent from the previous year.  But Blue Ribbon was still on fragile ground, it seemed.  Knight then thought of asking their retailers to sign up for large and unrefundable orders, six months in advance, in exchange for hefty discounts, up to 7 percent.  Such long-term commitments from well-established retailers like Nordstrom, Kinney, Athlete’s Foot, United Sporting Goods, and others, could then be used to get more credit from Nissho and the Bank of California.

Much later, after much protesting, the retailers signed on to the long-term commitments.

 

1974

The trial.  Federal courthouse in downtown Portland.  Wayne Hilliard was the lead lawyer for the opposition.  He was fiery and eloquent.  Cousin Houser was the lead for Blue Ribbon.  He’d convinced his firm to take the Blue Ribbon case on contingency.  But instead of a few months, it was now two years later.  Houser hadn’t seen a dime and costs were huge.  Moreover, Houser told Knight that his fellow law partners sometimes put a great deal of pressure on Houser to drop the Blue Ribbon case.

Houser stuck with the case.  He wasn’t fiery.  But he was prepared and dedicated.  Knight was initially disappointed, but later came to admire him.  “Fire or no, Cousin Houser was a true hero.”  (page 238)

After being questioned by both sides, Knight felt he hadn’t done well at all, a D minus.  Houser and Strasser didn’t disagree.

The judge in the case was the Honorable James Burns.  He called himself James the Just.  Johnson made the mistake of discussing the trail with a store manager after James the Just had expressly forbidden all discussion of the case outside the courtroom.  James the Just was upset.  Knight:

Johnson redeemed himself with his testimony.  Articulate, dazzlingly anal about the tiniest details, he described the Boston and the Cortez better than anyone else in the world could, including me.  Hilliard tried and tried to break him, and couldn’t.  (page 242)

Later on, the testimony of Iwano, the young assistant who’d been with Kitami, was heard.  Iwano testified that Kitami had a fixed plan already in place to break the contract with Blue Ribbon.  Kitami had openly discussed this plan on many occasions, said Iwano.

Bowerman’s testimony was so-so because, out of disdain, he hadn’t prepared.  Woodell, for his part, was nervous.

Mr. Onitsuka said he hadn’t known anything about the conflict between Kitami and Knight.  Kitami, in his testimony, lied again and again.  He said that he had no plan to break the contract with Blue Ribbon.  He also claimed that meeting with other distributors had just been market research.  As well, the idea of acquiring Blue Ribbon “was initiated by Phil Knight.”

James the Just was convinced that Blue Ribbon had been more truthful.  In particular, Iwano seemed truthful, while Kitami didn’t.  On the issue of trademarks, Blue Ribbon would retain all rights to the Boston and the Cortez.

A bit later, Hilliard offered $400,000.  Finally, Blue Ribbon accepted.  Knight was happy for Cousin Houser, who would get half.  It was the largest payment in the history of his firm.

Knight, with help from Hayes, convinced Strasser to come work for Blue Ribbon.  Strasser later accepted.

Japanese labor costs were rising.  The yen was fluctuating.  Knight decided Blue Ribbon needed to find factories outside of Japan.  He looked at Taiwan, but shoe factories there weren’t quite ready.  He looked next at Puerto Rico.

Then Knight went to the east coast to look for possible factories.  The first factory owner laughed in Knight’s face.

The next empty factory Knight visited – with Johnson – the owner was willing to lease the third floor to Blue Ribbon.  He suggested a local guy to manage the factory, Bill Giampietro.  Giampietro turned out to be “a true shoe dog,” said Knight.  All he’d ever done is make shoes, like his father.  Perfect.  Could he get the old Exeter factory up and running?  How much would it cost?  No problem.  About $250,000.  Deal.

Knight asked Johnson to run the new factory.  Johnson said, “…what do I know about running a factory?  I’d be in completely over my head.”

Knight couldn’t stop laughing:  “Over your head?  Over your head!  We’re all in over our heads!  Way over!”

Knight writes that, at Blue Ribbon, it wasn’t that they thought they couldn’t fail.  On the contrary, they thought they would fail.  But they believed they would fail fast, learn from it, and be better for it.

Finishing up 1974, the company was on track for $8 million in sales.  Their contact at Bank of California, Perry Holland, kept telling them to slow down.  So they sped up, as usual.

 

1975

Knight kept telling Hayes, “Pay Nissho first.”  Blue Ribbon had a line of credit at the bank for $1 million.  They had a second million from Nissho.  That was absolutely essential.

…Grow or die, that’s what I believed, no matter the situation.  Why cut your order from $3 million down to $2 million if you believed in your bones that demand out there was for $5 million?  So I was forever pushing my conservative bankers to the brink, forcing them into a game of chicken.  I’d order a number of shoes that seemed to them absurd, a number we’d need to stretch to pay for, and I’d always just barely pay for them, in the nick of time, and then just barely pay our other monthly bills, at the last minute, always doing just enough, and no more, to prevent the bankers from booting us.  And then, at the end of the month, I’d empty our accounts to pay Nissho and start from zero again.  (pages 257-258)

Demand was always greater than sales, so Knight concluded his approach was reasonable.  There was a new manager at Nissho’s Portland office, Tadayuki Ido, in place of Sumeragi.  (Sumeragi still helped with the Blue Ribbon account, though.)

One day in the spring of 1975, Blue Ribbon was $75,000 short of the $1 million they owed Nissho.  Blue Ribbon would have to completely drain every other account to make up for the shortfall.  Retail stores.  Johnson’s Exeter factory.  All of them.

In Exeter, a mob of angry workers was at Johnson’s door.  Giampetro drove with Johnson to see an old friend who owned a box company that depended on Blue Ribbon.  Giampetro asked for a loan of $5,000 (more than $25,000 in 2017), which was outrageous.  The man counted out fifty crisp hundred-dollar bills, says Knight.

Then Holland called Knight and Hayes to a meeting at the Bank of California.  The bank would no longer do business with Blue Ribbon.

Knight was worried how Ito and Sumeragi, representing Nissho, would react.  Ito and Sumeragi, after hearing what happened, said they would need to look at Blue Ribbon’s books.

On the weekend, Knight called a company-wide meeting to discuss the situation.  The Exeter factory had been a secret kept from Nissho.  But everyone agreed to give Nissho all information.

During this meeting, two creditors – owed $500,000 and $100,000 – called and were livid.  They were on their way to Oregon to collect and cash out.

On Monday, Ito and Sumeragi arrived at Blue Ribbon’s office.  Without a word, they went through the lobby to the conference room, sat down with the books and got to work.  Then Ito came to information related to the Exeter factory.  He did a slow double-take and then looked up at Knight.  Knight nodded.  Ito smiled.  Knight:

I gave him a weak half smile in return, and in that brief wordless exchange countless fates and futures were decided.  (page 268)

It turned out that Sumeragi had been trying to help Blue Ribbon by hiding Nissho’s invoices in a drawer.  Blue Ribbon had been stressing out trying to pay Nissho on time, but they’d never paid them on time because Sumeragi thought he was helping, writes Knight.

Ito accused Sumeragi of working for Blue Ribbon.  Sumeragi swore on his life that he’d acted independently.  Ito asked why.  Sumeragi answered that he thought Blue Ribbon would be a great success, perhaps a $20 million account.  Ito eventually forgave Blue Ribbon.  “There are worse things than ambition,” he said.

Ito accompanied Knight and Hayes to a meeting with the Bank of California.  Only this time, Ito – whom Knight saw as a “mythic samurai, wielding a jeweled sword” – was on their side.

According to Knight, Ito opened the meeting and “went all in.”  After confirming that Bank of California no longer wanted to handle Blue Ribbon’s account, Ito said Nissho wanted to pay off Blue Ribbon’s outstanding debt.  He asked for the number and it was the same number he’d learned earlier.  Ito already had a check made out for the amount and slid an envelope with the check across the table.  Ito insisted the check be deposited immediately.

After the meeting, Knight and Hayes bowed to Ito.  Ito remarked:

‘Such stupidity… I do not like such stupidity.  People pay too much attention to numbers.’

***

Blue Ribbon still needed a bank.  They started calling.  “The first six hung up on us,” recalls Knight.  First State Bank of Oregon didn’t hang up.  They offered one million in credit.

Pre died in a tragic car accident at the age of twenty-four.  At the time of his death, he held every American record from 2,000 to 10,000 meters, from two miles to six miles.  People created a shrine where Pre had died.  They left flowers, letters, notes, gifts.  Knight, Johnson, and Woodell decided that Blue Ribbon would curate Pre’s rock, making it a holy site forever.

 

1976

Knight had several meetings early in 1976 with Woodell, Hayes, and Strasser about the company’s cash situation.  Nissho was lending Blue Ribbon millions, but to keep up with demand, they needed millions more.  The most logical solution was to go public.  But Knight and the others felt that it just wasn’t who they were.  No way.

They found other ways to raise money, including a million-dollar loan guaranteed by the U.S. Small Business Administration.

Meanwhile, Bowerman’s waffle trainer was getting even more popular.

With its unique outer sole, and its pillowy midsole cushion, and its below-market price ($24.95), the waffle trainer was continuing to capture the popular imagination like no previous shoe.  It didn’t just feel different, or fit different – it looked different.  Radically so.  Bright red upper, fat white swoosh – it was a revolution in aesthetics.  Its look was drawing hundreds of thousands of new customers into the Nike fold, and its performance was sealing their loyalty.  It had better traction and cushioning than anything on the market.

Watching that shoe evolve in 1976 from popular accessory to cultural artifact, I had a thought.  People might start wearing this thing to class.

And the office.

And the grocery store.

And throughout their everyday lives.

It was a rather grandiose idea… So I ordered the factories to start making the waffle trainer in blue, which would go better with jeans, and that’s when it really took off.

We couldn’t make enough.  Retailers and sales reps were on their knees, pleading for all the waffle trainers we could ship.  The soaring pair counts were transforming our company, not to mention the industry.  We were seeing numbers that redefined our long-term goals, because they gave us something we’d always lacked – an identify.  More than a brand, Nike was now becoming a household word, to such an extent that we would have to change the company name.  Blue Ribbon, we decided, had run its course.  We would have to incorporate as Nike, Inc.  (pages 284-285)

They needed to ramp up production.  Knight realized the time had come to visit Taiwan.  To help with the Taiwan effort, Knight turned to Jim Gorman.  Gorman had been raised in a series of foster homes.  Nike was the family he’d never had.

…In every instance, Gorman had done a fine job and never uttered a sour word.  He seemed the perfect candidate to take on the latest mission impossible – Taiwan.  But first I needed to give him a crash course on Asia.  So I scheduled a trip, just the two of us.  (page 285)

Gorman was full of questions for Knight and took notes on everything.  Knight enjoyed teaching Gorman, partly because Knight himself could learn what he knew even better through the process of teaching.

Taiwan had a hundred smaller factories, whereas South Korea had a few larger ones.  That’s why Nike needed to go to Taiwan at this juncture.  Demand for Nikes was exploding, but their volume was still too low for a giant shoe factory.  However, Knight knew it would be a challenge to get a shoe factory in Taiwan to improve its quality enough to be able to produce Nikes.

During the visit to various Taiwan shoe factories, Jerry Hsieh introduced himself to Knight and Gorman.  Hsieh was a genuine shoe dog, but quite young, twenty-something.  When Knight and Gorman found their way to Hsieh’s office – a room stuffed with shoes everywhere – Hsieh started sharing his deep knowledge of shoes.  Also, Hsieh told them he knew the very best shoe factories in Taiwan and for a small fee, would be happy to introduce them.  They agreed on a commission per pair.

The 1976 Olympic trials, again in Eugene.  In the 10,000 meter race, all top three finishers wore Nikes.  Some top finishers in other qualifying races also wore Nikes.  Meanwhile, Penny created a great number of Nike T-shirts.  People would see other people wearing the Nike T-shirts and want to buy one.  The Nike employees heard people whispering.  “Nike.”  “Nike.”  “Nike.”

At the close of 1976, Nike had doubled its sales to $14 million.  The company still had no cash, though.  Its bank accounts were often at zero.

The company’s biannual retreat was taking place.  People called it Buttface.

Johnson coined the phrase, we think.  At one of our earliest retreats he muttered:  “How many multi-million dollar companies can you yell out, ‘Hey, Buttface,’ and the entire management team turns around?”  It got a laugh.  And then it stuck.  And then it became a key part of our vernacular.  Buttface referred to both the retreat and the retreaters, and it not only captured the informal mood of those retreats, where no idea was too sacred to be mocked, and no person was too important to be ridiculed, it also summed up the company spirit, mission and ethos.  (page 297)

Knight continues:

…The problems confronting us were grave, complex, insurmountable… And yet we were always laughing.  Sometimes, after a really cathartic guffaw, I’d look around the table and feel overcome by emotion.  Camaraderie, loyalty, gratitude.  Even love.  Surely love.  But I also remember feeling shocked that these were the men I’d assembled.  These were the founding fathers of a multi-million dollar company that sold athletic shoes?  A paralyzed guy, two morbidly obese guys, a chain-smoking guy?  It was bracing to realize that, in this group, the one with whom I had the most in common was… Johnson.  And yet, it was undeniable.  While everyone else was laughing, rioting, he’d be the sane one, sitting quietly in the middle of the table reading a book.  (page 297)

A bit later, Knight writes:

Undoubtedly we looked, to any casual observer, like a sorry, motley crew, hopelessly mismatched.  But in fact we were more alike than different, and that gave a coherence to our goals and our efforts.  We were mostly Oregon guys, which was important.  We had an inborn need to prove ourselves, to show the world that we weren’t hicks and hayseeds.  And we were nearly all merciless self-loathers, which kept the egos in check.  There was none of that smartest-guy-in-the-room foolishness.  Hayes, Strasser, Woodell, Johnson, each would have been the smartest guy in any room, but none believed of himself, or the next guy.  Our meetings were defined by contempt, disdain, and heaps of abuse.  (pages 298-299)

Finally, Knight records:

…Each of us had been misunderstood, misjudged, dismissed.  Shunned by bosses, spurned by luck, rejected by society, short-changed by fate when looks and other natural graces were handed out.  We’d each been forged by early failure.  We’d each given ourselves to some quest, some attempt at validation or meaning, and fallen short.

I identified with the born loser in each Buttface, and vice versa, and I knew that together we could become winners… (pages 301-302)

Knight’s management style continued to be very hands-off, following Patton’s leadership belief:

Don’t tell people how to do things, tell them what to do and let them surprise you with their results.

Nike’s culture seemed to be working thus far.  Since Bork, no one had gotten really upset, not even what they were paid, which is unusual, notes Knight.  Knight created a culture he himself would have wanted:  let people be, let people do, let people make their own mistakes.

 

1977

M. Frank Rudy, a former aerospace engineer, and his business partner, Bob Bogert, presented to Nike the idea of putting air in the soles of shoes.  Great cushioning, great support, a wonderful ride.  Knight tried wearing a pair Rudy showed him on a six-mile run.  Unstable, but one great ride.

Strasser, who by this point had become Nike’s negotiator, offered Rudy 10 cents for every pair we sold.  Rudy asked for twenty.  They settled somewhere in the middle.  Knight sent Rudy and his partner back to Exeter, which “was becoming our de facto Research and Development Department.”

Knight calls this time “an odd moment,” saying furthermore that “a second strange shoe dog showed up on our door step.  His name was Sonny Vaccaro…”.  Vaccaro had founded the Dapper Dan Classic, a high school all-star game that had become very popular.  Though it, Vaccaro had gotten to know many coaches.  Knight hired Vaccaro and sent him, with Strasser, to sign up college basketball coaches.  Knight expected them to fail.  But they succeeded.

Knight knew he had to meet again with Chuck Robinson, who’d served with distinction as a lieutenant commander on a battle ship in World War II.  Chuck knew business better than anyone Knight had ever met.  Recently, he’d been the number two guy under Henry Kissinger, so he wasn’t available for meetings.  Now Chuck was free.

Chuck took a look at Nike’s financials and couldn’t stop laughing, saying, “Compositionally, you are a Japanese trading company – 90 percent debt!”

Chuck told Buck, “You can’t live like this.”  The solution was to go public in order to raise a large amount of cash.  Knight invited Chuck to join the board.  Chuck agreed, to Knight’s surprise.

When Knight put the question of going public to a company vote, however, the consensus was still to remain private.

Then they received a letter from the U.S. Customs Service containing a bill for $25 million.  Nike’s competitors, Converse and Keds – plus a few small factories – were behind it.  They had been lobbying in Washington, DC, trying to slow Nike by enforcing the American Selling Price, an old law dating back to protectionist days.

ASP – American Selling Price – said that import duties on nylon shoes should be 20 percent of the shoe’s manufacturing cost.  Unless there was a “similar shoe” made by a U.S. competitor.  Then it should be 20 percent of that shoe’s selling price.  Nike’s competitors just needed to make some shoes deemed “similar,” price them very high, and voila – high import duties for Nike.

They’d managed to pull the trick off, raising Nike’s import duties retroactively by 40 percent.

Near the end of 1977, Nike’s sales were approaching $70 million.

 

1978

Knight calls Strasser the “five-star general” in the battle with the U.S. government.  But they knew they needed “a few good men.”  Strasser suggested a friend of his, a young Portland lawyer, Richard Werschkul.  Stanford undergrad, University of Oregon law.  A sharp guy with a presence.  And an eccentric streak.  Some worried he was too serious and obsessive.  But that seemed good to Knight.  And Knight trusted Strasser.  Werschkul was dispatched to Washington, DC.

Meanwhile, sales were on track for $140 million.  Furthermore, Nike shoes were finally recognized as higher quality than Adidas shoes.  Knight thought Nike had led in quality and innovation for years.

Nike had to start selling clothes, announced Knight at Buttface in 1978.  First, Adidas sold more apparel than shoes.  Second, it would be easier to get athletes into endorsement deals.

Knight decided to hire a young accountant, Bob Nelson, and put him in charge of the new line of Nike apparel.  But Nelson had no sense of style, unfortunately.  When he presented his ideas, they didn’t look good.  Knight decided to transfer him to an accounting position, where he would excel.  Knight writes:

…Then I quietly shifted Woodell to apparel.  He did his typically flawless job, assembling a line that gained immediate attention and respect in the industry.  I asked myself why I didn’t just let Woodell do everything.  (page 331)

Tailwind – a new Nike shoe with air – came out in late 1978.  Then Nike had to recall it due to a design flaw.  Knight concluded they’d learned a valuable lesson.  “Don’t put twelve innovations into one shoe.”

Around this time, many seemed to be suffering from burnout, including Knight.  And back in DC, Werschkul was becoming hyper obsessive.  He’d tried to talk with everyone possible.  They all told him to put something in writing so they could study it.

Werschkul spent months writing.  It became hundreds of pages.  “Without a shred of irony Werschkul called it:  Werschkul on American Selling Price, Volume I.”  Knight:

When you thought about it, when you really thought about it, what really scared you was that Volume I.  (page 333)

Knight sent Strasser to calm Werschkul down.  Knight realized that he himself would have to go to DC.  “Maybe the cure for any burnout… is just to work harder.”  (page 334)

 

1979

Senators Mark O. Hatfield and Bob Packwood helped Nike deal with the $25 million bill from U.S. Customs.  Knight started the process of looking for a factory in China.

 

1980

Chuck Robinson suggested to Knight that Nike could go public but have two classes of stock, class A and class B.  Nike insiders would own class A shares, which would allow them to name three-quarters of the board of directors.  The Washington Post Company and a few other companies had done this.

Knight explained the idea – going public with two classes of stock – to colleagues at Nike.  All agreed that it was time to go public to raise badly needed cash.

In China, Knight – with Strasser, Hayes, and others – signed a deal with China’s Ministry of Sports.  Four years later, at the Olympics in Los Angeles, the Chinese track-and-field team entered the stadium wearing Nike shoes and warm-ups.  Before leaving China, Nike signed a deal with two Chinese factories.

Knight then muses about “business”:

It seems wrong to call it “business.”  It seems wrong to throw all those hectic days and sleepless nights, all those magnificent triumphs and desperate struggles, under that bland, generic banner:  business.  What we were doing felt like so much more.  Each new day brought fifty new problems, fifty tough decisions that needed to be made, right now, and we were always acutely aware that one rash move, one wrong decision could be the end.  The margin for error was forever getting narrower, while the stakes were forever creeping higher – and none of us wavered in the belief that “stakes” didn’t mean “money.”  For some, I realize, business is the all-out pursuit of profits, period, full stop, but for us business was no more about making money than being human is about making blood.  Yes, the human body needs blood.  It needs to manufacture red and white cells and platelets and redistribute them evenly, smoothly, to all the right places, on time, or else.  But that day-to-day mission of the human body isn’t our mission as human beings.  It’s a basic process that enables our higher aims, and life always strives to transcend the basic processes of living – and at some point in the late 1970s, I did, too.  I redefined winning, expanded it beyond my original definition of not losing, of merely staying alive.  That was no longer enough to sustain me, or my company.  We wanted, as all great businesses do, to create, to contribute, and we dared to say so aloud.  When you make something, when you improve something, when you add to some new thing or service to the lives of strangers, making them happier, or healthier, or safer, or better, and when you do it all crisply and efficiently, smartly, the way everything should be done but so seldom is – you’re participating more fully in the whole grand human drama.  More than simply alive, you’re helping others to live more fully, and if that’s business, all right, call me a businessman.  (pages 352-353)

 

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 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  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.)

December 3, 2017

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 just had the enormous pleasure of reading Business Adventures for the second time.  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.  (page 3)

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.  (page 4)

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.  (page 5)

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.  (page 8)

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.  (page 27)

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.  (page 29)

 

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.  (pages 30-31)

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.  (page 32)

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.  (page 34)

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.  (pages 38-39)

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.’  (pages 40-41)

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.  (page 51)

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 2017 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… (page 56)

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.  (pages 56-57)

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.’  (page 61)

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.  (pages 63-64)

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…  (page 68)

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… (pages 72-73)

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.  (page 85)

 

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…  (page 137)

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.”  (page 138)

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.  (page 140)

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.  (page 142)

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.” (page 144)

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.  (page 144)

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.  (page 146)

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.’  (page 148)

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.  (page 149)

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.  (page 156)

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.  (page 156-157)

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.  (page 158)

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…  (page 159)

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.  (page 163)

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.  (page 165)

 

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.  (pages 169-170)

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.  (page 171)

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.  (page 172)

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 2017 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.  (page 174)

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.’  (page 176)

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.  (page 177)

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.  (page 192)

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.  (page 196)

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.  (page 202)

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.  (pages 203-204)

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.  (pages 218-219)

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.  (page 221)

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.’  (pages 222-223)

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 2017), 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.’  (pages 224-225)

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.  (page 227)

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.  (page 228)

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 2017 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 2017 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 2017 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.’  (pages 231-232)

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.  (page 234)

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.  (page 235)

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.’  (page 236)

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.  (page 237)

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

Erben’s extraordinary communicative prowess carried the day, and Ginn continued to meet with competitors.  (page 238)

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.  (page 240)

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…’  (pages 240-241)

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.  (page 242)

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.”  (page 246)

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.  (page 247)

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.  (page 248)

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.  (page 253)

 

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.  (pages 256-257)

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.  (page 262)

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 2017 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.  (pages 262-263)

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.  (page 265)

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.’  (pages 272-273)

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 2017 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.  (pages 290-291)

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.’  (page 295)

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.  (page 308)

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.  (pages 309-310)

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.  (page 311)

 

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.)  (page 316)

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.  (page 319)

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.  (page 320)

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.  (page 330)

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.  (page 335)

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.  (page 336)

 

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.  (page 339)

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 2017 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.  (page 341)

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.  (page 342)

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.  (page 343)

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.’  (pages 343-344)

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.  (page 347)

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.  (page 348)

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?  (pages 350-351)

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.

 

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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.

You’re deluding yourself

(Image: Zen Buddha Silence, by Marilyn Barbone)

November 26, 2017

You’re deluding yourself.  I’m deluding myself.  Our brains just do this automatically, all the time.  We invent simple stories based on cause and effect.  Often this is harmless.  But sometimes it’s important to recognize that reality is far more unpredictable than we’d like.

We’re not wired to understand probabilities.  As Daniel Kahneman and Amos Tversky have demonstrated, even many professional statisticians are not good “intuitive statisticians.”  They’re usually only good if they slow down and work through the problem at hand step-by-step.  Otherwise, they too tend to create overly simplistic, overly deterministic stories.

(Photo by Wittayayut Seethong)

To develop better mental habits, a good place to start is by recognizing delusions and biases, which are widespread in business, politics, and economics.  To that end, here are four of the best books:

  • Thinking, Fast and Slow (Farrar, Straus and Giroux, 2011), by Daniel Kahneman
  • Poor Charlie’s Almanack (Walsworth, 3rd edition, 2005), by Charles T. Munger
  • The Halo Effect…and Eight Other Business Delusions That Deceive Managers (Free Press, 2007), by Phil Rosenzweig
  • Expert Political Judgment: How Good Is It? How Can We Know? (Princeton University Press, 2006), by Philip Tetlock

Tetlock’s work is particularly important.  He tracked over 27,000 predictions made in real time by 284 experts from 1984 to 2003.  Tetlock found that the expert predictions—on the whole—were no better than chance.  Many of these experts have deep historical knowledge of politics or economics, which can give us important insights and is often a precursor to scientific knowledge.  But it’s not yet science—the ability to make predictions.

Kahneman and Munger both show how our intuition uses mental shortcuts (heuristics) to jump to conclusions.  Often these conclusions are fine.  But not if probabilistic reasoning is needed to reach a good decision.

This blog post focuses on Rosenzweig’s book, which examines delusions in business, with particular emphasis on the Halo Effect.

Outline for this blog post:

  • The Halo Effect
  • Illusions and Delusions
  • How Little We Know
  • The Story of Cisco
  • Up and Down with ABB
  • Halos All Around Us
  • Research to the Rescue?
  • Searching for Stars, Finding Halos
  • The Mother of All Business Questions, Take Two
  • Managing Without Coconut Headsets

 

THE HALO EFFECT

Rosenzweig quotes John Kay of the Financial Times:

The power of the halo effect means that when things are going well praise spills over to every aspect of performance, but also that when the wheel of fortune spins, the reappraisal is equally extensive.  Our search for excessively simple explanations, our desire to find great men and excellent companies, gets in the way of the complex truth.

(Image by Ileezhun)

Rosenzweig explains the essence of the Halo Effect:

If you select companies on the basis of outcomes—whether success or failure—and then gather data that are biased by those outcomes, you’ll never know what drives performance.  You’ll only know how high performers or low performers are described.

Rosenzweig describes his book as “a guide for the reflective manager,” a way to avoid delusions and to think critically.  It’s quite natural for us to construct simple stories about why things happen.  But many events—including business success and failure—don’t happen in a straightforward way.  There’s a large measure of uncertainty (chance) involved.

Rosenzweig adds:

Of course, for those who want a book that promises to reveal the secret of success, or the formula to dominate their market, or the six steps to greatness, there are plenty to choose from.  Every year, dozens of new books claim to reveal the secrets of leading companies… Others tell you how to become an innovation powerhouse, or craft a failsafe strategy, or devise a boundaryless organization, or make the competition irrelevant.

But if anything, the world is getting more unpredictable:

In fact, for all the secrets and formulas, for all the self-proclaimed thought leadership, success in business is as elusive as ever.  It’s probably more elusive than ever, with increasingly global competition and technological change moving at faster and faster rates—which might explain why we’re tempted by promises of breakthroughs and secrets and quick fixes in the first place.  Desperate circumstances push us to look for miracle cures.

Rosenzweig explains that business managers are under great pressure to increase profits.  So they naturally look for clear solutions that they can implement right away.  Business writers and experts are happy to supply what is demanded.  However, reality is usually far more unpredictable than is commonly assumed.

 

ILLUSIONS AND DELUSIONS

Science is the ability to predict things:  if x, then y (with probability z).  (If we’re talking about physics—other than quantum mechanics—then z = 100% in the vast majority of cases.)  But the sciences that deal with human behavior still haven’t discovered enough to make many predictions.  There are specific experiments or circumstances where good predictions can be made—such as where to place specific items in a retailer to maximize sales.  And good research has uncovered numerous statistical correlations.

But on the whole, there’s still much unpredictability in business and in human behavior generally.  There’s still not much scientific knowledge.

Rosenzweig says some of the biggest recent business blockbusters contain several delusions:

For all their claims of scientific rigor, for all their lengthy descriptions of apparently solid and careful research, they operate mainly at the level of storytelling.  They offer tales of inspiration that we find comforting and satisfying, but they’re based on shaky thinking.  They’re deluded.

Rosenzweig explains that most management books seek to understand what leads to high performance.  By contrast, Rosenzweig asks why it is so difficult to understand high performance.  We suffer from many delusions.  Our intuition leads us to construct simple stories to explain things, even when those stories are false.

(Image by Edward H. Adelson, via Wikimedia commons)

Look at squares A and B just above:  Are they the same color?  Or is one square lighter than the other?

A and B are exactly the same color.  However, our visual system automatically uses contrast.  If it didn’t, then as Steven Pinker has pointed out, we would think a lump of coal in bright sunlight was white.  We would think a lump of snow inside a dark house was black.  We don’t make these mistakes because our visual system works in part by contrast.  Kathryn Schulz mentions this in her excellent book, Being Wrong (HarperCollins, 2010).

This use of contrast is a heuristic—a shortcut—used by our visual system.  This happens automatically.  And usually this heuristic helps us, as in Pinker’s examples.

The important point is that our intuition (part of our mental system) is like our visual system Our intuition also uses heuristics.

  • If we are asked a difficult question, our intuition substitutes an easier question and then answers that question.  This happens automatically and without our conscious awareness. 
  • Similarly, our intuition constructs simple stories in terms of cause and effect, even if reality is far more complex and random.  This happens automatically and without our conscious awareness.

(Image by Edward H. Adelson, via Wikimedia Commons)

This second image is the same as the previous one—except this one has two vertical grey bars.  This helps (to some extent) our eyes to see that squares A and B are exactly the same color.

Rosenzweig mentions that some rigorous research of business has been conducted.  But this research often reaches far more modest conclusions than what we seek.  As a result, it’s not popular or well-known.  For instance, there may be a 0.2 correlation between certain approaches of a CEO and business performance.  That’s a huge finding—20% of business performance is based on specific CEO behavior.

But that means 80% of business performance is due to other factors, including chance.  That’s not the type of information people in business want to hear when they’re busy and under pressure.

 

HOW LITTLE WE KNOW

In January 2004, after a disastrous holiday season, Lego—the Danish toymaker—fired its chief operating officer, Poul Ploughman.  Rosenzweig points out that when a company does well, we tend to automatically think its leaders did the right things and should be praised or promoted.  When a company does poorly, we tend to jump to the conclusion that its leaders did the wrong things and should be replaced.

But reality is far more complex.  Good leadership may represent 20-30% of the reason a company is doing well now, but luck may be an even bigger factor.  Similarly, bad leadership may be responsible for 20-30% of a company’s poor performance, whereas bad luck—unforeseeable events—may be a bigger factor.

(Photo by Marco Clarizia)

As humans, we’re driven to construct stories in which success and failure are completely explainable—without reference to luck—based on the actions of people and systems.  This satisfies our psychological need to see the world as a predictable place.

However, reality is unpredictable to an extent.  We understand far less than we think.  Luck usually plays a large role in business success and failure.

When Lego hired Ploughman, it was seen as a coup.  Ploughman helped Lego expand into electronic toys.  When the initial results of this expansion were not positive, Lego’s CEO Kjeld Kirk Kristiansen lost patience and fired Ploughman.

The business press reported that Lego had “strayed from its core.”  However, the company tried to expand because its traditional operations were not as profitable as before.  If the company’s attempted expansion had been more profitable, the business press would have reported that Lego “wisely expanded.”

(Photo of lego bricks by Benjamin D. Esham)

When it comes to business performance, there are many factors—including luck.  A company may move forward on an absolute basis, but fall behind relative to competitors.  Also, consumer tastes are unpredictable.

  • A company may attempt expansion and fail, but the decision may have been wise based on available information.  Regardless, observers are likely to say the company “unwisely strayed from its core.”
  • Or a company may try to expand and succeed, but it may have been a stupid decision based on available information.  Regardless, observers are likely to claim that the company “brilliantly expanded.”

To understand better how businesses succeed, we should try to understand what factors are involved in good decisions, even though good decisions often don’t work and bad decisions sometimes do.  We want to avoid outcome bias, where our evaluation of the quality of a decision is colored by whether the result was favorable or not.

Science is:  if x, then y (with probability z).  This is a slightly modified definition (I added “with probability z”) Rosenzweig borrowed from physicist Richard Feynman.

In some areas of business, scientists have discovered reliable statistical correlations.  For instance, this set of behaviors—a, b, and c—has a 0.10 correlation with revenues.  If you do a, b, and c—holding all else constant—then revenues will increase approximately 10%.

The difficult thing about studying business is that often you cannot run controlled experiments.  Of course, sometimes you can.  For instance, you can experiment with where to place various items in a store (or chain of stores).  You can compare results and gain good statistical information.  Also, there are promotions and advertising campaigns that you can test.  And you can track consumer behavior online.

Often, however, you cannot run controlled experiments.  As Rosenzweig observes, you can’t do 100 acquisitions, and manage half of them one way, the other half another way, and then compare the results.

There’s nothing wrong with stories, which are satisfying explanations we construct about various events.  But stories are not science, and it’s important to keep the distinction straight, especially when we’re trying to understand why things happen.

An even better term than pseudo-science is Feynman’s term, Cargo Cult Science.  Rosenzweig quotes Feynman:

In the South Seas, there is a cult of people.  During the war, they saw airplanes land with lots of materials, and they want the same thing to happen now.  So they’ve arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas—he’s the controller—and they wait for the airplanes to land.  They’re doing everything right.  The form is perfect.  But it doesn’t work.  No airplanes land.  So I call these things Cargo Cult Science, because they follow all the apparent precepts and forms of scientific investigation, but they’re missing something essential, because the planes don’t land.

(Photo of Richard Feynman in 1984, by Tamiko Thiel)

Rosenzweig concludes:

The business world is full of Cargo Cult Science, books and articles that claim to be rigorous scientific research but operate mainly at the level of storytelling.  In later chapters, we’ll look at some of this research—some that meet the standard of science but aren’t satisfying as stories, and some that offer wonderful stories but are doubtful as science.  As we’ll see, some of the most successful business books of recent years, perched atop the bestseller list for months on end, cloak themselves in the mantle of science, but have little more predictive power than a pair of coconut headsets on a tropical island.

It’s not that stories have nothing to teach us.  For instance, experts may develop deep historical knowledge that offers us useful insights into human behavior.  And such knowledge is often an antecedent to scientific knowledge.

But we have to be careful not to confuse stories with science.  Otherwise, it’s very easy and natural to delude ourselves that we understand something scientifically, when in fact we don’t.  Our intuition creates simply stories of cause and effect just as automatically as our visual system is unable to avoid optical illusions.

(Holy grail or two girls, by Micka)

 

THE STORY OF CISCO

Rosenzweig tells the story of Cisco.  Sandra K. Lerner and Leonard Bosack met in graduate school, fell in love, and got married.  After graduating, they each took jobs managing computer networks at different corners of the Stanford campus.  They wanted to communicate, and they invented a multiprotocol router.  Rosenzweig:

Like many start-ups, Cisco began by operating out of a basement and at first sold its wares to friends and professional acquaintances.  Once revenues approached $1 million, Lerner and Bosack went in search of venture capital.  The man who finally said yes was Donald Valentine at Sequoia Capital, the seventy-seventh moneyman they approached, who invested $2.5 million for a third of the stock and management control.  Valentine began to professionalize Cisco’s management, bringing in as CEO an industry veteran, John Morgridge.  Sales grew rapidly, from $1.5 million in 1987 to $28 million in 1989, and in February 1990, Cisco went public.

Valentine and Morgridge brought on John Chambers as a sales executive in 1991.  Chambers had worked at IBM and Wang Labs, and was ready to work at a smaller company where he might have more of an impact.  Chambers came up with a plan for Cisco to dominate the market for computer infrastructure.  Over the next three years, Cisco acquired two dozen companies.

(Cisco Logo, via Wikimedia Commons)

Chambers became CEO in 1995 and Cisco continued acquiring companies.  Cisco’s revenues reached $4 billion in 1997.  Rosenzweig:

Cisco rode the crest of the internet wave in 1998… Cisco had a 40 percent share of the $20 billion data-networking equipment industry—routers, hubs, and devices that made up the so-called plumbing of the Internet—and a massive 80 percent share of the high-end router market.  But Cisco wasn’t just growing revenues.  It was profitable, too.  At a time when even the most admired Internet start-ups, like Amazon.com, were losing money, Cisco posted operating margins of 60 percent.  This wasn’t some dot-com with a business plan, way out there in the blue, riding on a smile and a shoeshine.  It wasn’t panning for Internet gold, it was selling picks and shovels to miners who were lining up around the corner to buy them…

Cisco reached $100 billion market capitalization in just twelve years.  It had taken Microsoft twenty years (the previous record).

Accounts explaining Cisco’s success nearly always gave credit to John Chambers.  He’d overcome dyslexia to go to law school.  And Chambers said he learned from working at IBM and Wang that if you don’t react to shifts in technology, your work will be lost and the lives of employees disrupted.  Cisco wouldn’t make that mistake, Chambers declared.

Cisco had a disciplined, detailed process for making acquisitions, and an even more disciplined process for integrating acquisitions into Cisco’s operations.  Cisco had made “a science” of acquisitions.  And it cared a lot about the human side—turnover rate for acquired employees was only 2.1% versus an industry average of 20%.

After the Internet stock bubble burst, business reporters completely reversed their opinion of Cisco on every major point:

  • Customer service—from excellent to poor
  • Forecasting ability—from outstanding to terrible
  • Innovation—from nearly perfect to visibly flawed
  • Acquisitions—from scientific process to binge buying
  • Senior leadership—from amazing to arrogant

Business reporters recalled that Chambers had claimed that Cisco “was faster, smarter, and just plain better than competitors.”  Rosenzweig says this is fascinating because only business reporters had said this when Cisco was doing well.  Chambers himself never said it, but now business writers seemed to recall that he had.

Rosenzweig points out that it was possible that Cisco had changed.  But that’s not what business reporters were saying.  They viewed Cisco through an entirely different lens, now that the company was struggling.

The essence of the Halo Effect: If a company is performing well, then it’s easy to view virtually everything it does through a positive lens.  If a company is doing poorly, then it’s natural to view virtually everything it does through a negative lens.  The story of Cisco certainly fits this pattern.

As Rosenzweig remarks, the fundamental problem is twofold:

  • We have little scientific knowledge of what leads to business success or failure.
  • But we do know about revenues, profits, and the stock price.  If these observable measures are positive, we intuitively jump to the conclusion that the company must be doing many things well.  If these observable measures are declining, we conclude that the company must be doing many things poorly.

 

UP AND DOWN WITH ABB

ABB is a Swedish-Swiss industrial company that was created in 1988 by the merger of two leading engineering companies, Sweden’s ASEA and Switzerland’s Brown Boveri.

(ABB Logo, via Wikimedia Commons)

Rosenzweig thought it would be interesting to look at a non-American, non-Internet company.  The Halo Effect is still clearly visible in the accounts of ABB’s rise and fall.

When it came to ABB’s rise, from the late 1980’s to the late 1990’s, we see that business experts drew similar conclusions.  First, the CEO, Percy Barnevik, was widely and highly praised.  Rosenzweig describes Barnevik as a “Scandinavian who combined old world manners and language skills with American pragmatism and an orientation for action.”  Barnevik was described in the press as very driven, but also unpretentious and accessible.  He met frequently with all levels of ABB management.  He was a speed reader and highly analytical.  Away from work, he climbed mountains and went for long jogs (lasting up to 10 hours).  On top of all this, Barnevik was viewed as humble, not arrogant.

By 1993, Barnevik had become a legend.  Another explanation for ABB’s success was its culture.  Despite its conservative Swedish and Swiss roots, ABB had a strong bias for action.  Barnevik said so on several occasions, asserting that the only unacceptable thing was to do nothing.  He claimed that if you do 50 things, and 35 are in the right direction, that is enough.

Third, ABB was designed to be globally efficient, but still able to compete in local markets.  Barnevik wanted people in different locations to be able to launch new products, make design changes, or alter production methods.  ABB had a matrix structure, with fifty-one business areas and forty-one country managers.  This resulted in 5,000 profit centers, with each one empowered to achieve high performance and accountable to do so.

In 1996, ABB was named Europe’s Most Respected Company for the third year in a row by the Financial Times.  Kevin Barham and Claudia Heimer, of Ashridge Management Centre in England, published a 382-page book about ABB.  They identified five reasons for ABB’s success:  customer focus, connectivity, communication, collegiality, and convergence.  They placed ABB in the same category as Microsoft and General Electric.

In 1997, Barnevik stepped down as CEO, replaced by Goran Lindahl.  Then the company transitioned towards businesses based on intellectual capital.  ABB entered new areas, like financial services.  It exited the trains and trams business, as well as the nuclear fuels business.  Rosensweig asks if ABB was “straying from its core.”  Not at all because ABB was still seen as a success.  Lindahl was CEO of the year in 1999 according to the American publication, Industry Week.  Lindahl was the first European to get this award.

In November 2000, Lindahl abruptly stepped down, saying he wanted to be replaced by someone with more expertise in IT.  Jürgen Centerman became the new CEO.

ABB’s performance entered a steep decline.  Centerman was replaced by Jürgen Dormann in September 2002.  Dormann sold the company’s petrochemicals business and its structured finance business.  ABB focused on automation technologies and power technologies.  But the company’s market cap dipped below $4 billion, down from a peak of $40 billion.

When ABB was on the rise in terms of performance, it was described as bold and daring because of its bias for action and experimentation.  Now, with performance being poor, ABB was described as impulsive and foolish.  Moreover, whereas ABB’s decentralized strategy had been praised when ABB was rising, now the same strategy was criticized.  As for Barnevik, while he had previously been described as bold and visionary, now he was called arrogant and imperial.

Most interesting of all, notes Rosenzweig, is that neither the company nor Barnevik was thought to have changed.  It was only how they were characterized that had changed—clear examples of the Halo Effect.

Rosenzweig writes:

…one of the main reasons we love stories is that they don’t simply report disconnected facts but make connections about cause and effect, often ascribing credit or blame to individuals.  Our most compelling stories often place people at the center of events… Once widely revered, Percy Barnevik was now an exemplar of arrogance, of greed, of bad leadership.

 

HALOS ALL AROUND US

During World War I, the American psychologist Edward Thorndike studied how superiors rated their subordinates.  Thorndike noticed that good soldiers were good on nearly every attribute, whereas underperforming soldiers were bad on nearly every attribute.  Rosenzweig comments:

It was as if officers figured that a soldier who was handsome and had good posture should also be able to shoot straight, polish his shoes well, and play the harmonica, too.

Thorndike called this the Halo Effect.  Rosenzweig:

There are a few kinds of Halo Effect.  One refers to what Thorndike observed, a tendency to make inferences about specific traits on the basis of a general impression.  It’s difficult for most people to independently measure separate features; there’s a common tendency to blend them together.  The Halo Effect is a way for the mind to create and maintain a coherent and consistent picture, to reduce cognitive dissonance.

(Image by Aliaksandra Molash)

Rosenzweig gives the example of George W. Bush.  After the September 11 attacks in 2001, Bush’s approval ratings rose sharply, not surprisingly as the public rallied behind him.  But Bush’s ratings on other factors, such as his management of the economy, also rose significantly.  There was no logical reason to think Bush’s handling of the economy was suddenly much better after the attacks.  This is an instance of the Halo Effect.

By October 2005, the situation had reversed.  Support for the Iraq War waned, and people were upset about the government response to Hurricane Katrina.   Bush’s overall ratings were at 37 percent.  His rating was also lower in every individual category.

Rosenzweig then explains another kind of Halo Effect:

…the Halo Effect is not just a way to reduce cognitive dissonance.  It’s also a heuristic, a sort of rule of thumb that people use to make guesses about things that are hard to assess directly.  We tend to grasp information that is relevant, tangible, and appears to be objective, and then make attributions about other features that are more vague or ambiguous.

Rosenzweig later adds:

All of which helps explain what we saw at Cisco and ABB.  As long as Cisco was growing and profitable and setting records for its share price, managers and journalists and professors inferred that it had a wonderful ability to listen to its customers, a cohesive corporate culture, and a brilliant strategy.  And when the bubble burst, observers were quick to make the opposite attribution.  It all made sense.  It told a coherent story.  Same for ABB, where rising sales and profits led to favorable evaluations of its organization structure, its risk-taking culture, and most clearly the man at the top—and then to unfavorable evaluations when performance fell.

Rosenzweig recounts an experiment by professor Barry Staw.  Various groups of people were asked to forecast future sales and earnings based on a set of financial data.  Then some groups were told they’d done a good job, while other groups were told the opposite.  But this was done at random, completely independent of actual performance.

Later, each group was asked about how it had functioned as a group.  Groups that had been told that they did well on their forecasts reported that their group had been cohesive, with good communication, openness to change, and good motivation.  Groups that had been told that they didn’t do well on their forecasts reported that they lacked cohesion, had poor communication, and were unmotivated.

Staw’s experiment is a clear demonstration of the Halo Effect.  Completely irrespective of whether the group actually is effective or not—which, after all, can be very difficult to measure:

  • If people believe that a group is effective, then they attribute one set of characteristics to it.
  • If people believe that a group is ineffective, then they attribute the opposite set of characteristics to it.

This doesn’t mean that cohesiveness, motivation, etc., is unimportant for group communication.  Rather, it means that people typically cannot assess these types of qualities with much (or any) objectivity, especially if they already have a belief about how a given group has performed in some task.

When it’s hard to measure something objectively, people tend to look for something that is objective and use that as a heuristic, inferring that harder-to-measure attributes must be similar to whatever is objective (like financial peformance).

As yet another example, Rosenzweig mentions that IBM’s employees were viewed as smart, creative, and hardworking in 1984 when IBM was doing well.  In 1992, after IBM had faltered, the same people were described as complacent and bureauratic.

As we’ve seen, the Halo Effect is particularly frequent when people try to judge how good a leader is.  Just as we don’t have much scientific knowledge for how a company can succeed, we also don’t have much scientific knowledge about what makes a good leader.  Experts, when they look at a company that is doing well, tend to think that the leader has many good qualities such as courage, clear vision, and integrity.  When the same experts examine a company that is doing poorly, they tend to conclude that the leader lacks courage, vision, and integrity.  This happens even when experts are looking at the same company and that company is doing the same things.

(Image by Kirsty Pargeter)

When Microsoft was doing well, Bill Gates was described as ambitious, brilliant, and visionary.  When Microsoft appeared to falter in 2001, after Judge Thomas Penfield Jackson ordered Microsoft to be broken up, Bill Gates was described as arrogant and stubborn.

Rosenzweig gives two more examples:  Fortune’s World’s Most Admired Companies, and the Great Places to Work Institute’s Best Companies to Work For index.  Both lists appear to be significantly impacted by the Halo Effect.  Companies that have been doing well financially tend to be viewed and described much more favorably on a range of metrics.

Rosenzweig closes the chapter by noting that the Halo Effect is the most basic delusion, but that there are several more delusions he will examine in the coming chapters.

 

RESEARCH TO THE RESCUE?

Rosenzweig:

The Halo Effect shapes how we commonly talk about so many topics in business, from decision processes to people to leadership and more.  It shows up in our everyday conversations and in newspaper and magazine articles.  It affects case studies and large-sample surveys.  It’s not so much the result of conscious distortion as it is a natural human tendency to make judgments about things that are abstract and ambiguous on the basis of other things that are salient and seemingly objective.  The Halo Effect is just too strong, the desire to tell a coherent story too great, the tendency to jump on bandwagons too appealing.

The most fundamental business question is:

What leads to high business performance?

The Halo Effect is far from inevitable, despite being very common.  There are researchers who use careful statistical tests to isolate the effects of independent variables on dependent variables.

The dependent variables relate to company performance.  And we have good data on that, from revenues to profits to return on capital.

As for the independent variables, some of these, such as R&D spending, are not tainted.  Much trickier is what happens inside a company, such as quality of management, customer orientation, company culture, etc.

Rosenzweig explores the question of whether customer focus leads to better company performance.  It probably does.  However, in order to measure the effect of customer focus on performance objectively, we should not look at magazine and newspaper articles—since these are impacted by the Halo Effect.  Nor should we ask company employees about their customer focus.  How a company is performing—well or poorly—will impact the opinions of managers and employees regarding customer focus.

Similar logic applies to the question of how corporate culture impacts business performance.  Surveys of managers and employees will be tainted by the Halo Effect.  Yes, corporate culture impacts business performance.  But to figure out the statistical correlation, we have to be sure to avoid data likely to be skewed by the Halo Effect.

Delusion Two: The Delusion of Correlation and Causality

Rosenzweig gives the example of employee turnover and company performance.  If there is a statistical correlation between the two, then what does that mean?  Does lower employee turnover lead to higher company performance?  That sounds reasonable.  On the other hand, does higher company performance lead to lower employee turnover?  That could very well be the case.

Potential confusion about correlation versus causality is widespread when it comes to the study of business.

One way to get some insight into potential causality is to conduct a longitudinal study, looking at independent variables in one period and hypothetically dependent variables in some later period.  Rosenzweig:

One recent study, by Benjamin Schneider and colleagues at the University of Maryland, used a longitudinal design to examine the question of employee satisfaction and company performance to try to find out which one causes which.  They gathered data over several years so they could watch both changes in satisfaction and changes in company performance.  Their conclusion?  Financial performance, measured by return on assets and earnings per share, has a more powerful effect on employee satisfaction than the reverse.  It seems that being on a winning team is a stronger cause of employee satisfaction; satisfied employees don’t have as much of an effect on company performance.  How were Schneider and his colleagues able to break the logjam and answer the question of which leads to which?  By gathering data over time.

Delusion Three: The Delusion of Single Explanations

Rosenzweig describes two studies that were carefully conducted, one on the effect of market orientation on company performance, and the other on the effect of CSR—corporate social responsibility—on company performance.  The studies were careful in that they didn’t just ask for opinions.  They asked about different activities in which the company did or did not engage.

The conclusion of the first study was that market orientation is responsible for 25 percent of company performance.  The second study concluded that CSR is responsible for 40 percent of company performance.  Rosenzweig asks: Does that mean that market orientation and CSR together explain 65 percent of company performance?  Or do the variables overlap to an extent?  The problem with studying a single cause of company performance is that you don’t know if part of the effect may be due to some other variable you’re not measuring.  If a company is well-managed, then wouldn’t that be seen in market orientation and also in CSR?

(Photo by Jörg Stöber)

We could throw human resource management—HRM—into the mix, too.  Same goes for leadership.  One study found that good leadership is responsible for 15 percent of company performance.  But is that in addition to market orientation, CSR, and HRM?  Or do these things overlap to an extent?  It’s likely that there is significant overlap among these four variables.

One problem is that many researchers would like to tell a clear story about cause and effect.  Admitting that many key variables likely overlap means that the story is much less clear.  People—especially if busy or pressured—prefer simple stories where cause and effect seem obvious.

Furthermore, many important questions are at the intersection of different fields.  Rosenzweig gives the example of decision making, which involves psychology, sociology, and economics.  The trouble is that an expert in marketing will tend to exaggerate the importance of marketing.  An expert in CSR will tend to exaggerate the importance of CSR.  And so forth for other specialties.

 

SEARCHING FOR STARS, FINDING HALOS

Rosenzweig lists the eight practices of America’s best companies according to In Search of Excellence: Lessons from America’s Best-Run Companies, published by Tom Peters and Bob Waterman in 1982:

  • A bias for action—a preference for doing something—anything—rather than sending a question through cycles and cycles of analyses and committee reports.
  • Staying close to the customer—learning his preferences and catering to them.
  • Autonomy and entrepreneurship—breaking the corporation into small companies and encouraging them to think independently and competitively.
  • Productivity through people—creating in all employees the awareness that their best efforts are essential and that they will share in the rewards of the company’s success.
  • Hands-on, value-driven—insisting that executives keep in touch with the firm’s essential business.
  • Stick to the knitting—remaining with the business the company knows best.
  • Simple form, lean staff—few administrative layers, few people at the upper levels.
  • Simultaneous loose-tight properties—fostering a climate where there is dedication to the central values of the company combined with a tolerance for all employees who accept those values.

Rosenzweig points out that this list looks familiar:  Care about your customers.  Have strong values.  Create a culture where people can thrive.  Empower your employees.  Stay focused.

If these look correlated, says Rosenzweig, that’s because they are.  The best companies do all of them.  Of course, again there’s the Halo Effect.  If you isolate the top-performing companies (43 of them in this case), and then ask managers and employees about customer focus, values, culture, leadership, focus, etc., then you won’t know what caused what.  Did clear strategy, good organization, strong corporate culture, and customer focus lead to the high performance?  Or do people view high-performing companies as doing well in these areas?

(Image by Eriksvoboda)

When the book was published in 1982, there was a widespread concern among American businesses that Japanese companies were better overall.  Peters and Waterman made the point that the leading American businesses were doing well in a variety of key areas.  This message was viewed not only as inspirational, but even as patriotic.  It was the right story for the times.

Many thought that In Search of Excellence contained scientific knowledge:  if x, then y (with probability z).  People thought that if they implemented the principles highlighted by Peters and Waterman, then they would be successful in business.

However, just two years later, some of the excellent companies did not seem as excellent as before.  Some were blamed for changing—not sticking to their knitting.  Others were blamed for NOT changing—not being adaptable enough, not taking action.  More generally, some were blamed for overemphasizing certain principles, while underemphasizing other principles.

Rosenzweig examined the profitability of 35 of the 43 excellent companies—the 35 companies for which data were available because these companies were public.  He found that, in the five years after 1982, 30 out of 35 had a decline in profitability.  If these were truly excellent companies, then such a decline for 30 of 35 doesn’t make sense.

(Image by Dejan Lazarevic)

Rosenzweig observes that it’s possible that the previous success of these companies was due to more than the eight principles identified by Peters and Waterman.  And so changes in other variables may explain the subsequent declines in profitability.  It’s also possible—because Peters and Waterman identified 43 highly successful companies and then interviewed managers at those companies—that the Halo Effect came into play.  The eight principles may reflect attributions that people tend to make about currently successful companies.

Delusion Four: The Delusion of Connecting the Winning Dots

You can’t choose a sample based only on the dependent variable you’re trying to test.  The dependent variable in this case is successful companies.  If all you look at is successful companies, then you won’t be able to compare successful companies directly to unsuccessful companies in order to learn about their respective causes—the independent variables.  Rosenzweig refers to this error as the Delusion of Connecting the Winning Dots.  You can connect the dots any way you wish, but following this approach, you can’t learn about the independent variables that lead to success.

Like many areas of social science, it’s not easy.  You can’t run an experiment where you take 100 companies, and manage half of them one way, and half of them another way, and then compare results.

(Image by Macrovector)

Jim Collins and Jerry Porras isolated 18 companies based on excellent performance over a long period of time.  Also, for each of these companies, Collins and Porras identified a similar company that had been less successful.  This at least could avoid the error that Peters and Waterman made.  As Collins and Porras said, if all you looked at were successful companies, you might find that they all reside in buildings.

Collins, Porras, and their team read more than 100 books and looked at more than 3,000 documents.  All told, they had a huge amount of data.  They certainly worked very hard.  But that in itself does not increase the scientific validity of their study.

Collins and Porras claimed to have found “timeless principles,” which they listed:

  • Having a strong core ideology that guides the company’s decisions and behavior
  • Building a strong corporate culture
  • Setting audacious goals that can inspire and stretch people—so-called big hairy audacious goals, or BHAGs
  • Developing people and promoting them from within
  • Creating a spirit of experimentation and risk taking
  • Driving for excellence

Unfortunately, much of the data came from books, the business press, and company documents, all likely to contain Halos.  They also conducted interviews with managers, who were asked to look back on their success and explain the reasons.  These interviews were probably tinged by Halos in many cases.  Some of the principles identified may have led to success.  However, successful companies were also likely to be described in these terms.  The Halo Effect hadn’t been dealt with by Collins and Porras.

Rosenzweig looked at profitability over the subsequent five years.  Eleven companies saw profits decline.  One was unchanged.  Only five of the best companies had profits increase.  It seems the “master blueprint for long-term prosperity” is largely a delusion, writes Rosenzweig.

(Graph by Experimental)

It’s not just some of the companies, but most of the companies that saw profits decline.  Characterizations of the “best” companies were probably impacted significantly by the Halo Effect.  The very fact that these companies had been doing well for some time led many to see them as having positive attributes across the board.

Delusion Five: The Delusion of Rigorous Research

As noted, psychologist Philip Tetlock tracked the predictions of 284 leading experts over two decades.  Tetlock looked at over 27,000 predictions in real time of the form:  more of x, no change in x, or less of x.  He found that these predictions were no better than random chance.

Many experts have deep knowledge—historical or otherwise—that can give us valuable insights into human affairs.  Some of this expertise is probably accurate.  But until we have testable predictions, it’s difficult to say which hypotheses are true and to what degree.

We should never forget the difference between scientific knowledge and other types of knowledge, including stories.  It’s very easy for us humans to be overconfident and deluded, especially if certain stories are the result of “many years of hard work.”

Delusion Six: The Delusion of Lasting Success

Richard Foster and Sarah Kaplan looked at companies in the S&P 500 from 1957 to 1997.  By 1997, only 74 out of the original largest 500 companies were still in the S&P 500.  Of those 74 survivors, how many outperformed the S&P 500 over those 40 years?  Only 12.

Foster and Kaplan conclude:

KcKinsey’s long-term studies of corporate birth, survival, and death in America clearly show that the corporate equivalent of El Dorado, the golden company that continually performs better than the markets, has never existed.  It is a myth.  Managing for survival, even among the best and most revered corporations, does not guarantee strong long-term performance for shareholders.  In fact, just the opposite is true.  In the long run, the markets always win.

It’s not that busines success is completely random.  Of course not.  But there is usually a large degree of luck involved.  More fundamentally, capitalism is about competition through innovation, or creative destruction, as the great Austrian economist Joseph Schumpeter called it.  There is some inherent unpredictability—or luck—in this endless process.

Delusion Seven: The Delusion of Absolute Performance

Kmart improved noticeably from 1994 to 2002, but Wal-Mart and Target were ahead at the beginning of that period, and they improved even faster than Kmart.  Thus, although it would seem Kmart was doing the right things in terms of absolute performance, Kmart was falling even further behind in terms of relative performance.

In 2005, GM was making much better cars than in the 1980s.  But its market share kept slipping, from 35 percent in 1990 to 25 percent in 2005.  GM’s competitors were improving faster.

Rosenzweig sums it up:

The greater the number of rivals, and the easier for competitors to enter the market, and the more rapidly technology changes, the more difficult it is to sustain success.  That’s an uncomfortable truth, because it admits that some elements of business performance are outside of our control.  It’s far more appealing to downplay the relative nature of performance or ignore it completely.  Telling a company it can achieve high performance, regardless of what competitors do, makes for a more attractive story.

Delusion Eight: The Delusion of the Wrong End of the Stick

In Good to Great, Collins argues that a company can decide to become great and follow the blueprint in the book.  Part of the recipe is to be like a Hedgehog—to have a narrow focus and pursue it with great discipline.  The problem, again, is that the role of chance—or factors outside one’s control—is not considered.  (The terms “Hedgehog” and “Fox” come from an essay by Isaiah Berlin.  The Hedgehog knows one big thing, whereas the Fox knows many things.)

(Image by Marek Uliasz)

Statistically, it’s possible that, on the whole, more Hedgehogs than Foxes failed.  You could still argue that the potential upside for becoming a great company is so large that it’s worth taking the risk of being like a Hedgehog.  But Collins doesn’t mention risk, or chance, at all.

Of course, we’d all prefer a story where greatness is purely a matter of choice.  But it’s rarely that simple and luck nearly always plays a pivotal role.

Delusion Nine: The Delusion of Organizational Physics

For many questions in business, we can’t run experiments.  That said, with enough care, important statistical correlations can be discovered.  Other things can be measured even more precisely.

But to think that the study of business is like the science of physics is a delusion, at least for now.

It’s reasonable to suppose that, with enough scientific knowledge in neuroscience, genetics, psychology, economics, artificial intelligence, and related areas, eventually human behavior may become largely predictable.  But there’s a long way to go.

 

THE MOTHER OF ALL BUSINESS QUESTIONS, TAKE TWO

By nature, we prefer stories where business success is entirely a result of choosing to do the right things, while not reaching success must be due to a failure to do the right things.  But stories like this neglect the role of chance.  Rosenzweig writes:

…all the emphasis on steps and formulas may obscure a more simple truth.  It may further the fiction that a specific set of steps will lead, predictably, to success.  And if you never achieve greatness, well, the problem isn’t with our formula—which was, after all, the product of rigorous research, of extensive data exhaustively analyzed—but with you and your failure to follow the formula.  But in fact, the truth may be considerably simpler than these formula suggest.  They may divert our attention from a more powerful insight—that while we can do many things to improve our chances of success, at its core business performance contains a large measure of uncertainty.  Business performance may actually be simpler than it is often made out to be, but may also be less certain and less amenable to engineering with predictable outcomes.

There is a simpler way to think about business performance—suggested by Michael Porter—without neglecting the role of chance.  Strategy is doing certain things different from rivals.  Execution is people working together to create products by implementing the strategy.  This is a reasonable way to think about business performance as long as you also note the role of chance.

It’s usually hard to know how potential customers will behave.  There are, of course, many examples where, contrary to expectations, a product was embraced or rejected.  Moreover, even if you correctly understand customers, competitors may come up with a better product.

There’s also the issue of technological change, which can be a significant source of unpredictability in some industries.

(Illustration by T. L. Furrer)

Clayton Christensen has demonstrated—in The Innovator’s Dilemma—that frequently companies fail because they keep doing the right things, giving customers what they want.  Meanwhile, competitors develop a new technology that, at first, is not profitable—which is part of why the company “doing the right things” ignores it.  But then, unpredictably, some of these new technologies end up being popular and also profitable.

One good question is:  What should a company do when its core comes under pressure?  Should it redouble its focus on the core, like a Hedgehog?  Or should it be adaptable, like a Fox?  There are no good answers at the moment, says Rosenzweig.  There are too many variables.  Chance—or uncertainty—plays a key role.

Rosenzweig continues:

In the meantime, we’re left with the brutal fact that strategic choice is hugely consequential for a company’s performance yet also inherently risky.  We may look at successful companies and applaud them for what seem, in retrospect, to have been brilliant decisions, but we forget that at the time those decisions were made, they were controversial and risky.  McDonald’s bet on franchising looks smart today, but in the 1950s it was a leap in the dark.  Dell’s strategy of selling direct now seems brilliant but was attempted only after multiple failures with conventional channels.  Or, recalling companies we discussed in earlier chapters, remember Cisco’s decision to assemble a full range of product offerings through acquisitions or ABB’s bet on leading rationalization of the European power industry through consolidation and cost cutting.  The managers who took those choices appraised a wide variety of factors and decided to be different from their rivals.  We remember all of these decisions because they turned out well, but success was not inevitable.  As James March of Stanford and Zur Shapira of New York University explained, “Post hoc reconstruction permits history to be told in such a way that ‘chance,’ either in the sense of genuinely probabilistic phenomena or in the sense of unexplained variation, is minimized as an explanation.”  But chance DOES play a role, and the difference between a brilliant visionary and a foolish gambler is usually inferred after the fact, an attribution based on outcomes.  The fact is, strategic choices always involve risk.  The task of strategic leadership is to gather appropriate information and evaluate it thoughtfully, then make choice that, while risky, provide the best chances for success in a competitive industry setting.

(Image by Donfiore)

As for execution, certain practices do correlate with modestly higher performance.  If leaders can identify the few areas where better execution is needed, then some progress can be made.

But inherent unpredictability is hidden by the Halo Effect.  If a company succeeds, it’s easy to say it executed well.  If a company fails, it’s natural to conclude that execution was poor.  Often to a large extent, these conclusions are driven by the Halo Effect, even if there is some truth to them.

In brief, smart strategic choices and good execution—plus good luck—may lead to success, at least temporarily.  But success brings challengers, some of whom will take greater risks that may work.  There’s no formula to guarantee success.  And if success is achieved, there’s no way to guarantee continued success over time.

 

MANAGING WITHOUT COCONUT HEADSETS

Given that there’s no simple formula that brings business success, what should we do?  Rosenzweig answers:

A first step is to set aside the delusions that color so much of our thinking about business performance.  To recognize that stories of inspiration may give us comfort but have little more predictive power than a pair of coconut headsets on a tropical island.  Instead, managers would do better to understand that business success is relative, not absolute, and that competitive advantage demands calculated risks.  To accept that few companies achieve lasting success, and that those that do are perhaps best understood as having strung together several short-term successes rather than having consciously pursued enduring greatness.  To admit that, as Tom Lester of the Financial Times so neatly put it, “the margin between success and failure is often very narrow, and never quite as distinct or as enduring as it appears at a distance.”  By extension, to recognize that good decisions don’t always lead to favorable outcomes, that unfavorable outcomes are not always the result of mistakes, and therefore to resist the natural tendency to make attributions based solely on outcomes.  And finally, to acknowledge that luck often plays a role in company success.  Successful companies aren’t “just lucky”—high performance is not purely random—but good fortune does play a role, and sometimes a pivotal one.

Rosenzweig mentions Robert Rubin as a good example of someone who learned to make decisions in terms of scenarios and their probabilities.

(Image by Elnur)

Rubin worked for eight years in the Clinton administration, first as director of the White House National Economic Council and later as secretary of the Treasury.  Prior to working in the Clinton administration, Rubin toiled for twenty-six years at Goldman Sachs.

Rubin first learned about the fundamental uncertainties of the world when he studied philosophy as an undergraduate.  He learned to view every proposition with skepticism.  Later at Goldman Sachs, Rubin saw first-hand that one had to consider possible outcomes and their associated probabilities.

Rubin spent years in risk arbitrage.  Many times Goldman made money, but roughly one out of every seven times, Goldman lost money.  Sometimes the loss would greatly exceed Goldman’s worst-case scenario.  But occasionally large and painful losses didn’t mean that Goldman’s decision-making process was flawed.  In fact, if Goldman wasn’t taking some losses, then they almost certainly weren’t taking enough risk.

(Photo by Alain Lacroix)

Rosenzweig asks:  If a large and painful loss doesn’t mean a mistake, then what does?

We have to take a close look at the decision process itself, setting aside the eventual outcome.  Had the right information been gathered, or had some important data been overlooked?  Were the assumptions reasonable, or had they been flawed?  Were calculations accurate, or had there been errors?  Had the full set of eventualities been identified and their impact estimated?  Had Goldman Sachs’s overall risk portfolio been properly considered?

Once again, a profitable outcome doesn’t necessarily mean the decision was good.  An unprofitable outcome doesn’t necessarily mean the decision was bad.  If you’re making decisions under uncertainty—probabilistic decisions—the only way to improve is to evaluate the process of decision-making independently of specific outcomes.

Of course, often important decisions for an individual business are quite infrequent.  Rosenzweig highlights important lessons for managers:

  • If independent variables aren’t measured independently, we may find ourselves standing hip-deep in Halos.
  • If the data are full of Halos, it doesn’t matter how much we’ve gathered or how sophisticated our analysis appears to be.
  • Success rarely lasts as long as we’d like—for the most part, long-term success is a delusion based on selection after the fact.
  • Company performance is relative, not absolute.  A company can get better and fall further behind at the same time.
  • It may be true that many successful companies bet on long shots, but betting on long shots does not often lead to success.
  • Anyone who claims to have found laws of business physics either understands little about business, or little about physics, or both.
  • Searching for the secrets of business success reveals little about the world of business but speaks volumes about the searchers—their aspirations and their desires for certainty.

Getting rid of delusions is a crucial step.  Furthermore, writes Rosenzweig, a wise manager knows:

  • Any good strategy involves risk.  If you think your strategy is foolproof, the fool may well be you.
  • Execution, too, is uncertain—what works in one company with one workforce may have different results elsewhere.
  • Chance often plays a greater role than we think, or than successful managers usually like to admit.
  • The link between inputs and outcomes is tenuous.  Bad outcomes don’t always mean that managers made mistakes; and good outcomes don’t always mean they acted brilliantly.
  • But when the die is cast, the best managers act as if chance is irrelevant—persistence and tenacity are everything.

Of course, none of this guarantees success.  But the sensible goal is to improve your chances of success.

 

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 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  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.