Capitalism without Capital

(Image:  Zen Buddha Silence by Marilyn Barbone.)

November 11, 2018

Capitalism without Capital: The Rise of the Intangible Economy, by Jonathan Haskel and Stian Westlake, is an excellent book that everyone should read.

Historically most assets were tangible rather than intangible.  Houses, castles, temples, churches, farms, farm animals, equipment, horses, weapons, jewels, precious metals, art, etc.  These types of tangible assets tended to hold their value, and naturally they were included on accountants’ balance sheets.

(Photo by W. Scott McGill)

Intangible assets are different.  It’s harder to account for investing in intangibles.  But intangible investment is important.  Haskel and Westlake explain why:

Investment is what builds up capital, which, together with labor, constitutes the two measured inputs to production that power the economy, the sinews and joints that make the economy work.  Gross domestic product is defined as the sum of the value of consumption, investment, government spending, and net exports; of these four, investment is often the driver of booms and recessions, as it tends to rise and fall in response to monetary policy and business confidence.

The problem is that national statistical offices have, until very recently, measured only tangible investments.

The Dark Matter of Investment

In 2002 in Washington, at a meeting of the Conference on Research in Income and Wealth, economists considered investments people made in the “new economy.”  Carol Corrado and Dan Sichel of the US Federal Reserve Board and Charles Hulten of the University of Maryland developed a framework for thinking about different types of investments.

Haskel and Westlake mention Microsoft as an example.  In 2006, Microsoft’s market value was about $250 billion.  There was $70 billion in assets, $60 billion of which was cash and cash equivalents.  Plant and equipment totaled only $3 billion, 4 percent of Microsoft’s assets and 1 percent of its market value.  In a sense, Microsoft is a miracle:  capitalism without capital.

(Photo by tashatuvango)

Charles Hulten sought to explain Microsoft’s value by using intangible assets:

Examples include the ideas generated by Microsoft’s investments in R&D and product design, the value of its brands, its supply chains and internal structures, and the human capital built up by training.

Such intangible assets are similar to tangible assets in that the company had to spend time and money on them up-front, while the value to the company was delivered over time.

Why Intangible Investment is Different

Businesses change what they invest in all the time, so how is intangible investment different?  Haskel and Westlake:

Our central argument in this book is that there is something fundamentally different about intangible investment, and that understanding the steady move to intangible investment helps us understand some of the key issues facing us today:  innovation and growth, inequality, the role of management, and financial and policy reform.

We shall argue there are two big differences with intangible assets.  First, most measurement conventions ignore them.  There are some good reasons for this, but as intangibles have become more important, it means we are now trying to measure capitalism without counting all the capital.  Second, the basic economic properties of intangibles make an intangible-rich economy behave differently from a tangible-rich one.

Outline for this blog post:

Part I  The Rise of the Intangible Economy

  • Capital’s Vanishing Act:  The Rise of Intangible Investment
  • How to Measure Intangible Investment
  • What’s Different About Intangible Investment?  The Four S’s of Intangibles

Part II  The Consequences of the Rise of the Intangible Economy

  • Intangibles, Investment, Productivity, and Secular Stagnation
  • Intangibles and the Rise of Inequality
  • Infrastructure for Intangibles, and Intangible Infrastructure
  • The Challenge of Financing an Intangible Economy
  • Competing, Managing, and Investing in the Intangible Economy
  • Public Policy in an Intangible Economy:  Five Hard Questions

 

Part I  The Rise of the Intangible Economy

CAPITAL’S VANISHING ACT

Investment has changed:

The type of investment that has risen inexorably is intangible: investment in ideas, in knowledge, in aesthetic content, in software, in brands, in networks and relationships.

Investment, assets, and capital all have multiple meanings.

For investment, Haskel and Westlake stick with the internationally agreed upon definition as given by the UN’s System of National Accounts:

Investment is what happens when a producer either acquires a fixed asset or spends resources (money, effort, raw materials) to improve it.

An asset is an economic resource that is expected to provide a benefit over a period of time.  A fixed asset is an asset that results from using up resources in the process of its production.

Spending resources:  To be an investment, the business doing the investing has to acquire the asset or pay some cost to produce it themselves.

Haskel and Westlake offer some examples of intangible investments:

Suppose a solar panel manufacturer researches and discovers a cheaper process for making photovoltaic cells:  it is incurring expense in the present to generate knowledge it expects to benefit from in the future.  Or consider a streaming music start-up that spends months designing and negotiating deals with record labels to allow it to use songs the record labels own—again, short-term expenditure to create longer-term gain.  Or imagine a training company pays for the long-term rights to run a popular psychometric test:  it too is investing.

(Photo by magele-picture)

Intangible investing results in intangible assets.  More examples of intangible investments:

  • Software
  • Databases
  • R&D
  • Mineral exploration
  • Creating entertainment, literary or artistic originals
  • Design
  • Training
  • Market research and branding
  • Business process re-engineering

Intangible Investment Has Steadily Grown

Supermarkets have developed complex pricing systems, more ambitious branding and marketing campaigns, and more detailed processes and systems (including better use of bar codes).  Moreover, as you might expect, tech firms make heavy use of intangible investments, as Haskel and Westlake explain:

Fast-growing tech companies are some of the most intangible-intensive of firms.  This is in part because software and data are intangibles, and the growing power of computers and telecommunications is increasing the scope of things that software can achieve.  But the process of “software eating the world,” in venture capitalist Marc Andreesen’s words, is not just about software:  it involves other intangibles in abundance.  Consider Apple’s designs and its unrivaled supply chain, which has helped it to bring elegant products to market quickly and in sufficient numbers to meet customer demand, or the networks of drivers and hosts that sharing-economy giants like Uber and AirBnB have developed, or Tesla’s manufacturing know-how.  Computers and the Internet are important drivers of this change in investment, but the change is long running and predates not only the World Wide Web but even the Internet and the PC.

By the mid-1990s, intangible investment in the United States exceeded tangible investment.  There is a similar pattern for the UK, Sweden, and Finland.  But tangible investment is still greater than intangible investment in Spain, Italy, Germany, Austria, Denmark, and the Netherlands.

Reasons for the Growth of Intangible Investment

Because the productivity of the manufacturing sector typically increases faster than that of the services sector, labor-intensive services gradually become more expensive compared to manufactured goods.  (This is called Baumol’s Cost Disease.)  This implies that intangible investing will grow faster than tangible investing over time.

Furthermore, new technology seems to create greater opportunities for businesses to invest productively in intangibles.  Haskel and Westlake give Uber as an example.  It would have been possible before computers and smartphones for Uber to develop its large network of drivers.  But smartphones—which connect people quickly, allow the rating of drivers, and make payment quick and easy—significantly boosted the return on investment for Uber.

It’s natural to wonder if computers are the cause of increased intangible investment.  Haskel and Westlake suggest that while computers may be a primary cause, they do not seem to be the only cause:

First of all, as we saw earlier, the rise of intangible investment began before the semiconductor revolution, in the 1940s and 1950s and perhaps before.  Second, while some intangibles like software and data strongly rely on computers, others do not:  brands, organizational development, and training, for example.  Finally, a number of writers in the innovation studies literature argue that it may be that it was the rise of intangibles that led to the development of modern IT as much as the other way around.

 

HOW TO MEASURE INTANGIBLE INVESTMENT

Productivity growth in the United States starting in the mid-1970s and throughout the 1980s seemed quite low.  Economists found this puzzling because computers seemed to be making a difference in a variety of areas.  Statistical agencies, led by the US Bureau of Economic Analysis (BEA), made two adjustments:

First, in the 1980s, in conjunction with IBM, the BEA started to produce indexes of computer prices that were quality adjusted.  This turned out to make a very big difference to measuring how much investment businesses were making in computer hardware.

In most cases—for products, for example—prices for the same good tend to rise gently in line with overall inflation.  But even if sticker prices for computers were rising, they were decidedly not the same good, since every dimension of their quality (speed, memory, and space) was improving incredibly.  So their “quality-adjusted” prices were, in fact, falling and falling very fast, meaning that the quality you could buy per dollar spent on computers was in fact rising very fast.

In the 1990s, statisticians looked at business spending that creates computer software.  Haskel and Westlake comment that banks are huge spenders on the creation of software (at one point, Citibank employed more programmers than Microsoft).  Software is an intangible good—knowledge written down in lines of code.

(Photo by Krisana Antharith)

By the early 2000s, many business economists realized that knowledge more generally is an intangible investment that should be included in GDP and productivity measures.  Gradually statistical offices began to incorporate various intangible investments into GDP statistics.  Haskel and Westlake:

And these changes added up.  In the United States, for example, the capitalization of software added about 1.1 percent to 1999 US GDP and R&D added 2.5 percent to 2012 GDP, with these numbers growing all the time…

What Sorts of Intangibles Are There?

Corrado, Hulten, and Sichel divided intangible investment into three broad types:

  • Computerized Information:  Software development;  Database development.
  • Innovative Property:  R&D;  Mineral exploration;  Creating entertainment and artistic originals;  Design and other product development costs.
  • Economic Competencies:  Training;  Market research and branding;  Business process re-engineering.

Right now, design and other product development costs are not included in official GDP measures.  Also not included:  training, market research and branding, and business process re-engineering.

Measuring Investment in Intangibles

Haskel and Westlake:

Measuring investment requires a number of steps.  First, we need to find out how much firms are spending on the intangible.  Second, in some cases, not all of that spending will be creating a long-lived asset… So we may have to adjust that spending to measure investment—that is, that part of spending creating a long-lived asset.  Third, we need to adjust that investment for inflation and quality change so we can compare investment in different periods when prices and quality are changing.

For most investment goods, national accountants simply send out a survey to companies asking them how much there are spending on each good.  It’s trickier, however, if it’s an intangible good that the company makes for itself, like writing its own software or doing its own R&D.  In this case, statisticians can figure out how much it costs a company—over and above wages—to produce the intangible good.  Statisticians also must estimate how much of that additional spending is an investment that will last for more than a year.  The third step is to adjust for inflation and quality changes.

To measure the intangible asset created by intangible investment, economists have to estimate depreciation.  Once you know the flow of intangible investment and you adjust for depreciation, you can then estimate the stock—the value of intangible assets in a given year.  For software, design, marketing, and training, depreciation is about 33 percent a year.  For R&D, depreciation is roughly 15 percent a year.  For entertainment and artistic originals and mineral exploration, depreciation is lower.

 

WHAT’S DIFFERENT ABOUT INTANGIBLE INVESTMENT?

An intangible-rich economy has four characteristics—the four S’s—that distinguish it from a tangible-rich economy.  Intangible assets:

  • Are more likely to be scalable;
  • Their costs are more likely to be sunk;
  • They are inclined to have spillovers;
  • They tend to exhibit synergies with each other.

Scalability

Why Are Intangibles Scalable?

Scalability derives from what economists call “non-rivalry” goods.  A rival good is like a loaf of bread.  Once one person eats the loaf of bread, no one else can eat that loaf.  In contrast, a non-rival good is not used up when one person uses it.  For instance, once a software program has been created, it can be reproduced an infinite number of times at almost no cost.  There’s virtually no limit to how many people can make use of that one software program.  Another example, given by Paul Romer—a pioneer of how economists think about economic growth—is oral rehydration therapy (ORT).  ORT is a simple treatment that has saved many lives in the developing world by stopping children’s deaths from diarrhea.  The idea of ORT can be used again and again—it’s never used up.

Note:  Scalability can really take off if there are “network effects.”  Haskel and Westlake mention networks like Uber drivers or Instagram users as examples.

(Illustration by Aquir)

Why Does Scalability Matter?

Haskel and Westlake say that we will see three unusual things happening in an economy where more investments are clearly scalable:

  • There will be some highly intangible-intensive businesses that have gotten very large.  Google, Microsoft, and Facebook are good examples.  Their software can be reproduced countless times at almost no cost.
  • Given the prospects of such large markets, ever more firms feel incentivized to go for it.
  • Businesses who compete with owners of scalable assets are in a tough position.  In markets with hugely scalable assets, the rewards for runners-up are often meager.

Sunkenness

Why Are Intangibles Sunk Costs?

Intangible assets are much harder to sell than tangible assets.  If an intangible investment works, creating value for the company that made the investment, then there’s no issue.  However, if an intangible investment doesn’t work or the company wants to back out, it’s often hard to sell.  Specifically, if knowledge isn’t protected by intellectual property rights, it’s often impossible to sell.

(Image by OpturaDesign)

Why Does Sunkenness Matter?

Because intangible investments frequently involve unrecoverable costs, they can be difficult to finance, especially with debt.  There’s a reason why many small business loans require a lien on directors’ houses:  a house is a tangible asset with ascertainable value.

Moreover, people tend to fall for the sunk-cost fallacy, whereby they overvalue an intangible asset that hasn’t worked out because of the time, energy, and resources they’ve poured into it.  People are inclined to continue putting in more time and resources.  This may contribute to bubbles.

Spillovers

Why Do Intangibles Generate Spillovers?

Intangible investments can be used relatively easily by companies that didn’t make the investments.  Consider R&D.  Unless it is protected by patents, knowledge gained through R&D can be re-used again and again.  Haskel and Westlake remark:

Patents and copyrights are, on the whole, less secure and more subject to challenge than the title deeds to farmland or the ownership of a shipping container or a computer.

One reason is that property rights related to tangible assets have been around for thousands of years.

Why Do Spillovers Matter?

(Photo by Vs1489)

Haskel and Westlake remark that spillovers matter for three reasons:

  • First, in a world where companies can’t be sure they will obtain the benefits of their investments, we would expect them to invest less.
  • Second, there is a premium on the ability to manage spillovers:  companies that can make the most of their own investments in intangibles, or that are especially good at exploiting the spillovers from others’ investments, will do particularly well.
  • Third, spillovers affect the geography of modern economies.

The U.S. government funds 30 percent of the R&D that happens in the country.  It’s the classic answer to the issue of companies being unsure about the benefits of intangible investments they’re considering.  Public R&D is particularly important for basic research.

Haskel and Westlake:

Patent trolls and copyright lawsuits catch our attention because they are newsworthy, but other ways of capturing the spillovers of intangible investment are common—in fact, they’re part of the invisible fabric of everyday business life.  They often involve reciprocity rather than compulsion or legal threats.  Software developers use online repositories like GitHub to share code; being an active contributor and an effective user of GitHub is a badge of honor for some developers.  Firms sometimes pool their patents; they realize that the spillovers from each company’s technologies are valuable, and that enforcing everyone’s individual legal rights is not worth it.  (Indeed, the US government helped end the patent war between the Wright Brothers and Curtiss Aeroplane and Motor Company that was holding back the US aircraft industry in the 1910s by getting everyone to set up a patent pool, the Manufacturers Aircraft Association.)

Synergies

Why Do Intangibles Exhibit Synergies?

Haskel and Westlake give the example of the microwave.  Near the end of World War II, Raytheon was mass-producing cavity magnetrons (similar to a vacuum tube), a crucial part of the radar defenses the British had invented.  A Raytheon engineer, Percy Spenser, realized the microwaves from magnetrons could heat food by creating electromagnetic fields in a box.

Haskel and Westlake write:

A few companies tried to sell domestic microwave ovens, but none were very successful.  Then, in the 1960s, Raytheon bought Amana, a white goods manufacturer, and combined their microwave expertise with Amana’s kitchen appliance knowledge to build a more successful product.  At the same time, Litton, another defense contractor, invented the modern microwave oven shape and tweaked the magnetron to make it safer.

In 1970 forty thousand microwaves were sold.  By 1975 it was a million.  What made this possible was the gradual accumulation of ideas and innovations.  The magnetron on its own wasn’t very useful to a customer, but combined with other incremental bits of R&D and the design and marketing ideas of Litton and Amana, it became a defining innovation of the late twentieth century.

The point of the microwave story is that intangible assets have synergies with one another.  Also, it’s hard to predict where innovations will come from or how they will combine.  In this example, military technology led to a kitchen appliance.

(Synergies in digital business, science, and technology:  Illustration by Agsandrew)

Intangible assets have synergies with tangible assets as well.  In the 1990s, productivity increased and at first people didn’t know why.  Haskel and Westlake explain:

In 2000 the McKinsey Global Institute analyzed the sources of this productivity increase.  Counterintuitively, they found that the bulk of it came from the way big chains retailers, in particular Walmart, were using computers and software to reorganize their supply chains, improve efficiency, and lower prices.  In a sense, it was a technological revolution.  But the gains were realized through organizational and business practice changes in a low-tech sector.  Or, to put it another way, there were big synergies between Walmart’s investment in computers and its investment in processes and supply chain development to make the most of the computers.

Why Do the Synergies of Intangible Assets Matter?

While spillovers cause firms to be protective of their intangible investments, synergies have the opposite effect and lead to open innovation.

In its simplest form, open innovation happens when a firm deliberately connects with and benefits from new ideas that arise outside the firm itself.  Cooking up ideas in a big corporate R&D lab is not open innovation; getting ideas by buying start-ups, partnering with academic researchers, or undertaking joint ventures with other companies is.

(Illustration by mindscanner)

Besides open innovation, there’s a second reason why synergies matter:

They also matter because they create an alternative way for firms to protect their intangible investments against competition:  by building synergistic clusters of intangible investments, rather than by protecting individual assets.

 

Part II  The Consequences of the Rise of the Intangible Economy

INTANGIBLES, INVESTMENT, PRODUCTIVITY, AND SECULAR STAGNATION

Two characteristics of secular stagnation are low investment and low interest rates.  Investment fell in the 1970s, recovered some in the mid-1980s, but fell sharply in the financial crisis (2008) and hasn’t recovered.

What’s puzzling is that investment hasn’t recovered despite low interest rates.  In the past, central banks relied on lowering rates to spur investment activity.  But that seems not to have worked this time.

(Illustration by ibreakstock)

One possible explanation is that technological progress has slowed.  Robert Gordon makes this argument in The Rise and Fall of American Growth (2016).  But technological progress is quite difficult to measure.

There are three more aspects to secular stagnation.

  • Corporate profits in the United States are higher than they’ve been for decades, and they seem to keep increasing.  Return on invested capital (ROIC) has grown significantly since the 1990s.
  • When it comes to both profitability and productivity, there is a growing gap between leaders and laggards.
  • Productivity growth has slowed due mostly to a decline in total factor productivity—workers are working less effectively with the capital they have.

Haskel and Westlake note that a good explanation for secular stagnation should explain four facts:

  • A fall in measured investment at the same time as a fall in interest rates
  • Strong profits
  • Increasingly unequal productivity and profits
  • Weak total factor productivity growth

Intangibles can help explain these facts.

Mismeasurement:  Intangibles and Apparently Low Investment

Intangible investment exceeds tangible investment in countries including the United States and the UK.  Are economies growing faster than reported because the value of intangibles is not being properly measured?  Haskel and Westlake show that including intangibles does not noticeably change investment/GDP.

Profits and Productivity Differences:  Scale, Spillovers, and the Incentives to Invest

Haskel and Westlake state:

…leading firms, which are confident of their ability to create scalable assets and to appropriate most of their benefits, will continue to invest (and enjoy a high rate of return on those investments); but laggard firms, expecting low private returns from their investments, will not.  In a world where there are a few leaders and many laggards, the net effect of this could be lower aggregate rates of investment, combined with high returns on those investments that do get made.

Spillovers:  Intangibles and Slowing TFP Growth A Lower Pace of Intangible Growth?

The slowdown in intangible investment since the financial crisis does seem to account for slowing TFP (Total Factor Productivity) growth, although the data are noisy and more exploration is needed.

Are Intangibles Generating Fewer Spillovers?

Lagging firms may be less able to absorb spillovers from leaders, possibly because leading firms can gain from synergies between different intangibles to a much greater extent than laggards.

 

INTANGIBLES AND THE RISE OF INEQUALITY

In addition to inequality of income and inequality of wealth, there is also what Haskel and Westlake call “inequality of esteem.”  Some communities feel left-behind and overlooked by America’s prosperous coastal cities.

Standard explanations for inequality

One standard explanation for inequality is that new technologies replace workers, which causes wages to fall and profits to rise.

A second explanation relates to trade.  In the 1980s, before the collapse of the Soviet Union and before market reforms in China and India, the global economy had 1.46 billion workers.  Then in the 1990s, the number of workers doubled to 2.93 billion workers.  This puts pressure on lower-skilled workers in developed economies.  The flip side is that lower-skilled workers in China and India end up far better off than they were before.

A third explanation for inequality is that capital tends to accumulate.  Capital tends to grow faster than the economy—this is Thomas Piketty’s famous r > g inequality—which causes capital to build up over time.

(Illustration by manakil)

How Intangibles Affect Income, Wealth, and Esteem Inequality

Intangibles, Firms, and Income Inequality

The best firms—owning scalable intangibles and able to extract spillovers from other businesses—will be highly productive and profitable while their competitors will lose out.  But that doesn’t necessarily mean the best firms pays all their workers more.  To explain rising wage inequality, more is needed.

Who is Benefiting from Intangible-Based Firm Inequality?

“Superstars” benefit by being associated with exceptionally valuable intangibles that can scale massively.  Whereas in most markets a top worker could probably be replaced by two not-as-fast workers, this isn’t true for superstar markets:  you can’t replace the best opera singer or the best basketball player with two not-quite-as-good ones.  Tech billionaires also tend to be superstars with large equity stakes in companies they founded—companies that probably scaled massively.

However, senior managers have also done very well.  Haskel and Westlake explain why:

Intangible investment increases.  Because of its scalability and the benefits to companies that can appropriate intangible spillovers, leading companies pull ahead of laggards in terms of productivity, especially in the more intangible-intensive industries.  The employees of these highly productive companies benefit from higher wages.  Because intangibles are contestable, companies are especially eager to hire people who are good at contesting them—appropriating spillovers from other firms or identifying and maximizing synergies.

Why are CEOs at many companies being paid so much more than other workers?  One reason relates to a “fundamental attribution error” whereby people explain a good business outcome by referring to what is simple and salient—like the skill of the CEO—rather than by acknowledging complexity and the fact that luck typically plays a major role.  It’s also possible, say Haskel and Westlake, that shareholders—especially those who are most diversified—are not paying much attention to CEO pay.

Housing Prices, Cities, Intangibles, and Wealth Inequality

Intangibles can help explain wealth inequality.  First, intangibles tend to drive up property prices.  Second, the mobility of intangible capital means it’s harder to tax.

In a world where intangibles are becoming more abundant and a more important part of the way businesses create value, the benefits to exploiting spillovers and synergies increase.  And as these benefits increase, we would expect businesses and their employees to want to locate in diverse, growing cities where synergies and spillovers abound.

Haskel and Westlake summarize how intangibles impact long-run inequality:

  • First, inequality of income.  The synergies and spillovers that intangibles create increase inequality between competing companies, and this inequality leads to increasing differences in employee pay… In addition, managing intangibles requires particular skills and education, and people with these skills are clustering in high-paid jobs in intangible-intensive firms.  Finally, the growing economic importance of the kind of people who manage intangibles helps foster myths that can be used to justify excessive pay, especially for top managers.
  • Second, inequality of wealth.  Thriving cities are places where spillovers and synergies abound.  The rise of intangibles makes cities increasingly attractive places to be, driving up the prices of prime property.  This type of inflation has been shown to be one of the major causes of the increase in the wealth of the richest.  In addition, intangibles are often mobile; they can be shifted across firms and borders.  This makes capital more mobile, which makes it harder to tax.  Since capital is disproportionately owned by the rich, this makes redistributive taxation to reduce wealth inequality harder.
  • Finally, inequality of esteem.  There is some evidence that supporters of populist movements… are more likely to hold traditional views and to score low on tests for the psychological trait of openness to experience.

 

INFRASTRUCTURE FOR INTANGIBLES, AND INTANGIBLE INFRASTRUCTURE

On the one hand, in order to thrive, the intangible economy needs new buildings in and around cities.  On the other hand, artistic and creative institutions are important for combinatorial innovation.  In the longer term, face-to-face interaction may eventually be phased out, but often these kinds of changes can take much longer than initially supposed.

(Illustration by Panimoni)

Haskel and Westlake comment:

The death of distance has failed to take place.  Indeed, the importance of spillovers and synergies has increased the importance of places where people come together to share ideas and the importance of the transport and social spaces that make cities work.

But the death of distance may have been postponed rather than cancelled.  Information technologies are slowly, gradually, replacing some aspects of face-to-face interaction.  This may be a slow-motion change, like the electrification of factories—if so, the importance of physical infrastructure will radically change.

Soft infrastructure will also matter increasingly.  The synergies between intangibles increase the importance of standards and norms, which together make up a kind of social infrastructure for intangible investment.  And standards and norms are underpinned by trust and social capital, which are particularly important in an intangible economy.

 

THE CHALLENGE OF FINANCING AN INTANGIBLE ECONOMY

Banks are often criticized for not providing enough capital for businesses to succeed.  Equity markets are criticized for being too short-term and also too influential.  Managers seem to fixate more and more on shorter term stock prices.  Managers may cut R&D to try to please short-term investors.  Haskel and Westlake remark:

These concerns drive public policy across the developed world:  most governments to some extent subsidize or coerce banks to lend to businesses, and they give tax advantages to companies that finance using debt.  Many countries are considering measures to make equity investors take a longer-term perspective, such as imposing taxes on short-term shareholdings or changing financial reporting requirements.  And most governments have spent money trying to encourage alternative forms of financing, particularly venture capital (VC), which is regarded as providing a big potential source of business growth and national wealth.

Banking:  The Problem of Lending in a World of Intangibles

When a bank lends money to a business, the bank usually has some recourse to the assets of the business if the debt isn’t repaid.  However, intangible assets are typically much harder to value than tangible assets, and frequently intangible assets don’t have much value at all when a business fails.  Thus it is difficult for a bank to lend to a business whose assets are mostly intangible.

This is why industries with mostly tangible assets—like oil and gas producers—have high leverage (are funded more with debt than equity), while industries with mostly intangible assets—like software—have less debt and more equity.

One way to increase bank lending to businesses with more intangible assets is for the government to cofund or guarantee bank loans.  A second way is financial innovation, such as finding ways to value intangible assets—like patents—more accurately.  A third way to deal with the issue of lending against intangibles is to get businesses to rely more on equity than debt.

Haskel and Westlake on how equity markets impact intangible investing:

There is some evidence that markets are short-termist, to the extent that management can sometimes boost their company’s share price by cutting intangible investment to preserve or increase profits, or cut investment to buy back stock.  But it also seems that some of what is happening is a sharpening of managerial incentives:  publicly held companies whose managers own stock focus on types of intangible investment that are more likely to be successful.  And the extent of market myopia varies:  companies with more concentrated, sophisticated investors are less likely to feel pressure to cut intangible investment than those with dispersed, unsophisticated ones.

Why VC Works for Intangibles

(Photo by designer491)

Haskel and Westlake observe:

VC has several characteristics that make it especially well-suited to intangible-intensive businesses:  VC firms take equity stakes, not debt, because intangible-rich businesses are unlikely to be worth much if they fail—all those sunk investments.  Similarly, to satisfy their own investors, VC funds rely on home-run successes, made possible by the scalability of assets like Google’s algorithms, Uber’s driver network, or Genentech’s patents.  Third, VC is often sequential, with rounds of funding proceeding in stages.  This is a response to the inherent uncertainty of intangible investment.

Leading VC firms and their partners are well-connected and credible, which helps in building networks to exploit synergies.

 

COMPETING, MANAGING, AND INVESTING IN THE INTANGIBLE ECONOMY

Businesses look to improve their performance in a way that is sustainable.  How can this be done?  The advice has always been to build and maintain distinctive assets.  Tangible assets are usually not distinctive, or at least not for long.  Haskel and Westlake:

It’s much more likely that the types of intangible assets we have talked about in this book are going to be distinctive:  reputation, product design, trained employees providing customer service.  Indeed, perhaps the most distinctive asset will be the ability to weave all these assets together; so a particularly valuable intangible asset will be the organization itself.

When it comes to management, Haskel and Westlake suggest replacing the question, “What are managers for?” with a deeper question, “What’s the role of authority in an economy?”

Markets work with minimal government interference.  However, firms can do a better job than dispersed individuals at organizing certain activities.  Managers are people at firms who have authority.  This is usually more efficient:  managers tell employees what to do rather than discussing or arguing about every step.

But if management is largely just monitoring, and software can do the job of monitoring, then what is the role of managers in an intangible-intensive economy?  For one, note Haskel and Westlake, the stakes tend to be much higher in the intangible economy.  Moreover, in synergistic firms, only managers may understand the big picture.

How can managers build a good organization in an intangible-intensive firm?  Haskel and Westlake explain:

…if you are primarily a producer of intangible assets (writing software, doing design, producing research) you probably want to build an organization that allows information to flow, helps serendipitous interactions, and keeps the key talent.  That probably means allowing more autonomy, fewer targets, and more access to the boss, even if that is at the cost of influence activities.

Leadership is important in an intangible economy.

(Photo by Raywoo)

Having voluntary followers is really useful in an intangible economy.  A follower will stay loyal to the firm, which keeps the tacit intangible capital at the firm.  Better, if they are inspired by and empathize with the leader, they will cooperate with each other and feed information up to the leader.  This is why leadership is going to be so valued in an intangible economy.  It can at best replace, and likely mitigate, the costly and possibly distortive aspects of managing by authority.

Investing

How can an investor discern if a business is building intangible assets?  Can investors learn about intangibles from accounting data?

Accountants try to match revenues with costs.  If the company has a long-lived asset that produces revenues, then the company measures the annual cost by depreciation or amortization of that asset.

The other way to measure the cost of a long-lived asset is to expense the entire cost of creating the asset in the year in which the expenditures are made.  However, this can lead to distortions.  First, the costs in creating the asset can make profits in that year appear unusually low.  By the same logic, if the asset in question continues producing revenues, then in future years profits will appear unusually high.

In the case of intangible assets, if the asset is bought from outside the company, then it is capitalized (and annual expenses are calculated based on depreciation or amortization).  If the asset is created within the company, then the costs are recognized when they are spent (even if the asset is long-lived).

The result is that much intangible investment is hidden because it is expensed.  This is a challenge for investors because economies are coming to rely increasingly on intangible assets.  Book value—which is frequently based largely on tangible assets—is less relevant for a company that relies on intangible assets—especially if the company develops those assets internally.

What Should Investors Do?

The simplest solution for investors is to invest in low-cost broad market index funds.  In this way, the investor will benefit from companies that rely on intangible assets.

Because index funds outpace 90-95% of all active investors if you measure performance over several decades, it already makes excellent sense for many investors to invest in index funds.

Haskel and Westlake sum up the chapter:

The growth of intangible investment has significant implications for managers, but it will affect different firms in different ways.  Firms that produce intangible assets will want to maximize synergies, create opportunities to learn from the ideas of others (and appropriate the spillovers from others’ intangibles), and retain talent.  These workplaces may end up looking rather like the popular image of hip knowledge-based companies.  But companies that rely on exploiting existing intangible assets may look very different, especially where the intangible assets are organizational structure and processes.  These may be much more controlled environments—Amazon’s warehouses rather than its headquarters.  Leadership will be increasingly prized, to the extent that it allows firms to coordinate intangible investments in different areas and exploit their synergies.

Financial investors who can understand the complexity of intangible-rich firms will also do well.  The greater uncertainty of intangible assets and the decreasing usefulness of company accounts put a premium on good equity research and on insight into firm management.

 

PUBLIC POLICY IN AN INTANGIBLE ECONOMY:  FIVE HARD QUESTIONS

Haskel and Westlake highlight five of the most important challenges in an intangible-rich economy:

  • First, intangibles tend to be contested:  it is hard to prove who owns them, and even then their benefits have a tendency to spill over to others.  Good intellectual property frameworks are important for an economy increasingly dependent on intangibles.
  • Second, in an intangible economy, synergies are very important. Combining different ideas and intangible assets is central to successful business innovation.  An important objective for policy makers is to create conditions for ideas to come together.
  • The third challenge relates to finance and investment.  Businesses and financial markets seem to underinvest in scalable, sunk intangible investments with a tendency to generate spillovers and synergies.  The current system of business finance exacerbates the problem.  A thriving intangible economy will significantly improve its financial system to make it easier for companies to invest in intangibles.
  • Fourth, it will probably be harder for most businesses to appropriate the benefits of capital investment in the economies of the future than in the tangible-rich economies we are familiar with.  Successful intangible-rich economies will have higher levels of public investment in intangibles.
  • Fifth, governments must work out how to deal with the dilemma of the particular type of inequality that intangibles seem to encourage.
(Illustration by Robert Wilson)

Clearer Rules and Norms about the Ownership of Intangibles

Stronger IP rights are not necessarily best because while they can increase incentive to invest, productivity gains are lowered.  Also, strengthening IP rights might accidentally favor incumbent rights-holders and patent trolls.

Clearer IP rights can be helpful, though.  They can reduce lawsuits that often end up in the notoriously troll-friendly Eastern District of Texas court.

Moreover, since intangible assets are often much more difficult to value than tangible assets, there are ways to help with this.  For instance, Ian Hargreaves in 2011 suggested that the UK have a Digital Copyright Exchange.  Another example is patent pools where firms coinvest in research and agree to share the resulting rights.

Helping Ideas Combine:  Maximizing the Benefits of Synergies

Good public policy should be just as assiduous about creating the conditions for knowledge to spread, mingle, and fructify as it is about creating property rights for those who invest in intangibles.

It should be easy to build new workplaces and homes in cities.  But simultaneously, cities have to be connected and livable.

A Financial Architecture for Intangible Investment

Governments should encourage new forms of debt that facilitate the ability to borrow against intangible assets.  Longer term, governments should help a shift from debt to equity financing.  Currently, debt is cheaper than equity due to the tax benefits of debt.  This must change, but it will be very difficult because vested interests still rely on debt.  Furthermore, new institutions will be required that provide equity financing to small and medium-size businesses.  Although these shifts will be challenging, the rewards will be ever greater, note Haskel and Westlake.

Solving the Intangible Investment Gap

Some large firms seem able to gain from both their own intangible investments and from intangible investments made by others.  These companies—like Google or Facebook—can be expected to continue making intangible investments.

Outside of these companies, the government and other public interest bodies (like large non-profit foundations) must make intangible investments.

The government is the investor of last resort.  Here are three practical tips given by Haskel and Westlake for government investment in intangibles:

  • Public R&D Funding.  This means the government spending more on university research, public research institutes, or research undertaken by businesses.  This type of government spending is not at all ideologically controversial and it can help a great deal over time.
  • Public Procurement.  When the US military funded the development of the semiconductor industry in the 1950s, they also acted as a lead customer.  This helped Texas Instruments and other firms not just to invest in R&D, but also to build the capacity to produce and sell chips.
  • Training and Education. Because it’s hard to predict what skills will be needed in 20 to 30 years, adult education may be a good area in which to invest.  This could also help with inequality to some extent.

 

BOOLE MICROCAP FUND

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

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

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

The 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.

Ten Attributes of Great Investors

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 28, 2018

Michael Mauboussin is the author of several excellent books, including More Than You Know and Think Twice.  I wrote about these books here:

He has also written numerous papers, including Thirty Years: Reflections on the Ten Attributes of Great Investorshttps://bit.ly/2zlaljc

When it comes to value investing, Mauboussin is one of the best writers in the world.  Mauboussin highlights market efficiency, competitive strategy analysis, valuation, and decision making as chief areas of focus for him the past couple of decades.  Mauboussin:

What we know about each of these areas today is substantially greater than what we did in 1986, and yet we have an enormous amount to learn.  As I like to tell my students, this is an exciting time to be an investor because much of what we teach in business schools is a work-in-progress.

(Image by magele-picture)

Here are the Ten Attributes of Great Investors:

  • Be numerate (and understand accounting).
  • Understand value (the present value of free cash flow).
  • Properly assess strategy (or how a business makes money).
  • Compare effectively (expectations versus fundamentals).
  • Think probabilistically (there are few sure things).
  • Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected).
  • Beware of behavioral biases (minimizing constraints to good thinking).
  • Know the difference between information and influence.
  • Position sizing (maximizing the payoff from edge).
  • Read (and keep an open mind).

 

BE NUMERATE (AND UNDERSTAND ACCOUNTING)

Mauboussin notes that there are two goals when analyzing a company’s financial statements:

  • Translate the financial statements into free cash flow.
  • Determine how the competitive strategy of the company creates value.

The value of any business is the future free cash flow it will produce discounted back to the present.

(Photo by designer491)

Free cash flow is cash earnings minus investments that must be made to grow future earnings.  Free cash flow represents what owners of the business receive.  Warren Buffett refers to free cash flow as owner earnings.

Earnings alone cannot give you the value of a company.  You can grow earnings without growing value.  Whether earnings growth creates value depends on how much money the company invests to generate that growth.  If the ROIC (return on invested capital) of the company’s investment is below the cost of capital, then the resulting earnings growth destroys value rather than creates it.

After calculating free cash flow, the next goal in financial statement analysis is to figure out how the company’s strategy creates value.  For the company to create value, the ROIC must exceed the cost of capital.  Analyzing the company’s strategy means determining precisely how the company can get ROIC above the cost of capital.

Mauboussin writes that one way to analyze strategy is to compare two companies in the same business.  If you look at how the companies spend money, you can start to understand competitive positions.

Another way to grasp competitive position is by analyzing ROIC.

Photo by stanciuc

You can break ROIC into two parts:

  • profitability (net operating profit after tax / sales)
  • capital velocity (sales / invested capital)

Companies with high profitability but low capital velocity are using a differentiation strategy.  Their product is positioned in such a way that the business can earn high profit margins.  (For instance, a luxury jeweler.)

Companies with high capital velocity but low profitability have adopted a cost leadership strategy.  These businesses may have very thin profit margins, but they still generate high ROIC because their capital velocity is so high.  (Wal-Mart is a good example.)

Understanding how the company makes money can lead to insight about how long the company can maintain a high ROIC (if ROIC is high) or what the company must do to improve (if ROIC is low).

 

UNDERSTAND VALUE (THE PRESENT VALUE OF FREE CASH FLOW)

Mauboussin:

Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow.  Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the economics of the business, and management’s skill at allocating capital.

It’s worth repeating: The value of any business (or any financial asset) is the future free cash flow it will produce discounted back to the present.  Successful investors understand the variables that impact free cash flow.

Illustration by OpturaDesign

 

PROPERLY ASSESS STRATEGY (OR HOW A COMPANY MAKES MONEY)

Mauboussin says this attribute has two elements:

  • How does the company make money?
  • Does the company have a sustainable competitive advantage, and if so, how durable is it?

To see how a business makes money, you have to figure out the basic unit of analysis.  Mauboussin points out that the basic unit of analysis for a retailer is store economics:  How much does it cost to build a store?  What revenues will it generate?  What are the profit margins?

Regarding sustainable competitive advantage, Warren Buffett famously said:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

If a company has a sustainable competitive advantage, then ROIC (return on invested capital) is above the cost of capital.  To assess the durability of that advantage, you have to analyze the industry and how the company fits in.  Looking at the five forces that determine industry attractiveness is a common step.  You should also examine potential threats from disruptive innovation.

Mauboussin:

Great investors can appreciate what differentiates a company that allows it to build an economic moat around its franchise that protects the business from competitors.  The size and longevity of the moat are significant inputs into any thoughtful valuation.

Bodiam Castle, Photo by valeryegorov

Buffett popularized the term economic moat to refer to a sustainable competitive advantage.  Here’s what Buffett said at the Berkshire annual meeting in 2000:

So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business.  And we tell our managers we want the moat widened every year.  That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes.  However, if the moat is widened every year, the business will do very well.

 

COMPARE EFFECTIVELY (EXPECTATIONS VERSUS FUNDAMENTALS)

Mauboussin:

Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations.  Fundamentals capture a sense of a company’s future financial performance.  Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals.  Expectations reflect the financial performance implied by the stock price.

Mauboussin mentions pari-mutuel betting, specifically horse racing.

(Photo by Elshaneo)

Fundamentals are how fast the horse will run, while expectations are the odds.

  • If a company has good fundamentals, but the stock price already reflects that, then you can’t expect to beat the market by investing in the stock.
  • If a company has bad fundamentals, but the stock price is overly pessimistic, then you can expect to beat the market by investing in the stock.

The best business in the world will not bring excess returns if the stock price already fully reflects the high quality of the business.  Similarly, a terrible business can produce excess returns if the stock price indicates that investors have overreacted.

To make money by investing in a stock, you have to have what great investor Michael Steinhardt calls a variant perception—a view at odds with the consensus view (as reflected in the stock price).  And you have to be right.

Mauboussin observes that humans are quick to compare but aren’t good at it.  This includes reasoning by analogy, e.g., asking whether a particular turnaround is similar to some other turnaround.  However, it’s usually better to figure out the base rate:  What percentage of all turnarounds succeed?  (Not a very high number, which is why Buffett quipped, “Turnarounds seldom turn.)

Another limitation of humans making comparisons is that people tend to see similarities when they’re looking for similarities, but they tend to see differences when they’re looking for differences.  For instance, Amos Tversky did an experiment in which the subjects were asked which countries are more similar, West Germany and East Germany, or Nepal and Ceylon?  Two-thirds answered West Germany and East Germany.  But then the subjects were asked which countries seemed more different.  Logic says that they would answer Nepal and Ceylon, but instead subjects again answered West Germany and East Germany.

 

THINK PROBABILISTICALLY (THERE ARE FEW SURE THINGS)

Great investors are always seeking an edge, where the price of an asset misrepresents the probabilities or the outcomes.  By similar logic, great investors evaluate each investment decision based on the process used rather than based on the outcome.

  • A good investment decision is one that if repeatedly made would be profitable over time.
  • A bad investment decision is one that if repeatedly made would lead to losses over time.

However, a good decision will sometimes lead to a bad outcome, while a bad decision will sometimes lead to a good outcome.  Investing is similar to other forms of betting in that way.

Photo by annebel146

Furthermore, what matters is not how often an investor is right, but rather how much the investor makes when he is right versus how much he loses when he is wrong.  In other words, what matters is not batting average but slugging percentage.  This is hard to put into practice due to loss aversion—the fact that as humans we feel a loss at least twice as much as an equivalent gain.

There are three ways of determining probabilities.  Subjective probability is a number that corresponds with your state of knowledge or belief.  Mauboussin gives an example:  You might come up with a probability that two countries will go to war.  Propensity is usually based on the physical properties of the system.  If a six-sided die is a perfect cube, then you know that the odds of a particular side coming up must be one out of six.  Frequency is the third approach.  Frequency—also called the base rate—is measured by looking at the outcomes of a proper reference class.  How often will a fair coin land on heads?  If you gather all the records you can of a fair coin being tossed, you’ll find that it lands on heads 50 percent of the time.  (You could run your own trials, too, by tossing a fair coin thousands or millions of times.)

Often subjective probabilities are useful as long as you remain open to new information and properly adjust your probabilities based on that information.  (The proper way to update such beliefs is using Bayes’s theorem.)  Subjective probabilities are useful when there’s no clear reference class—no relevant base rate.

When you’re looking at corporate performance—like sales or profit growth—it’s usually best to look at frequencies, i.e., base rates.

An investment decision doesn’t have to be complicated.  In fact, most good investment decisions are simple.  Mauboussin quotes Warren Buffett:

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.  That is what we’re trying to do.  It’s imperfect, but that’s what it’s all about.

Buffett again:

Investing is simple, but not easy.

 

UPDATE YOUR VIEWS EFFECTIVELY (BELIEFS ARE HYPOTHESES TO BE TESTED, NOT TREASURES TO BE PROTECTED)

People have a strong preference for consistency when it comes to their own beliefs.  And they expect others to be consistent.  The problem is compounded by confirmation bias, the tendency to look for and see only information that confirms your beliefs, and the tendency to interpret ambiguous information in a way that supports your beliefs.  As long as you feel like your beliefs are consistent, you’ll feel comfortable and won’t challenge your beliefs.

Illustration by intheskies

Great investors seek data and arguments that challenge their views.  Great investors also update their beliefs when they come across evidence that suggests they should.  The proper way to update beliefs is using Bayes’s theorem.  To see Bayes’s theorem and also a clear explanation and example, see: http://boolefund.com/the-signal-and-the-noise/

Mauboussin:

The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous.  They actively seek varied points of view and update their beliefs as new information dictates.  The consequence of updated views can be action: changing a portfolio stance or weightings within a portfolio.  Others, including your clients, may view this mental flexibility as unsettling.  But good thinking requires maintaining as accurate a view of the world as possible.

 

BEWARE OF BEHAVIORAL BIASES (MINIMIZING CONSTRAINTS TO GOOD THINKING)

Mauboussin:

Keith Stanovich, a professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions.  His claim is that the overlap between these abilities is much lower than most people think.  Importantly, you can cultivate your RQ.

Rationality is only partly genetic.  You can train yourself to be more rational.

Great investors relentlessly train themselves to be as rational as possible.  Typically they keep an investment journal in which they write down the reasoning for every investment decision.  Later they look back on their decisions to analyze what they got right and where they went wrong.

Great investors also undertake a comprehensive study of cognitive biases.  For a list of cognitive biases, see these two blog posts:

It’s rarely enough just to know about cognitive biases.  Great investors take steps—like using a checklist—designed to mitigate the impact that innate cognitive biases have on investment decision-making.

Photo by Kenishirotie

 

KNOW THE DIFFERENCE BETWEEN INFORMATION AND INFLUENCE

A stock price generally represents the collective wisdom of investors about how a given company will perform in the future.  Most of the time, the crowd is more accurate than virtually any individual investor.

(Illustration by Marrishuanna)

However, periodically a stock price can get irrational.  (If this weren’t the case, great value investors could not exist.)  People regularly get carried away with some idea.  For instance, as Mauboussin notes, many investors got rich on paper by investing in dot-com stocks in the late 1990’s.  Investors who didn’t own dot-com stocks felt compelled to jump on board when they saw their neighbor getting rich (on paper).

Mauboussin mentions the threshold model from Mark Granovetter, a professor of sociology at Stanford University.  Mauboussin:

Imagine 100 potential rioters milling around in a public square.  Each individual has a “riot threshold,” the number of rioters that person would have to see in order to join the riot.  Say one person has a threshold of 0 (the instigator), one has a threshold of 1, one has a threshold of 2, and so on up to 99.  This uniform distribution of thresholds creates a domino effect and ensures that a riot will happen.  The instigator breaks a window with a rock, person one joins in, and then each individual piles on once the size of the riot reaches his or her threshold.  Substitute “buy dotcom stocks” for “join the riot” and you get the idea.

The point is that very few of the individuals, save the instigator, think that rioting is a good idea.  Most would probably shun rioting.  But once the number of others rioting reaches a threshold, they will jump in.  This is how the informational value of stocks is set aside and the influential component takes over.

Great investors are not influenced much at all by the behavior of other investors.  Great investors know that the collective wisdom reflected in a stock price is usually right, but sometimes wrong.  These investors can identify the occasional mispricing and then make an investment while ignoring the crowd.

 

POSITION SIZING (MAXIMIZING THE PAYOFF FROM EDGE)

Great investors patiently wait for situations where they have an edge, i.e., where the odds are in their favor.  Many investors understand the need for an edge.  However, fewer investors pay much attention to position sizing.

If you know the odds, there’s a formula—the Kelly criterion—that tells you exactly how much to bet in order to maximize your long-term returns.  The Kelly criterion can be written as follows:

  • F = p – [q/o]

where

  • F = Kelly criterion fraction of current capital to bet
  • o = Net odds, or dollars won per $1 bet if the bet wins (e.g., the bet may pay 5 to 1, meaning you win $5 per each $1 bet if the bet wins)
  • p = probability of winning
  • q = probability of losing = 1 – p

The Kelly criterion has a unique mathematical property: if you know the probability of winning and the net odds (payoff), then betting exactly the percentage determined by the Kelly criterion leads to the maximum long-term compounding of capital.  (This assumes that you’re going to make a long series of bets.)  Betting any percentage that is not equal to that given by the Kelly criterion will inevitably lead to lower compound growth over a long period of time.

Mauboussin adds:

Proper portfolio construction requires specifying a goal (maximize sum for one period or parlayed bets), identifying an opportunity set (lots of small edge or lumpy but large edge), and considering constraints (liquidity, drawdowns, leverage).   Answers to these questions suggest an appropriate policy regarding position sizing and portfolio construction.

In brief, most investors are ineffective at position sizing, but great investors are good at it.

 

READ (AND KEEP AN OPEN MIND)

Great investors generally read a ton.  They also read widely across many disciplines.  Moreover, as noted earlier, great investors seek to learn about the arguments of people who disagree with them.  Mauboussin:

Berkshire Hathaway’s Charlie Munger said that he really liked Albert Einstein’s point that “success comes from curiosity, concentration, perseverance and self-criticism. And by self-criticism, he meant the ability to change his mind so that he destroyed his own best-loved ideas.”  Reading is an activity that tends to foster all of those qualities.

(Photo by Lapandr)

Mauboussin continues:

Munger has also said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time—none, zero.”  This may be hyperbolic, but seems to be true in the investment world as well.

 

BOOLE MICROCAP FUND

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

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

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

The 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 Outsiders: Radically Rational CEOs

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 21, 2018

William Thorndike is the author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Harvard Business Review Press, 2012).  It’s an excellent book profiling eight CEOs who compounded shareholder value at extraordinary rates over decades.

Through this book, value investors can improve their understanding of how to identify CEOs who maximize long-term returns to shareholders.  Also, investors can become better businesspeople, while businesspeople can become better investors.

I am a better investor because I am a businessman and a better businessman because I am an investor. – Warren Buffett

Thorndike explains that you only need three things to evaluate CEO performance:

  • the compound annual return to shareholders during his or her tenure
  • the return over the same period for peer companies
  • the return over the same period for the broader market (usually measured by the S&P 500)

Thorndike notes that 20 percent returns is one thing during a huge bull market—like 1982 to 1999.  It’s quite another thing if it occurs during a period when the overall market is flat—like 1966 to 1982—and when there are several bear markets.

Moreover, many industries will go out of favor periodically.  That’s why it’s important to compare the company’s performance to peers.

Thorndike mentions Henry Singleton as the quintessential outsider CEO.  Long before it was popular to repurchase stock, Singleton repurchased over 90% of Teledyne’s stock.  Also, he emphasized cash flow over earnings.  He never split the stock.  He didn’t give quarterly guidance.  He almost never spoke with analysts or journalists.  And he ran a radically decentralized organization.  Thorndike:

If you had invested a dollar with Singleton in 1963, by 1990, when he retired as chairman in the teeth of a severe bear market, it would have been worth $180.  That same dollar invested in a broad group of conglomerates would have been worth only $27, and $15 if invested in the S&P 500.  Remarkably, Singleton outperformed the index by over twelve times.

Thorndike observes that rational capital allocation was the key to Singleton’s success.  Thorndike writes:

Basically, CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity.  Think of these options collectively as a tool kit.  Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options.  Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

Warren Buffett has noted that most CEOs reach the top due to their skill in marketing, production, engineering, administration, or even institutional politics.  Thus most CEOs have not been prepared to allocate capital.

Thorndike also points out that the outsider CEOs were iconoclastic, independent thinkers.  But the outsider CEOs, while differing noticeably from industry norms, ended up being similar to one another.  Thorndike says that the outsider CEOs understood the following principles:

  • Capital allocation is a CEO’s most important job.
  • What counts in the long run is the increase in per share value, not overall growth or size.
  • Cash flow, not reported earnings, is what determines long-term value.
  • Decentralized organizations release entrepreneurial energy and keep both costs and ‘rancor’ down.
  • Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press, etc.) can be distracting and time-consuming.
  • Sometimes the best investment opportunity is your own stock.
  • With acquisitions, patience is a vital… as is occasional boldness.

(Illustration by yiorgosgr)

Here are the sections in the blog post:

  • Introduction
  • Tom Murphy and Capital Cities Broadcasting
  • Henry Singleton and Teledyne
  • Bill Anders and General Dynamics
  • John Malone and TCI
  • Katharine Graham and The Washington Post Company
  • Bill Stiritz and Ralston Purina
  • Dick Smith and General Cinema
  • Warren Buffett and Berkshire Hathaway
  • Radical Rationality

 

INTRODUCTION

Only two of the eight outsider CEOs had MBAs.  And, writes Thorndike, they did not attract or seek the spotlight:

As a group, they shared old-fashioned, premodern values including frugality, humility, independence, and an unusual combination of conservatism and boldness.  They typically worked out of bare-bones offices (of which they were inordinately proud), generally eschewed perks such as corporate plans, avoided the spotlight wherever possible, and rarely communicated with Wall Street or the business press.  They also actively avoided bankers and other advisers, preferring their own counsel and that of a select group around them.  Ben Franklin would have liked these guys.

Thorndike describes how the outsider CEOs were iconoclasts:

Like Singleton, these CEOs consistently made very different decisions than their peers did.  They were not, however, blindly contrarian.  Theirs was an intelligent iconoclasm informed by careful analysis and often expressed in unusual financial metrics that were distinctly different from industry or Wall Street conventions.

Thorndike compares the outsider CEOs to Billy Beane as described by Michael Lewis in Moneyball.  Beane’s team, despite having the second-lowest payroll in the league, made the playoffs in four of his first six years on the job.  Beane had discovered newand unorthodoxmetrics that were more correlated with team winning percentage.

Thorndike mentions a famous essay about Leo Tolstoy written by Isaiah Berlin.  Berlin distinguishes between a “fox” who knows many things and a “hedgehog” who knows one thing extremely well.  Thorndike continues:

Foxes… also have many attractive qualities, including an ability to make connections across fields and to innovate, and the CEOs in this book were definite foxes.  They had familiarity with other companies and industries and disciplines, and this ranginess translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results.

(Photo by mbridger68)

 

TOM MURPHY AND CAPITAL CITIES BROADCASTING

When Murphy became CEO of Capital Cities in 1966, CBS’ market capitalization was sixteen times than that of Capital Cities.  Thirty years later, Capital Cities was three times as valuable as CBS.  Warren Buffett has said that in 1966, it was like a rowboat (Capital Cities) against QE2 (CBS) in a trans-Atlantic race.  And the rowboat won decisively!

Bill Paley, who ran CBS, used the enormous cash flow from its network and broadcast operations and undertook an aggressive acquisition program of companies in entirely unrelated fields.  Paley simply tried to make CBS larger without paying attention to the return on invested capital (ROIC).

Without a sufficiently high ROIC, growth destroys shareholder value instead of creating it.  But, like Paley, many business leaders at the time sought growth for its own sake.  Even if growth destroys value (due to low ROIC), it does make the business larger, bringing greater benefits to the executives.

Murphy’s goal, on the other hand, was to make his company as valuable as possible.  This meant maximizing profitability and ROIC:

…Murphy’s goal was to make his company more valuable… Under Murphy and his lieutenant, Dan Burke, Capital Cities rejected diversification and instead created an unusually streamlined conglomerate that focused laser-like on the media businesses it knew well.  Murphy acquired more radio and TV stations, operated them superbly well, regularly repurchased his shares, and eventually acquired CBS’s rival broadcast network ABC.

(Capital Cities/ABC, Inc. logo, via Wikimedia Commons)

Burke excelled in operations, while Murphy excelled in making acquisitions.  Together, they were a great team—unmatched, according to Warren Buffett.  Burke said his ‘job was to create free cash flow and Murphy’s was to spend it.’

During the mid-1970s, there was an extended bear market.  Murphy aggressively repurchased shares, mostly at single-digit price-to-earnings (P/E) multiples.

Thorndike writes that in January 1986, Murphy bought the ABC Network and its related broadcasting assets for $3.5 billion with financing from his friend Warren Buffett.  Thorndike comments:

Burke and Murphy wasted little time in implementing Capital Cities’ lean, decentralized approach—immediately cutting unnecessary perks, such as the executive elevator and the private dining room, and moving quickly to eliminate redundant positions, laying off fifteen hundred employees in the first several months after the transaction closed.  They also consolidated offices and sold off unnecessary real estate, collecting $175 million for the headquarters building in midtown Manhattan…

In the nine years after the transaction, revenues and cash flows grew significantly in every major ABC business line, including the TV stations, the publishing assets, and ESPN.  Even the network, which had been in last place at the time of the acquisition, was ranked number one in prime time ratings and was more profitable than either CBS or NBC.

In 1993, Burke retired.  And in 1995, Murphy, at Buffett’s suggestion, met with Michael Eisner, the CEO of Disney.  Over a few days, Murphy sold Capital Cities/ABC to Disney for $19 billion, which was 13.5 times cash flow and 28 times net income.  Thorndike:

He left behind an ecstatic group of shareholders—if you had invested a dollar with Tom Murphy as he became CEO in 1966, that dollar would have been worth $204 by the time he sold the company to Disney.  That’s a remarkable 19.9 percent internal rate of return over twenty-nine years, significantly outpacing the 10.1 percent return for the S&P 500 and 13.2 percent return for an index of leading media companies over the same period.

Thorndike points out the decentralization was one the keys to success for Capital Cities.  There was a single paragraph on the inside cover of every Capital Cities annual report:

‘Decentralization is the cornerstone of our philosophy.  Our goal is to hire the best people we can and give them the responsibility and authority they need to perform their jobs.  All decisions are made at the local level… We expect our managers… to be forever cost conscious and to recognize and exploit sales potential.’

Headquarters had almost no staff.  There were no vice presidents in marketing, strategic planning, or human resources.  There was no corporate counsel and no public relations department.  The environment was ideal for entrepreneurial managers.  Costs were minimized at every level.

Burke developed an extremely detailed annual budgeting process for every operation.  Managers had to present operating and capital budgets for the coming year, and Burke (and his CFO, Ron Doerfler) went through the budgets line-by-line:

The budget sessions were not perfunctory and almost always produced material changes.  Particular attention was paid to capital expenditures and expenses.  Managers were expected to outperform their peers, and great attention was paid to margins, which Burke viewed as ‘a form of report card.’  Outside of these meetings, managers were left alone and sometimes went months without hearing from corporate.

High margins resulted not only from cost minimization, but also from Murphy and Burke’s focus on revenue growth and advertising market share.  They invested in their properties to ensure leadership in local markets.

When it came to acquisitions, Murphy was very patient and disciplined.  His benchmark ‘was a double-digit after-tax return over ten years without leverage.’  Murphy never won an auction as a result of his discipline.  Murphy also had a unique negotiating style.

Murphy thought that, in the best transactions, everyone comes away happy.  He believed in ‘leaving something on the table’ for the seller.  Murphy would often ask the seller what they thought the property was worth.  If Murphy thought the offer was fair, he would take it.  If he thought the offer was high, he would counter with his best price.  If the seller rejected his counter-offer, Murphy would walk away.  He thought this approach saved time and avoided unnecessary friction.

Thorndike concludes his discussion of Capital Cities:

Although the focus here is on quantifiable business performance, it is worth noting that Murphy built a universally admired company at Capital Cities with an exceptionally strong culture and esprit de corps (at least two different groups of executives still hold regular reunions).

 

HENRY SINGLETON AND TELEDYNE

Singleton earned bachelor’s, master’s, and PhD degrees in electrical engineering from MIT.  He programmed the first student computer at MIT.  He won the Putnam Medal as the top mathematics student in the country in 1939.  And he was 100 points away from being a chess grandmaster.

Singleton worked as a research engineer at North American Aviation and Hughes Aircraft in 1950.  Tex Thornton recruited him to Litton Industries in the late 1950s, where Singleton invented an inertial guidance system—still in use—for commercial and military aircraft.  By the end of the decade, Singleton had grown Litton’s Electronic Systems Group to be the company’s largest division with over $80 million in revenue.

Once he realized he wouldn’t succeed Thornton as CEO, Singleton left Litton and founded Teledyne with his colleague George Kozmetzky.  After acquiring three small electronics companies, Teledyne successfully bid for a large naval contract.  Teledyne became a public company in 1961.

(Photo of Teledyne logo by Piotr Trojanowski)

In the 1960’s, conglomerates had high price-to-earnings (P/E) ratios and were able to use their stock to buy operating companies at relatively low multiples.  Singleton took full advantage of this arbitrage opportunity.  From 1961 to 1969, he purchased 130 companies in industries from aviation electronics to specialty metals and insurance.  Thorndike elaborates:

Singleton’s approach to acquisitions, however, differed from that of other conglomerateurs.  He did not buy indiscriminately, avoiding turnaround situations, and focusing instead on profitable, growing companies with leading market positions, often in niche markets… Singleton was a very disciplined buyer, never paying more than twelve times earnings and purchasing most companies at significantly lower multiples.  This compares to the high P/E multiple on Teledyne’s stock, which ranged from a low of 20 to a high of 50 over this period.

In mid-1969, Teledyne was trading at a lower multiple, while acquisition prices were increasing.  So Singleton completely stopped acquiring companies.

Singleton ran a highly decentralized company.  Singleton also did not report earnings, but instead focused on free cash flow (FCF)—what Buffett calls owner earnings.  The value of any business is all future FCF discounted back to the present.

FCF = net income + DDA – capex

(There are also adjustments to FCF based on changes in working capital.  DDA is depreciation, depletion, and amortization.)

At Teledyne, bonus compensation for all business unit managers was based on the maximization of free cash flow.  Singleton—along with his roommate from the Naval Academy, George Roberts—worked to improve margins and significantly reduce working capital.  Return on assets at Teledyne was greater than 20 percent in the 1970s and 1980s.  Charlie Munger calls these results from Teledyne ‘miles higher than anybody else… utterly ridiculous.’  This high profitability generated a great deal of excess cash, which was sent to Singleton to allocate.

Starting in 1972, Singleton started buying back Teledyne stock because it was cheap.  During the next twelve years, Singleton repurchased over 90 percent of Teledyne’s stock.  Keep in mind that in the early 1970s, stock buybacks were seen as a lack of investment opportunity.  But Singleton realized buybacks were far more tax-efficient than dividends.  And buybacks done when the stock is noticeably cheap create much value.  Whenever the returns from a buyback seemed higher than any alternative use of cash, Singleton repurchased shares.  Singleton spent $2.5 billion on buybacks—an unbelievable amount at the time—at an average P/E multiple of 8.  (When Teledyne issued shares, the average P/E multiple was 25.)

In the insurance portfolios, Singleton invested 77 percent in equities, concentrated on just a few stocks.  His investments were in companies he knew well that had P/E ratios at or near record lows.

In 1986, Singleton started going in the opposite direction:  deconglomerating instead of conglomerating.  He was a pioneer of spinning off various divisions.  And in 1987, Singleton announced the first dividend.

From 1963 to 1990, when Singleton stepped down as chairman, Teledyne produced 20.4 percent compound annual returns versus 8.0 percent for the S&P 500 and 11.6 percent for other major conglomerates.  A dollar invested with Singleton in 1963 would have been worth $180.94 by 1990, nearly ninefold outperformance versus his peers and more than twelvefold outperformance versus the S&P 500.

 

BILL ANDERS AND GENERAL DYNAMICS

In 1989, the Berlin Wall came down and the U.S. defense industry’s business model had to be significantly downsized.  The policy of Soviet containment had become obsolete almost overnight.

General Dynamics had a long history selling major weapons to the Pentagon, including the B-29 bomber, the F-16 fighter plane, submarines, and land vehicles (such as tanks).  The company had diversified into missiles and space systems, as well as nondefense business including Cessna commercial planes.

(General Dynamics logo, via Wikimedia Commons)

W(hen Bill Anders took over General Dynamics in January 1991, the company had $600 million in debt and negative cash flow.  Revenues were $10 billion, but the market capitalization was just $1 billion.  Many thought the company was headed into bankruptcy.  It was a turnaround situation.

Anders graduated from the Naval Academy in 1955 with an electrical engineering degree.  He was an airforce fighter pilot during the Cold War.  In 1963 he earned a master’s degree in nuclear engineering and was chosen to join NASA’s elite astronaut corps.  Thorndike writes:

As the lunar module pilot on the 1968 Apollo 8 mission, Anders took the now-iconic Earthrise photograph, which eventually appeared on the covers of Time, Life, and American Photography.

Anders was a major general when he left NASA.  He was made the first chairman of the Nuclear Regulatory Commission.  Then he served as ambassador to Norway.  After that, he worked at General Electric and was trained in their management approach.  In 1984, Anders was hired to run the commercial operations of Textron Corporation.  He was not impressed with the mediocre businesses and the bureaucratic culture.  In 1989, he was invited to join General Dynamics as vice-chairman for a year before becoming CEO.

Anders realized that the defense industry had a great deal of excess capacity after the end of the Cold War.  Following Welch’s approach, Anders concluded that General Dynamics should only be in businesses where it was number one or two.  General Dynamics would stick to businesses it knew well.  And it would exit businesses that didn’t meet these criteria.

Anders also wanted to change the culture.  Instead of an engineering focus on ‘larger, faster, more lethal’ weapons, Anders wanted a focus on metrics such as return on equity (ROE).  Anders concluded that maximizing shareholder returns should be the primary business goal.  To help streamline operations, Anders hired Jim Mellor as president and COO.  In the first half of 1991, Anders and Mellor replaced twenty-one of the top twenty-five executives.

Anders then proceeded to generate $5 billion in cash through the sales of noncore businesses and by a significant improvement in operations.  Anders and Mellor created a culture focused on maximizing shareholder returns.  Anders sold most of General Dynamics’ businesses.  He also sought to grow the company’s largest business units through acquisition.

When Anders went to acquire Lockheed’s smaller fighter plane division, he met with a surprise:  Lockheed’s CEO made a high counteroffer for General Dynamics’ F-16 business.  Because the fighter plane division was a core business for General Dynamics—not to mention that Anders was a fighter pilot and still loved to fly—this was a crucial moment for Anders.  He agreed to sell the business on the spot for a very high price of $1.5 billion.  Anders’ decision was rational in the context of maximizing shareholder returns.

With the cash pile growing, Anders next decided not to make additional acquisitions, but to return cash to shareholders.  First he declared three special dividends—which, because they were deemed ‘return of capital,’ were not subject to capital gains or ordinary income taxes.  Next, Anders announced an enormous $1 billion tender offer for 30 percent of the company’s stock.

A dollar invested when Anders took the helm would have been worth $30 seventeen years later.  That same dollar would have been worth $17 if invested in an index of peer companies and $6 if invested in the S&P.

 

JOHN MALONE AND TCI

While at McKinsey, John Malone came to realize how attractive the cable television business was.  Revenues were very predictable.  Taxes were low.  And the industry was growing very fast.  Malone decided to build a career in cable.

Malone’s father was a research engineer and his mother a former teacher.  Malone graduated from Yale with degrees in economics and electrical engineering.  Then Malone earned master’s and PhD degrees in operations research from Johns Hopkins.

Malone’s first job was at Bell Labs, the research arm of AT&T.  After a couple of years, he moved to McKinsey Consulting.  In 1970, a client, General Instrument, offered Malone the chance to run its cable television equipment division.  He jumped at the opportunity.

After a couple of years, Malone was sought by two of the largest cable companies, Warner Communications and Tele-Communications Inc. (TCI).  Malone chose TCI.  Although the salary would be 60 percent lower, he would get more equity at TCI.  Also, he and his wife preferred Denver to Manhattan.

(TCI logo, via Wikimedia Commons)

The industry had excellent tax characteristics:

Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction.  These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows.  If an operator then used debt to buy or build additional systems and depreciated the newly acquired assets, he could continue to shelter his cash flow indefinitely.

Just after Malone took over as CEO of TCI in 1973, the 1973-1974 bear market left TCI in a dangerous position.  The company was on the edge of bankruptcy due to its very high debt levels.  Malone spent the next few years meeting with bankers and lenders to keep the company out of bankruptcy.  Also during this time, Malone instituted new discipline in operations, which resulted in a frugal, entrepreneurial culture.  Headquarters was austere.  Executives stayed together in motels while on the road.

Malone depended on COO J. C. Sparkman to oversee operations, while Malone focused on capital allocation.  TCI ended up having the highest margins in the industry as a result.  They earned a reputation for underpromising and overdelivering.

In 1977, the balance sheet was in much better shape.  Malone had learned that the key to creating value in cable television was financial leverage and leverage with suppliers (especially programmers).  Both types of leverage improved as the company became larger.  Malone had unwavering commitment to increasing the company’s size.

The largest cost in a cable television system is fees paid to programmers (HBO, MTV, ESPN, etc.).  Larger cable operators can negotiate lower programming costs per subscriber.  The more subscribers the cable company has, the lower its programming cost per subscriber.  This led to a virtuous cycle:

[If] you buy more systems, you lower your programming costs and increase your cash flow, which allows more financial leverage, which can then be used to buy more systems, which further improves your programming costs, and so on… no one else at the time pursued scale remotely as aggressively as Malone and TCI.

Malone also focused on minimizing reported earnings (and thus taxes).  At the time, this was highly unconventional since most companies focused on earnings per share.  TCI gained an important competitive advantage by minimizing earnings and taxes.  Terms like EBITDA were introduced by Malone.

Between 1973 and 1989, the company made 482 acquisitions.  The key was to maximize the number of subscribers.  (When TCI’s stock dropped, Malone repurchased shares.)

By the late 1970s and early 1980s, after the introduction of satellite-delivered channels such as HBO and MTV, cable television went from primarily rural customers to a new focus on urban markets.  The bidding for urban franchises quickly overheated.  Malone avoided the expensive urban franchise wars, and stayed focused on acquiring less expensive rural and suburban subscribers.  Thorndike:

When many of the early urban franchises collapsed under a combination of too much debt and uneconomic terms, Malone stepped forward and acquired control at a fraction of the original cost.

Malone also established various joint ventures, which led to a number of cable companies in which TCI held a minority stake.  Over time, Malone created a great deal of value for TCI by investing in young, talented entrepreneurs.

From 1973 to 1998, TCI shareholders enjoyed a compound annual return of 30.3 percent, compared to 20.4 percent for other publicly traded cable companies and 14.3 percent for the S&P 500.  A dollar invested in TCI at the beginning was worth over $900 by mid-1998.  The same dollar was worth $180 if invested in other publicly traded cable companies and $22 if invested in the S&P 500.

Malone never used spreadsheets.  He looked for no-brainers that could be understood with simple math.  Malone also delayed capital expenditures, generally until the economic viability of the investment had been proved.  When it came to acquisitions—of which there were many—Malone would only pay five times cash flow.

 

KATHARINE GRAHAM AND THE WASHINGTON POST COMPANY

Katharine Graham was the daughter of financier Eugene Meyer.  In 1940, she married Philip Graham, a brilliant lawyer.  Meyer hired Philip Graham to run The Washington Post Company in 1946.  He did an excellent job until his tragic suicide in 1963.

(The Washington Post logo, via Wikimedia Commons)

Katharine was unexpectedly thrust into the CEO role.  At age forty-six, she had virtually no preparation for this role and she was naturally shy.  But she ended up doing an amazing job.  From 1971 to 1993, the compound annual return to shareholders was 22.3 percent versus 12.4 percent for peers and 7.4 percent for the S&P 500.  A dollar invested in the IPO was worth $89 by the time she retired, versus $5 for the S&P and $14 for her peer group.  These are remarkable margins of outperformance.

After a few years of settling into the new role, she began to take charge.  In 1967, she replaced longtime editor in chief Russ Wiggins with the brash Ben Bradlee, who was forty-four years old.

In 1971, she took the company public to raise capital for acquisitions.  This was what the board had recommended.  At the same time, the newspaper encountered the Pentagon Papers crisis.  The company was going to publish a highly controversial (and negative) internal Pentagon opinion of the war in Vietnam that a court had barred the New York Times from publishing.  The Nixon administration threatened to challenge the company’s broadcast licenses if it published the report:

Such a challenge would have scuttled the stock offering and threatened one of the company’s primary profit centers.  Graham, faced with unclear legal advice, had to make the decision entirely on her own.  She decided to go ahead and print the story, and the Post’s editorial reputation was made.  The Nixon administration did not challenge the TV licenses, and the offering, which raised $16 million, was a success.

In 1972, with Graham’s full support, the paper began in-depth investigations into the Republican campaign lapses that would eventually become the Watergate scandal.  Bradlee and two young investigative reporters, Carl Bernstein and Bob Woodward, led the coverage of Watergate, which culminated with Nixon’s resignation in the summer of 1974.  This led to a Pulitzer for the Post—one of an astonishing eighteen during Bradlee’s editorship—and established the paper as the only peer of the New York Times.  All during the investigation, the Nixon administration threatened Graham and the Post.  Graham firmly ignored them.

In 1974, an unknown investor eventually bought 13 percent of the paper’s shares.  The board advised Graham not to meet with him.  Graham ignored the advice and met the investor, whose name was Warren Buffett.  Buffett quickly became Graham’s business mentor.

In 1975, the paper faced a huge strike led by the pressmen’s union.  Graham, after consulting Buffett and the board, decided to fight the strike.  Graham, Bradlee, and a very small crew managed to get the paper published for 139 consecutive days.  Then the pressmen finally agreed to concessions.  These concessions led to significantly improved profitability for the paper.  It was also the first time a major city paper had broken a strike.

Also on advice from Buffett, Graham began aggressively buying back stock.  Over the next few years, she repurchased nearly 40 percent of the company’s stock at very low prices (relative to intrinsic value).  No other major papers did so.

In 1981, the Post’s rival, the Washington Star, ceased publication.  This allowed the Post to significantly increase circulation.  At the same time, Graham hired Dick Simmons as COO.  Simmons successfully lowered costs and improved profits.  Simmons also emphasized bonus compensation based on performance relative to peer newspapers.

In the early 1980s, the Post spent years not acquiring any companies, even though other major newspapers were making more deals than ever.  Graham was criticized, but stuck to her financial discipline.  In 1983, however, after extensive research, the Post bought cellular telephone businesses in six major markets.  In 1984, the Post acquired the Stanley Kaplan test prep business.  And in 1986, the paper bought Capital Cities’ cable television assets for $350 million.  All of these acquisitions would prove valuable for the Post in the future.

In 1988, Graham sold the paper’s telephone assets for $197 million, a very high return on investment.  Thorndike continues:

During the recession of the early 1990s, when her overleveraged peers were forced to the sidelines, the company became uncharacteristically acquisitive, taking advantage of dramatically lower prices to opportunistically purchase cable television systems, underperforming TV stations, and a few education businesses.

When Kay Graham stepped down as chairman in 1993, the Post Company was by far the most diversified among its major newspaper peers, earning almost half its revenues and profits from non-print sources.  This diversification would position the company for further outperformance under her son Donald’s leadership.

 

BILL STIRITZ AND RALSTON PURINA

Bill Stiritz was at Ralston seventeen years before becoming CEO at age forty-seven.

This seemingly conventional background, however, masked a fiercely independent cast of mind that made him a highly effective, if unlikely, change agent.  When Stiritz assumed the CEO role, it would have been impossible to predict the radical transformation he would effect at Ralston and the broader influence it would have on his peers in the food and packaged goods industries.

(Purina logo, via Wikimedia Commons)

Stiritz attended the University of Arkansas for a year but then joined the navy for four years.  While in the navy, he developed his poker skills enough so that poker eventually would pay for his college tuition.  Stiritz completed his undergraduate degree at Northwestern, majoring in business.  (In his mid-thirties, he got a master’s degree in European history from Saint Louis University.)

Stiritz first worked at the Pillsbury Company as a field rep putting cereal on store shelves.  He was promoted to product manager and he learned about consumer packaged goods (CPG) marketing.  Wanting to understand advertising and media better, he started working two years later at the Gardner Advertising agency in St. Louis.  He focused on quantitative approaches to marketing such as the new Nielsen ratings service, which gave a detailed view of market share as a function of promotional spending.

In 1964, Stiritz joined Ralston Purina in the grocery products division (pet food and cereals).  He became general manager of the division in 1971.  While Stiritz was there, operating profits increased fiftyfold due to new product introductions and line extensions.  Thorndike:

Stiritz personally oversaw the introduction of Purina Puppy and Cat Chow, two of the most successful launches in the history of the pet food industry.  For a marketer, Stiritz was highly analytical, with a natural facility for numbers and a skeptical, almost prickly temperament.

Thorndike continues:

On assuming the CEO role in 1981, Stiritz wasted little time in aggressively restructuring the company.  He fully appreciated the exceptionally attractive economics of the company’s portfolio of consumer brands and promptly reorganized the company around these businesses, which he believed offered an attractive combination of high margins and low capital requirements.  He immediately began to remove the underpinnings of his predecessor’s strategy, and his first moves involved actively divesting businesses that did not meet his criteria for profitability and returns.

After a number of divestitures, Ralston was a pure branded products company.  In the early 1980s, Stiritz began repurchasing stock aggressively.  No other major branded products company was repurchasing stock at that time.

Stiritz then bought Continental Baking, the maker of Twinkies and Wonder Bread.  He expanded distribution, cut costs, introduced new products, and increased cash flow materially, creating much value for shareholders.

Then in 1986, Stiritz bought the Energizer Battery division from Union Carbide for $1.5 billion.  The business had been a neglected operation at Union Carbide.  Stiritz thought it was undermanaged and also part of a growing duopoly market.

By the late 1980s, almost 90 percent of Ralston’s revenues were from consumer packaged goods.  Pretax profit margins increased from 9 to 15 percent.  ROE went from 15 to 37 percent.  Since the share base was reduced by aggressive buybacks, earnings and cash flow per share increased dramatically.  Stiritz continued making very careful acquisitions and divestitures, with each decision based on an in-depth analysis of potential returns for shareholders.

Stiritz also began spinning off some businesses he thought were not receiving the attention they deserved—either internally or from Wall Street.  Spin-offs not only can highlight the value of certain business units.  Spin-offs also allow the deferral of capital gains taxes.

Finally, Stiritz sold Ralston itself to Nestle for $10.4 billion, or fourteen times cash flow.  This successfully concluded Stiritz’ career at Ralston.  A dollar invested with Stiritz when he became CEO was worth $57 nineteen years later.  The compound return was 20.0 percent versus 17.7 percent for peers and 14.7 percent for the S&P 500.

Stiritz didn’t like the false precision of detailed financial models.  Instead, he focused only on the few key variables that mattered, including growth and competitive dynamics.  When Ralston bought Energizer, Stiritz and his protégé Pat Mulcahy, along with a small group, took a look at Energizer’s books and then wrote down a simple, back of the envelope LBO model.  That was it.

Since selling Ralston, Stiritz has energetically managed an investment partnership made up primarily of his own capital.

 

DICK SMITH AND GENERAL CINEMA

In 1922, Phillip Smith borrowed money from friends and family, and opened a theater in Boston’s North End.  Over the next forty years, Smith built a successful chain of theaters.  In 1961, Phillip Smith took the company public to raise capital.  But in 1962, Smith passed away.  His son, Dick Smith, took over as CEO.  He was thirty-seven years old.

(General Cinema logo, via Wikimedia Commons)

Dick Smith demonstrated a high degree of patience in using the company’s cash flow to diversify away from the maturing drive-in movie business.

Smith would alternate long periods of inactivity with the occasional very large transaction.  During his tenure, he would make three significant acquisitions (one in the late 1960s, one in the mid-1980s, and one in the early 1990s) in unrelated businesses:  soft drink bottling (American Beverage Company), retailing (Carter Hawley Hale), and publishing (Harcourt Brace Jovanovich).  This series of transactions transformed the regional drive-in company into an enormously successful consumer conglomerate.

Dick Smith later sold businesses that he had earlier acquired.  His timing was extraordinarily good, with one sale in the late 1980s, one in 2003, and one in 2006.  Thorndike writes:

This accordion-like pattern of expansion and contraction, of diversification and divestiture, was highly unusual (although similar in some ways to Henry Singleton’s at Teledyne) and paid enormous benefits for General Cinema’s shareholders.

Smith graduated from Harvard with an engineering degree in 1946.  He worked as a naval engineer during World War II.  After the war, he didn’t want an MBA.  He wanted to join the family business.  In 1956, Dick Smith’s father made him a full partner.

Dick Smith recognized before most others that suburban theaters were benefitting from strong demographic trends.  This led him to develop two new practices.

First, it had been assumed that theater owners should own the underlying land.  But Smith realized that a theater in the right location could fairly quickly generate predictable cash flow.  So he pioneered lease financing for new theaters, which significantly reduced the upfront investment.

Second, he added more screens to each theater, thereby attracting more people, who in turn bought more high-margin concessions.

Throughout the 1960s and into the early 1970s, General Cinema was getting very high returns on its investment in new theaters.  But Smith realized that such growth was not likely to continue indefinitely.  He started searching for new businesses with better long-term prospects.

In 1968, Smith acquired the American Beverage Company (ABC), the largest, independent Pepsi bottler in the country.  Smith knew about the beverage business based on his experience with theater concessions.  Smith paid five times cash flow and it was a very large acquisition for General Cinema at the time.  Thorndike notes:

Smith had grown up in the bricks-and-mortar world of movie theaters, and ABC was his first exposure to the value of businesses with intangible assets, like beverage brands.  Smith grew to love the beverage business, which was an oligopoly with very high returns on capital and attractive long-term growth trends.  He particularly liked the dynamics within the Pepsi bottler universe, which was fragmented and had many second- and third-generation owners who were potential sellers (unlike the Coke system, which was dominated by a smaller number of large independents).  Because Pepsi was the number two brand, its franchises often traded at lower valuations than Coke’s.

ABC was a platform companyother companies could be added easily and efficiently.  Smith could buy new franchises at seemingly high multiples of the seller’s cash flow and then quickly reduce the effective price through reducing expenses, minimizing taxes, and improving marketing.  So Smith acquired other franchises.

Due to constant efforts to reduce costs by Smith and his team, ABC had industry-leading margins.  Soon thereafter, ABC invested $20 million to launch Sunkist.  In 1984, Smith sold Sunkist to Canada Dry for $87 million.

Smith sought another large business to purchase.  He made a number of smaller acquisitions in the broadcast media business.  But his price discipline prevented him from buying very much.

Eventually General Cinema bought Carter Hawley Hale (CHH), a retail conglomerate with several department store and specialty retail chains.  Woody Ives, General Cinema’s CFO, was able to negotiate attractive terms:

Ives negotiated a preferred security that guaranteed General Cinema a 10 percent return, allowed it to convert its interest into 40 percent of the common stock if the business performed well, and included a fixed-price option to buy Waldenbooks, a wholly owned subsidiary of CHH…

Eventually General Cinema would exchange its 40 percent ownership in CHH shares for a controlling 60 percent stake in the company’s specialty retail division, whose primary asset was the Neiman Marcus chain.  The long-term returns on the company’s CHH investment were an extraordinary 51.2 percent.  The CHH transaction moved General Cinema decisively into retailing, a new business whose attractive growth prospects were not correlated with either the beverage or the theater businesses.

In the late 1980s, Smith noticed that a newly energetic Coke was attacking Pepsi in local markets.  At the same time, beverage franchises were selling for much higher prices as their good economics were more widely recognized.  So Smith sold the bottling business in 1989 to Pepsi for a record price.  After the sale, General Cinema was sitting on $1 billion in cash.  Smith started looking for another diversifying acquisition.

It didn’t take him long to find one.  In 1991, after a tortuous eighteen-month process, Smith made his largest and last acquisition, buying publisher Harcourt Brace Jovanovich (HBJ) in a complex auction process and assembling General Cinema’s final third leg.  HBJ was a leading educational and scientific publisher that also owned a testing business and an outplacement firm.  Since the mid-1960s, the firm had been run as a personal fiefdom by CEO William Jovanovich.  In 1986, the company received a hostile takeover bid from the renegade British publisher Robert Maxwell, and in response Jovanovich had taken on large amounts of debt, sold off HBJ’s amusement park business, and made a large distribution to shareholders.

General Cinema management concluded, after examining the business, that HBJ would fit their acquisition criteria.  Moreover, General Cinema managers thought HBJ’s complex balance sheet would probably deter other buyers.  Thorndike writes:

After extensive negotiations with the company’s many debt holders, Smith agreed to purchase the company for $1.56 billion, which represented 62 percent of General Cinema’s enterprise value at the time—an enormous bet.  This price equaled a multiple of six times cash flow for HBJ’s core publishing assets, an attractive price relative to comparable transactions (Smith would eventually sell those businesses for eleven times cash flow).

Thorndike continues:

Following the HBJ acquisition in 1991, General Cinema spun off its mature theater business into a separate publicly traded entity, GC Companies (GCC), allowing management to focus its attention on the larger retail and publishing businesses.  Smith and his management team proceeded to operate both the retail and the publishing businesses over the next decade.  In 2003, Smith sold the HBJ publishing assets to Reed Elsevier, and in 2006 he sold Neiman Marcus, the last vestige of the General Cinema portfolio, to a consortium of private equity buyers.  Both transactions set valuation records within their industries, capping an extraordinary run for Smith and General Cinema shareholders.

From 1962 to 1991, Smith had generated 16.1 percent compound annual return versus 9 percent for the S&P 500 and 9.8 percent for GE.  A dollar invested with Dick Smith in 1962 would be worth $684 by 1991.  The same dollar would $43 if invested in the S&P and $60 if invested in GE.

 

WARREN BUFFETT AND BERKSHIRE HATHAWAY

Buffett was first attracted to the old textile mill Berkshire Hathaway because its price was cheap compared to book value.  Thorndike tells the story:

At the time, the company had only a weak market position in a brutally competitive commodity business (suit linings) and a mere $18 million in market capitalization.  From this undistinguished start, unprecedented returns followed;  and measured by long-term stock performance, the formerly crew-cut Nebraskan is simply on another planet from all other CEOs.  These otherworldly returns had their origin in that aging New England textile company, which today has a market capitalization of $140 billion and virtually the same number of shares.  Buffett bought his first share of Berkshire for $7;  today it trades for over $120,000 share.  [Value of Berkshire share as of 10/21/18:  $517.2 billion market capitalization, or $314,477 a share]

(Company logo, by Berkshire Hathaway Inc., via Wikimedia Commons)

Buffett was born in 1930 in Omaha, Nebraska.  His grandfather ran a well-known local grocery store.  His father was a stockbroker in downtown Omaha and later a congressman.  Starting at age six, Buffett started various entrepreneurial ventures.  He would buy a 6-pack of Coke for 25 cents and resell each one for 5 cents.  He later had several paper routes and then pinball machines, too.  Buffett attended Wharton, but didn’t feel he could learn much.  So he returned to Omaha and graduated from the University of Nebraska at age 20.

He’d always been interested in the stock market.  But it wasn’t until he was nineteen that he discovered The Intelligent Investor, by Benjamin Graham.  Buffett immediately realized that value investing—as explained by Graham in simple terms—was the key to making money in the stock market.

Buffett was rejected by Harvard Business School, which was a blessing in that Buffett attended Columbia University where Graham was teaching.  Buffett was the star in Graham’s class, getting the only A+ Graham ever gave in more than twenty years of teaching.  Others in that particular course said the class was often like a conversation between Graham and Buffett.

Buffett graduated from Columbia in 1952.  He applied to work for Graham, but Graham turned him down.  At the time, Jewish analysts were having a hard time finding work on Wall Street, so Graham only hired Jewish people.  Buffett returned to Omaha and worked as a stockbroker.

One idea Buffett had tried to pitch while he was a stockbroker was GEICO.  He realized that GEICO had a sustainable competitive advantage:  a permanently lower cost structure because GEICO sold car insurance direct, without agents or branches.  Buffett had trouble convincing clients to buy GEICO, but he himself loaded up in his own account.

Meanwhile, Buffett regularly mailed investment ideas to Graham.  After a couple of years, in 1954, Graham hired Buffett.

In 1956, Graham dissolved the partnership to focus on other interests.  Buffett returned to Omaha and launched a small investment partnership with $105,000 under management.  Buffett himself was worth $140,000 at the time (over $1 million today).

Over the next thirteen years, Buffett crushed the market averages.  Early on, he was applying Graham’s methods by buying stocks that were cheap relative to net asset value.  But in the mid-1960s, Buffett made two large investments—in American Express and Disney—that were based more on normalized earnings than net asset value.  This was the beginning of a transition Buffett made from buying statistically cheap cigar butts to buying higher quality companies.

  • Buffett referred to deep value opportunities—stocks bought far below net asset value—as cigar butts. Like a soggy cigar butt found on a street corner, a deep value investment would often give “one free puff.”  Such a cigar butt is disgusting, but that one puff is “all profit.”

Buffett started acquiring shares in Berkshire Hathaway—a cigar butt—in 1965.  In the late 1960s, Buffett was having trouble finding cheap stocks, so he closed down the Buffett partnership.

After getting control of Berkshire Hathaway, Buffett put in a new CEO, Ken Chace.  The company generated $14 million in cash as Chace reduced inventories and sold excess plants and equipment.  Buffett used most of this cash to acquire National Indemnity, a niche insurance company.  Buffett invested National Indemnity’s float quite well, buying other businesses like the Omaha Sun, a weekly newspaper, and a bank in Rockford, Illinois.

During this period, Buffett met Charlie Munger, another Omaha native who was then a brilliant lawyer in Los Angeles.  Buffett convinced Munger to run his own investment partnership, which he did with excellent results.  Later on, Munger became vice-chairman at Berkshire Hathaway.

Partly by reading the works of Phil Fisher, but more from Munger’s influence, Buffett realized that a wonderful company at a fair price was better than a fair company at a wonderful price.  A wonderful company would have a sustainably high ROIC, which meant that its intrinsic value would compound over time.  In order to estimate intrinsic value, Buffett now relied more on DCF (discounted cash flow) and private market value—methods well-suited to valuing good businesses (often at fair prices)—rather than an estimate of liquidation value—a method well-suited to valuing cigar butts (mediocre businesses at cheap prices).

In the 1970s, Buffett and Munger invested in See’s Candies and the Buffalo News.  And they bought large stock positions in the Washington Post, GEICO, and General Foods.

In the first half of the 1980s, Buffett bought the Nebraska Furniture Mart for $60 million and Scott Fetzer, a conglomerate of niche industrial businesses, for $315 million.  In 1986, Buffett invested $500 million helping his friend Tom Murphy, CEO of Capital Cities, acquire ABC.

Buffett then made no public market investments for several years.  Finally in 1989, Buffett announced that he invested $1.02 billion, a quarter of Berkshire’s investment portfolio, in Coca-Cola, paying five times book value and fifteen times earnings.  The return on this investment over the ensuing decade was 10x.

(Coca-Cola Company logo, via Wikimedia Commons)

Also in the late 1980s, Buffett invested in convertible preferred securities in Salomon Brothers, Gillette, US Airways, and Champion Industries.  The dividends were tax-advantaged, and he could convert to common stock if the companies did well.

In 1991, Salomon Brothers was in a major scandal based on fixing prices in government Treasury bill auctions.  Buffett ended up as interim CEO for nine months.  Buffett told Salomon employees:

“Lose money for the firm and I will be understanding.  Lose even a shred of reputation for the firm, and I will be ruthless.”

In 1996, Salomon was sold to Sandy Weill’s Travelers Corporation for $9 billion, which was a large return on investment for Berkshire.

In the early 1990s, Buffett invested—taking large positions—in Wells Fargo (1990), General Dynamics (1992), and American Express (1994).  In 1996, Berkshire acquired the half of GEICO it didn’t own.  Berkshire also purchased the reinsurer General Re in 1998 for $22 billion in Berkshire stock.

In the late 1990s and early 2000s, Buffett bought a string of private companies, including Shaw Carpets, Benjamin Moore Paints, and Clayton Homes.  He also invested in the electric utility industry through MidAmerican Energy.  In 2006, Berkshire announced its first international acquisition, a $5 billion investment in Iscar, an Israeli manufacturer of cutting tools and blades.

In early 2010, Berkshire purchased the nation’s largest railroad, the Burlington Northern Santa Fe, for $34.2 billion.

From June 1965, when Buffett assumed control of Berkshire, through 2011, the value of the company’s shares increased at a compound rate of 20.7 percent compared to 9.3 percent for the S&P 500.  A dollar invested in Berkshire was worth $6,265 forty-five years later.  The same dollar invested in the S&P 500 was worth $62.

The Nuts and Bolts

Having learned from Murphy, Buffett and Munger created Berkshire to be radically decentralized.  Business managers are given total autonomy over everything except large capital allocation decisions.  Buffett makes the capital allocation decisions, and Buffett is an even better investor than Henry Singleton.

Another key to Berkshire’s success is that the insurance and reinsurance operations are profitable over time, and meanwhile Buffett invests most of the float.  Effectively, the float has an extremely low cost (occasionally negative) because the insurance and reinsurance operations are profitable.  Buffett always reminds Berkshire shareholders that hiring Ajit Jain to run reinsurance was one of the best investments ever for Berkshire.

As mentioned, Buffett is in charge of capital allocation.  He is arguably the best investor ever based on the longevity of his phenomenal track record.

Buffett and Munger have always believed in concentrated portfolios.  It makes sense to take very large positions in your best ideas.  Buffett invested 40 percent of the Buffett partnership in American Express after the salad oil scandal in 1963.  In 1989, Buffett invested 25 percent of the Berkshire portfolio—$1.02 billion—in Coca-Cola.

Buffett and Munger still have a very concentrated portfolio.  But sheer size requires them to have more positions than before.  It also means that they can no longer look at most companies, which are too small to move the needle.

Buffett and Munger also believe in holding their positions for decades.  Over time, this saves a great deal of money by minimizing taxes and transaction costs.

Thorndike:

Buffett’s approach to investor relations is also unique and homegrown.  Buffett estimates that the average CEO spends 20 percent of his time communicating with Wall Street.  In contrast, he spends no time with analysts, never attends investment conferences, and has never provided quarterly earnings guidance.  He prefers to communicate with his investors through detailed annual reports and meetings, both of which are unique.

… The annual reports and meetings reinforce a powerful culture that values frugality, independent thinking, and long-term stewardship.

 

 

RADICAL RATIONALITY:  THE OUTSIDER’S MINDSET

You’re neither right nor wrong because other people agree with you.  You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right.  And if your facts and reasoning are right, you don’t have to worry about anybody else. – Warren Buffett

Thorndike sums up the outsider’s mindset:

  • Always Do the Math
  • The Denominator Matters
  • A Feisty Independence
  • Charisma is Overrated
  • A Crocodile-Like Temperament That Mixes Patience with Occasional Bold Action
  • The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small
  • A Long-Term Perspective

Always Do the Math

The outsider CEOs always focus on the ROIC for any potential investment.  They do the analysis themselves just using the key variables and without using a financial model.  Outsider CEOs realize that it’s the assumptions about the key variables that really matter.

The Denominator Matters

The outsider CEOs focus on maximizing value per share.  Thus, the focus is not only on maximizing the numerator—the value—but also on minimizing the denominator—the number of shares.  Outsider CEOs opportunistically repurchase shares when the shares are cheap.  And they are careful when they finance investment projects.

A Feisty Independence

The outsider CEOs all ran very decentralized organizations.  They gave people responsibility for their respective operations.  But outsider CEOs kept control over capital allocation decisions.  And when they did make decisions, outsider CEOs didn’t seek others’ opinions.  Instead, they liked to gather all the information, and then think and decide with as much independence and rationality as possible.

Charisma Is Overrated

The outsider CEOs tended to be humble and unpromotional.  They tried to spend the absolute minimum amount of time interacting with Wall Street.  Outsider CEOs did not offer quarterly guidance and they did not participate in Wall Street conferences.

A Crocodile-Like Temperament That Mixes Patience With Occasional Bold Action

The outsider CEOs were willing to wait very long periods of time for the right opportunity to emerge.

Like Katharine Graham, many of them created enormous shareholder value by simply avoiding overpriced ‘strategic’ acquisitions, staying on the sidelines during periods of acquisition feeding frenzy.

On the rare occasions when there was something to do, the outsider CEOs acted boldly and aggressively.  Tom Murphy made an acquisition of a company (ABC) larger than the one he managed (Capital Cities).  Henry Singleton repeatedly repurchased huge amounts of stock at cheap prices, eventually buying back over 90 percent of Teledyne’s shares.

The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small

The total value that any company creates over time is the cumulative difference between ROIC and the cost of capital.  The outsider CEOs made every capital allocation decision in order to maximize ROIC over time, thereby maximizing long-term shareholder value.

These CEOs knew precisely what they were looking for, and so did their employees.  They didn’t overanalyze or overmodel, and they didn’t look to outside consultants or bankers to confirm their thinking—they pounced.

A Long-Term Perspective

The outsider CEOs would make investments in their business as long as they thought that it would contribute to maximizing long-term ROIC and long-term shareholder value.  The outsiders were always willing to take short-term pain for long-term gain:

[They] disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.

Thorndike notes that the advantage the outsider CEOs had was temperament, not intellect (although they were all highly intelligent).  They understood that what mattered was rationality and patience.

 

BOOLE MICROCAP FUND

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

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

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

The 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.

Quantitative Deep Value Investing

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 14, 2018

Virtually all of the historical evidence shows that quantitative deep value investing—systematically buying stocks at low multiples (low P/B, P/E, P/S, P/CF, and EV/EBITDA)—does better than the market over time.

Deep value investing means investing in ugly stocks that are doing terribly—with low- or no-growth—and that are trading at low multiples.  Quantitative deep value investing means that the portfolio of deep value stocks is systematically constructed based solely on quantitative factors including cheapness.  (It’s a process that can easily be automated.)

One of the best papers on quantitative deep value investing is by Josef Lakonishok, Andrei Shleifer, and Robert Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.”  Link: http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf

Buffett has called deep value investing the cigar butt approach:

…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.

(Photo by Sensay)

Outline for this blog post:

  • Rare Temperament
  • Early Buffett: Deep Value Investor
  • Investors Much Prefer Income Over Assets
  • Companies at Cyclical Lows

 

RARE TEMPERAMENT

Many value investors prefer to invest in higher-quality companies rather than deep value stocks.  A high-quality company has a sustainable competitive advantage that allows it to earn a high ROIC (return on invested capital) for a long time.  When you invest in such a company, you can simply hold the position for years as it compounds intrinsic value.  Assuming you’ve done your homework and gotten the initial buy decision right, you typically don’t have to worry much.

Investing in cigar butts (deep value stocks), however, means that you’re investing in many mediocre or bad businesses.  These are companies that have terrible recent performance.  Some of these businesses won’t survive over the longer term, although even the non-survivors often survive many years longer than is commonly supposed.

Deep value investing can work quite well, but it takes a certain temperament not to care about various forms of suffering—such as being isolated and looking foolish.  As Bryan Jacoboski puts it:

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.

(Photo by Nikki Zalewski)

In The Manual of Ideas (Wiley, 2013), John Mihaljevic explains the difficulty of deep value investing:

It turns out that Graham-style investing may be appropriate for a relatively small subset of the investment community, as it requires an unusual willingness to stand alone, persevere, and look foolish.

On more than one occasion, we have heard investors respond as follows to a deep value investment thesis: ‘The stock does look deeply undervalued, but I just can’t get comfortable with it.’  When pressed on the reasons for passing, many investors point to the uncertainty of the situation, the likelihood of negative news flow, or simply a bad gut feeling.  Most investors also find it less rewarding to communicate to their clients that they own a company that has been in the news for the wrong reasons.

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.

Many investors will look at a list of statistically cheap stocks and conclude that most of them would be awful investments.  But in practice, a basket of deep value stocks tends to outperform, given enough time.  And typically some of the big winners include stocks that looked the worst prior to being included in the portfolio.

 

EARLY BUFFETT: DEEP VALUE INVESTOR

Warren Buffett started out as a cigar-butt investor.  That was the method he learned from his teacher and mentor, Ben Graham, the father of value investing.  When Buffett ran his partnership, he generated exceptional performance using a deep value strategy focused on microcap stocks: http://boolefund.com/buffetts-best-microcap-cigar-butts/

(Early Buffett teaching at the University of Nebraska, via Wikimedia Commons)

One reason Buffett transitioned from deep value to buying high-quality companies (and holding them forever) was simply that the assets he was managing at Berkshire Hathaway became much too large for deep value.  But in his personal account, Buffett recently bought a basket of South Korean cigar butts and ended up doing very well.

Buffett has made it clear that if your assets under management are relatively small, then deep value investing—especially when focused on microcap stocks—can do better than investing in high-quality companies.  Buffett has said he could make 50% a year by investing in deep value microcap stocks: http://boolefund.com/buffetts-best-microcap-cigar-butts/

In the microcap world, since most professional investors don’t look there, if you turn over enough rocks you can find some exceptionally cheap companies.  If you don’t have sufficient time and interest to find the most attractive individual microcap stocks, using a quantitative approach is an excellent alternative.  A good quantitative value fund focused on microcaps is likely to do much better than the S&P 500 over time.  That’s the mission of the Boole Fund.

 

INVESTORS MUCH PREFER INCOME OVER ASSETS

Outside of markets, people naturally assess the value of possessions or private businesses in terms of net asset value—which typically corresponds with what a buyer would pay.  But in markets, when the current income of an asset-rich company is abnormally low, most investors fixate on the low income even when the best estimate of the company’s value is net asset value.  (Mihaljevic makes this point.)

If an investor is considering a franchise (high-quality) business like Coca-Cola or Johnson & Johnson, then it makes sense to focus on income, since most of the asset value involves intangible assets (brand value, etc).

But for many potential investments, net asset value is more important than current income.  Most investors ignore this fact and stay fixated on current income.  This is a major reason why stock prices occasionally fall far below net asset value, which creates opportunities for deep value investors.

(Illustration by Teguh Jati Prasetyo)

Over a long period of time, the income of most businesses does relate to net asset value.  Bruce Greenwald, in his book Value Investing (Wiley, 2004), explains the connection.  For most businesses, the best way to estimate intrinsic value is to estimate the reproduction cost of the assets.  And for most businesses—because of competition—earnings power over time will not be more than what is justified by the reproduction cost of the assets.

Only franchise businesses like Coca-Cola—with a sustainable competitive advantage that allows it to earn more than its cost of capital—are going to have normalized earnings that are higher than is justified by the reproduction cost of the assets.

Because most investors view cigar butts as unattractive investments—despite the overwhelming statistical evidence—there are always opportunities for deep value investors.  For instance, when cyclical businesses are at the bottom of the cycle, and current earnings are far below earnings power, investors’ fixation on current earnings can create very cheap stocks.

A key issue is whether the current low income reflects a permanently damaged business or a temporary—or cyclical—decline in profitability.

 

COMPANIES AT CYCLICAL LOWS

Although you can make money by buying cheap businesses that are permanently declining, you can usually make more money by buying stocks at cyclical lows.

(Illustration by Prairat Fhunta)

Mihaljevic:

Assuming a low enough entry price, money can be made in both cheap businesses condemned to permanent fundamental decline and businesses that may benefit from mean reversion as their industry moves through the cycle.  We much prefer companies that find themselves at a cyclical low, as they may restore much, if not all, of their earning power, providing multi-bagger upside potential.  Meanwhile, businesses likely to keep declining for a long time have to be extremely cheap and keep returning cash to shareholders to generate a positive investment outcome.

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.

If you can stay calm and rational while being isolated and looking foolish, then you can buy deeply out of favor cyclical stocks, which often have multi-bagger upside potential.

Example: Ensco plc (ESV)

A good example of a cyclical stock with multi-bagger potential is Ensco plc, an offshore oil driller.  The Boole Microcap Fund had an investment in Atwood Oceanics, which was acquired by Ensco in 2017.  The Boole Fund continues to hold Ensco because it’s quite cheap.

Oil companies prefer offshore drillers that are well-capitalized and reliable.  Ensco has one of the best safety records in the industry.  Also, it was rated #1 in customer satisfaction for the eighth consecutive year in the leading independent industry survey.  Moreover, Ensco is one of the best capitalized drillers in the industry, with $2.9 billion in liquidity and only $236 million in debt due before 2024.

Here are intrinsic value scenarios:

  • Low case: If oil prices languish below $60 (WTI) for the next 3 to 5 years, then Ensco will be a survivor, due to its large fleet, globally diverse customer base, industry leading performance, and well-capitalized position.  In this scenario, Ensco is likely worth at least $12, over 35% higher than today’s $8.70.
  • Mid case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years—which is likely based on long-term supply and demand—then Ensco is probably worth at least $25 a share, over 185% higher than today’s $8.70.
  • High case: If oil prices average $85 or more over the next 3 to 5 years, then Ensco could easily be worth $37 a share, about 325% higher than today’s $8.70.

Last week, on October 8, Ensco plc and Rowan Companies plc announced that they were merging.  The merger is still subject to shareholder and regulatory approval.

The merger of Ensco and Rowan will likely be accretive to the current shareholders of Ensco.  Ensco and Rowan believe they will achieve cost savings of $150 million per year, which adds at least 5-10% of intrinsic value to Ensco shares.

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

In brief, the combination looks to be accretive for the shareholders of both companies.  Therefore, the potential upside for current Ensco shareholders is probably greater if the merger is completed.  So for the low, mid, and high cases, the potential upside for current Ensco shareholders is at least 50%, 200%, and 350%, respectively, and probably more.

 

BOOLE MICROCAP FUND

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

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

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

The 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.

Quantitative Microcap Value

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 7, 2018

Jack Bogle and Warren Buffett correctly maintain that most investors should invest in an S&P 500 index fund.  An index fund will allow you to outpace 90-95% of all active investors—net of costs—over the course of 4-5 decades.  This is purely a function of cost.  Active investors as a group will do the same as the S&P 500, but that is before costs.  After costs, active investors will do about 2.5% worse per year than the index.

An index fund is a wise choice.  But you can do much better if you invest in a quantitative microcap value strategy—focused on undervalued microcap stocks with improving fundamentals.  If you adopt such an approach, you can outperform the S&P 500 by roughly 7% per year.  For details, see: http://boolefund.com/cheap-solid-microcaps-far-outperform-sp-500/

But this can only work if you have the ability to ignore volatility and stay focused on the very long term.

“Investing is simple but not easy.” — Warren Buffett

(Photo by USA International Trade Administration)

Assume the S&P 500 index will return 8% per year over the coming decades.  The average active approach will produce roughly 5.5% per year.  A quantitative microcap approach—cheap micro caps with improving fundamentals—will generate about 15% per year.

What would happen if you invested $50,000 for the next 30 years in one of these approaches?

Investment Strategy Beginning Value Ending Value
Active $50,000 $249,198
S&P 500 Index $50,000 $503,133
Quantitative Microcap $50,000 $3,310,589

As you can see, investing $50,000 in an index fund will produce $503,133, which is more than ten times what you started with.  Furthermore, $503,133 is more than twice $249,198, which would be the result from the average active fund.

However, if you invested $50,000 in a quantitative microcap strategy, you would end up with $3,310,589.  This is more than 66 times what you started with, and it’s more than 6.5 times greater than the result from the index fund.

You could either invest in a quantitative microcap approach or you could invest in an index fund.  You’ll do fine either way.  You could also invest part of your portfolio in the microcap strategy and part in an index fund.

What’s the catch?

For most of us as investors, our biggest enemy is ourselves.  Let me explain.  Since 1945, there have been 27 corrections where stocks dropped 10% to 20%, and there have been 11 bear markets where stocks dropped more than 20%.  However, the stock market has always recovered and gone on to new highs.

Edgar Wachenheim, in the great book Common Stocks and Common Sense, gives the following example:

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… 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.

If you can stay the course through a 25% drop and even through a 40%+ drop, and remain focused on the very long term, then you should invest primarily in stocks, whether via an index fund, a quantitative microcap value fund, or some other investment vehicle.

The best way to stay focused on the very long term is simply to ignore the stock market entirely.  All you need to know or believe is:

  • The U. S. and global economies will continue to grow, mainly due to improvements in technology.
  • After every correction or bear market—no matter how severe—the stock market has always recovered and gone on to new highs.

If you’re unable to ignore the stock market, and if you might get scared and sell during a correction or bear market—don’t worry if you’re in this category since many investors are—then you should try to invest a manageable portion of your liquid assets in stocks.  Perhaps investing 50% or 25% of your liquid assets in stocks will allow you to stay the course through the inevitable corrections and bear markets.

The best-performing investors will be those who can invest for the very long term—several decades or more—and who don’t worry about (or even pay any attention to) the inevitable corrections and bear markets along the way.  In fact, Fidelity did a study of its many retail accounts.  It found that the best-performing accounts were owned by investors who literally forgot that they had an account!

  • Note: If you were to buy and hold twenty large-cap stocks chosen at random, your long-term performance would be very close to the S&P 500 Index.  (The Dow Jones Industrial Average is a basket of thirty large-cap stocks.)

Bottom Line

If you’re going to be investing for a few decades or more, and if you can basically ignore the stock market in the meantime, then you should invest fully in stocks.  Your best long-term investment is an index fund, a quantitative microcap value fund, or a combination of the two.

If you can largely ignore volatility, then you should consider investing primarily in a quantitative microcap value fund.  This is very likely to produce far better long-term performance than an S&P 500 index fund.

Many top investors—including Warren Buffett, perhaps the greatest investors of all time—earned the highest returns of their career when they could invest in microcap stocks.  Buffett has said that he’d still be investing in micro caps if he were managing small sums.

To learn more about Buffett getting his highest returns mainly from undervalued microcaps, here’s a link to my favorite blog post: http://boolefund.com/buffetts-best-microcap-cigar-butts/

The Boole Microcap Fund that I manage is a quantitative microcap value fund.  For details on the quantitative investment process, see: http://boolefund.com/why-invest-in-boole-microcap/

Although the S&P 500 index appears rather high—a bear market in the next year or two wouldn’t be a surprise—the positions in the Boole Fund are quite undervalued.  When looking at the next 3 to 5 years, I’ve never been more excited about the prospects of the Boole Fund relative to the S&P 500—regardless of whether the index is up, down, or flat.

(The S&P 500 may be flat for 5 years or even 10 years, but after that, as you move further into the future, eventually there’s more than a 99% chance that the index will be in positive territory.  The longer your time horizon, the less risky stocks are.)

 

BOOLE MICROCAP FUND

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

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

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

The 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)

September 30, 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 roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The 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.

Think Twice

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 23, 2018

In today’s blog post, I review some lessons from Michael Mauboussin’s excellent book Think Twice: Harnessing the Power of Counterintuition.   Each chapter is based on a common mistake in decision-making:

  • RQ vs. IQ
  • The Outside View
  • Open to Options
  • The Expert Squeeze
  • Situational Awareness
  • More Is Different
  • Evidence of Circumstance
  • Phase Transitions—”Grand Ah-Whooms”
  • Sorting Luck From Skill
  • Time to Think Twice
Illustration by Kheng Guan Toh

 

RQ vs IQ

Given a proper investment framework or system, obviously IQ can help a great deal over time.  Warren Buffett and Charlie Munger are seriously smart.  But they wouldn’t have become great investors without a lifelong process of learning and improvement, including learning how to be rational.  The ability to be rational may be partly innate, but it can be improved—sometimes significantly—with work.

Illustration by hafakot

An investor dedicated to lifelong improvements in knowledge and rationality can do well in value investing even without being brilliant.  A part of rationality is focusing on the knowable and remembering the obvious.

“We try more to profit from 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.” — Charlie Munger

Quite often, the best approach for a value investor is to invest in an index fund or in a quantitative value fund.  Lifelong improvements are still helpful in these cases.  Many value investors, including the father of value investing Ben Graham, have advocated and used a quantitative approach.

 

THE OUTSIDE VIEW

Mauboussin discusses why Big Brown was a bad bet to win the Triple Crown in 2008.  Big Brown had won the Kentucky Derby by four-and-three-quarters lengths, and he won the Preakness by five-and-one-quarter lengths.  The horse’s trainer, Rick Dutrow, said, “He looks as good as he can possibly look.  I can’t find any flaws whatsoever in Big Brown.  I see the prettiest picture.  I’m so confident, it’s unbelievable.”  UPS (after whom Big Brown was named) signed a marketing deal.  And enthusiasm for Big Brown’s chances in the Belmont Stakes grew.

(Photo of Big Brown by Naoki Nakashima, via Wikimedia Commons)

What happened?  Big Brown trailed the field during the race, so his jockey eased him out of the race.  This was a shocking result.  But the result of not winning could have been much more widely anticipated if people had used the outside view.

The outside view means identifying similar situations and finding the statistics on how things worked out.  Renowned handicapper Steven Crist developed an outside view, as Mauboussin summarizes:

Of the twenty-nine horses with a chance to capture the Triple Crown after winning the Kentucky Derby and the Preakness Stakes, only eleven triumphed, a success rate less than 40 percent.  But a closer examination of those statistics yielded a stark difference before and after 1950.  Before 1950, eight of the nine horses attempting to win the Triple Crown succeeded.  After 1950, only three of twenty horses won.  It’s hard to know why the achievement rate dropped from nearly 90 percent to just 15 percent, but logical factors include better breeding (leading to more quality foals) and bigger starting fields.

Most people naturally use the inside view.  This essentially means looking at more subjective factors that are close at hand, like how tall and strong the horse looks and the fact that Big Brown had handily won the Kentucky Derby and the Preakness.

Why do people naturally adopt the inside view?  Mauboussin gives three reasons:

  • the illusion of superiority
  • the illusion of optimism
  • the illusion of control

First is the illusion of superiority.  Most people say they are above average in many areas, such as looks, driving, judging humor, investing.  Most people have an unrealistically positive view of themselves.  In many areas of life, this does not cause problems.  In fact, unrealistic positivity may often be an advantage that helps people to persevere.  But in zero-sum games—like investing—where winning requires clearly being above average, the illusion of superiority is harmful.

Illustration by OptureDesign

Munger calls it the Excessive Self-Regard Tendency.  Munger also notes that humans tend to way overvalue the things they possess—the endowment effect.  This often causes someone already overconfident about a bet he is considering to become even more overconfident after making the bet.

The illusion of optimism, which is similar to the illusion of superiority, causes most people to see their future as brighter than that of others.

The illusion of control causes people to behave as if chance events are somehow subject to their control.  People throwing dice throw softly when they want low numbers and hard for high numbers.  A similar phenomenon is seen when people choose which lottery card to take, as opposed to getting one by chance.

Mauboussin observes that a vast range of professionals tends to use the inside view to make important decisions, with predictably poor results.

Encouraged by the three illusions, most believe they are making the right decision and have faith that the outcomes will be satisfactory.

In the world of investing, many investors believe that they will outperform the market over time.  However, after several decades, there are very few investors who have done better than the market.

Another area where people fall prey to the three illusions is mergers and acquisitions.  Two-thirds of acquisitions fail to create value, but most executives, relying on the inside view, believe that they can beat the odds.

The planning fallacy is yet another example of how most people rely on the inside view instead of the outside view.  Mauboussin gives one common example of students estimating when they’d finish an assignment:

…when the deadline arrived for which the students had given themselves a 50 percent chance of finishing, only 13 percent actually turned in their work.  At the point when the students thought there was 75 percent chance they’d be done, just 19 percent had completed the project.  All the students were virtually sure they’d be done by the final date.  But only 45 percent turned out to be right.

Illustration by OpturaDesign

Daniel Kahneman gives his own example of the planning fallacy.  He was part of a group assembled to write a curriculum to teach judgment and decision-making to high school students.  Kahneman asked everyone in the group to write down their opinion of when they thought the group would complete the task.  Kahneman found that the average was around two years, and everyone, including the dean, estimated between eighteen and thirty months.

Kahneman then realized that the dean had participated in similar projects in the past.  Kahneman asked the dean how long it took them to finish.

The dean blushed and then answered that 40 percent of the groups that had started similar programs had never finished, and that none of the groups completed it in less than seven years.  Kahneman then asked how good this group was compared to past groups.  The dean thought and then replied: ‘Below average, but not by much.’

 

OPEN TO OPTIONS

In making decisions, people often fail to consider a wide enough range of alternatives.  People tend to have “tunnel vision.”

Anchoring is an important example of this mistake.  Mauboussin:

Kahneman and Amos Tversky asked people what percentage of the UN countries is made up of African nations.  A wheel of fortune with the numbers 1 to 100 was spun in front of the participants before they answered.  The wheel was rigged so it gave either 10 or 65 as the result of a spin.  The subjects were then asked—before giving their specific prediction—if the answer was higher or lower than the number on the wheel.  The median response from the group that saw the wheel stop at 10 was 25%, and the median response from the group that saw 65 was 45%.

(Illustration by Olga Vainshtein)

Behavioral finance expert James Montier has run his own experiment on anchoring.  People are asked to write down the last four digits of their phone number.  Then they are asked whether the number of doctors in their capital city is higher or lower than the last four digits of their phone number.  Results: Those whose last four digits were greater than 7000 on average report 6762 doctors, while those with telephone numbers below 2000 arrived at an average 2270 doctors.

Stock prices often have a large component of randomness, but investors tend to anchor on various past stock prices.  The rational way to avoid such anchoring is to carefully develop different possible scenarios for the intrinsic value of a stock.  For instance, you could ask:

  • What is the business worth if things go better than expected?
  • What is the business worth if things go as expected?  Or: What is the business worth under normal conditions?
  • What is the business worth if things go worse than expected?

Ideally, you would not want to know about past stock prices—or even the current stock price—before developing the intrinsic value scenarios.

The Representativeness Heuristic

The representativeness heuristic is another bias that leads many people not to consider a wide range of possibilities.  Daniel Kahneman and Amos Tversky defined representativeness as “the degree to which [an event] (i) is similar in essential characteristics to its parent population, and (ii) reflects the salient features of the process by which it is generated.”

People naturally tend to believe that something that is more representative is more likely.  But frequently that’s not the case.  Here is an example Kahneman and Tversky have used:

“Steve is very shy and withdrawn, invariably helpful but with very little interest in people or in the world of reality.  A meek and tidy soul, he has a need for order and structure, and a passion for detail.  Question: Is Steve more likely to be a librarian or a farmer?”

Most people say “a librarian.”  But the fact that the description seems more representative of librarians than of farmers does not mean that it is more likely that Steve is a librarian.  Instead, one must look at the base rate: there are twenty times as many farmers as librarians, so it is far more likely that Steve is a farmer.

Another example Kahneman gives:

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

  1.  Linda is a bank teller.
  2.  Linda is a bank teller and is active in the feminist movement.”

Most people say the second option is more likely.  But just using simple logic, we know that the second option is a subset of the first option, so the first option is more likely.  Most people get this wrong because they use the representativeness heuristic.

Availability Bias, Vividness Bias, Recency Bias

If a fact is easily available—which often happens if a fact is vivid or recent—people generally far overestimate its probability.

A good example is a recent and vivid plane crash.  The odds of dying in a plane crash are one in 11 million—astronomically low.  The odds of dying in a car crash are one in five thousand.  But many people, after seeing recent and vivid photos of a plane crash, decide that taking a car is much safer than taking a plane.

Extrapolating the Recent Past

Most people automatically extrapolate the recent past into the future without considering various alternative scenarios.  To understand why, consider Kahneman’s definitions of two systems in the mind, System 1 and System 2:

System 1:   Operates automatically and quickly;  makes instinctual decisions based on heuristics.

System 2:   Allocates attention (which has a limited budget) to the effortful mental activities that demand it, including logic, statistics, and complex computations.

In Thinking, Fast and Slow, Kahneman writes that System 1 and System 2 work quite well on the whole:

The division of labor between System 1 and System 2 is highly efficient:  it minimizes effort and optimizes performance.  The arrangement works well most of the time because System 1 is generally very good at what it does: its models of familiar situations are accurate, its short-term predictions are usually accurate as well, and its initial reactions to challenges are swift and generally appropriate.  System 1 has biases, however, systematic errors that it is prone to make in specified circumstances.  As we shall see, it sometimes answers easier questions than the one it was asked, and it has little understanding of logic and statistics.

System 1 is automatic and quick, and it works remarkably well much of the time.  Throughout most of our evolutionary history, System 1 has been instrumental in keeping us alive.  However, when we were hunter-gatherers, the recent past was usually the best guide to the future.

  • If there was a rustling in the grass or any other sign of a predator, the brain automatically went on high alert, which was useful because otherwise you weren’t likely to survive long.  A statistical calculation wasn’t needed.
  • There were certain signs indicating the potential presence of animals to hunt or wild plants to collect.  You learned to recognize those signs.  You foraged or you died.  You didn’t need to know any statistics.
  • Absent any potential threats, and assuming enough to eat, then things were fine and you could relax for a spell.

In today’s world—unlike when we were hunter-gatherers—the recent past is often a terrible guide to the future.  For instance, when it comes to investing, extrapolating the recent past is one of the biggest mistakes that investors make.  In a highly random environment, you should expect reversion to the mean, rather than a continuation of the recent past.  Investors must learn to think counterintuitively.  That includes thinking probabilistically—in terms of possible scenarios and reversion to the mean.

Illustration by intheskies

Doubt Avoidance

Charlie Munger—see Poor Charlie’s Almanack, Expanded Third Edition—explains what he calls Doubt Avoidance Tendency as follows:

“The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision.”

System 1 is designed (by evolution) to jump to conclusions.  In the past, when things were simpler and less probabilistic, the ability to make a quick decision was beneficial.  In today’s complex world, you must train yourself to slow down when facing an important decision under uncertainty—a decision that depends on possible scenarios and their associated probabilities.

The trouble is that our mind—due to System 1—wants to jump immediately to a conclusion, even more so if we feel pressured, puzzled, or stressed.  Munger explains:

What triggers Doubt-Avoidance Tendency?  Well, an unthreatened man, thinking of nothing in particular, is not being prompted to remove doubt through rushing to some decision.  As we shall see later when we get to Social-Proof Tendency and Stress-Influence Tendency, what usually triggers Doubt-Avoidance Tendency is some combination of (1) puzzlement and (2) stress…

The fact that social pressure and stress trigger the Doubt-Avoidance Tendency supports the notion that System 1 excelled at keeping us alive when we lived in a much more primitive world.  In that type of environment where things usually were what they seemed to be, the speed of System 1 in making decisions was vital.  If the group was running in one direction, the immediate, automatic decision to follow was what kept you alive over time.

Inconsistency Avoidance and Confirmation Bias

Munger on the Inconsistency-Avoidance Tendency:

The brain of man conserves programming space by being reluctant to change, which is a form of inconsistency avoidance.  We see this in all human habits, constructive and destructive.  Few people can list a lot of bad habits that they have eliminated, and some people cannot identify even one of these.  Instead, practically everyone has a great many bad habits he has long maintained despite their being known as bad…. chains of habit that were too light to be felt before they became too heavy to be broken.

The rare life that is wisely lived has in it many good habits maintained and many bad habits avoided or cured.

Photo by Marek

Munger continues:

It is easy to see that a quickly reached conclusion, triggered by Doubt-Avoidance Tendency, when combined with a tendency to resist any change in that conclusion, will naturally cause a lot of errors in cognition for modern man.  And so it observably works out…

And so, people tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong.

Our brain will jump quickly to a conclusion and then resist any change in that conclusion.  How do we combat this tendency?  One great way to overcome first conclusion bias is to train our brains to emulate Charles Darwin:

One of the most successful users of an antidote to first conclusion bias was Charles Darwin.  He trained himself, early, to intensively consider any evidence tending to disconfirm any hypothesis of his, more so if he thought his hypothesis was a particularly good one.  The opposite of what Darwin did is now called confirmation bias, a term of opprobrium.  Darwin’s practice came from his acute recognition of man’s natural cognitive faults arising from Inconsistency-Avoidance Tendency.  He provides a great example of psychological insight correctly used to advance some of the finest mental work ever done.  (my emphasis)

Selective Attention and Inattentional Blindness

We tend to be very selective about what we hear and see, and this is partly a function of what we already believe.  We often see and hear only what we want, and tune out everything else.

On a purely visual level, there is something called inattentional blindness.  When we focus on certain aspects of our environment, this causes many of us to miss other aspects that are plainly visible.  There is a well-known experiment related to inattentional blindness.  People watch a thirty-second video that shows two teams, one wearing white and the wearing black.  Each team is passing a basketball back and forth.  In the middle of the video, a woman wearing a gorilla suit walks into the middle of the scene, thumps her chest, and walks off.  Roughly half of the people watching the video have no recollection of the gorilla.

Struggles and Stresses

Stress or fatigue causes many of us to make poorer decisions than we otherwise would.  Thus, we must take care.  With the right attitude, however, stress can slowly be turned into an advantage over a long period of time.

As Ray Dalio and Charlie Munger have pointed out, mental strength is one of life’s greatest gifts.  With a high degree of focus and discipline, a human being can become surprisingly strong and resilient.  But this typically only happens gradually, over the course of years or decades, as the result of an endless series of struggles, stresses, and problems.

A part of strength that can be learned over time is inner peace or total calm in the face of seemingly overwhelming difficulties.  The practice of transcendental meditation is an excellent way to achieve inner peace and total calm in the face of any adversity.  But there are other ways, too.

Wise men such as Munger or Lincoln are of the view that total calm in the face of any challenge is simply an aspect of mental strength that can be developed over time.  Consider Rudyard Kipling’s poem “If”:

If you can keep your head when all about you
    Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
    But make allowance for their doubting too;
If you can wait and not be tired by waiting,
    Or being lied about, don’t deal in lies,
Or being hated, don’t give way to hating,
    And yet don’t look too good, nor talk too wise…
(Image by nickolae)
In the 2016 Daily Journal Annual Meeting, Charlie Munger made the following remarks:

…So, maybe in that sense I think a tougher hand has been good for us.  My answer to that question reminds me of my old Harvard law professor who used to say, ‘Charlie, let me know what your problem is and I’ll try to make it harder for you.’  I’m afraid that’s what I’ve done to you.

As for how do I understand a new industry: the answer is barely.  I just barely have enough cognitive ability to do what I do.  And that’s because the world promoted me to the place where I’m stressed.  And you’re lucky if it happens to you, because that’s what you want to end up: stressed.  You want to have your full powers called for.  Believe you me, I’ve had that happen all my life.  I’ve just barely been able to think through to the right answer, time after time.  And sometimes I’ve failed…

Link to 2016 Daily Journal Meeting Notes (recorded courtesy of Whitney Tilson): https://www.scribd.com/doc/308879985/MungerDJ-2-16

Incentives

Mauboussin writes about the credit crisis of 2007-2008.  People without credit could buy nice homes.  Lenders earned fees and usually did not hold on to the mortgages.  Investment banks bought mortgages and bundled them for resale, earning a fee.  Rating agencies were paid to rate the mortgage-backed securities, and they rated many of them AAA (based partly on the fact that home prices had never declined nationwide).  Investors worldwide in AAA-rated mortgage-backed securities earned higher returns than they did on other AAA issues.  Some of these investors were paid based on portfolio performance and thus earned higher fees this way.

Incentives are extremely important:

Never, ever think about something else when you should be thinking about incentives.” – Charlie Munger

Under a certain set of incentives, many people who normally are good people will behave badly.  Often this bad behavior is not only due to the incentives at play, but also involves other psychological pressures like social proof, stress, and doubt-avoidance.  A bad actor could manipulate basically good people to do bad things using social proof and propaganda.  If that fails, he could use bribery or blackmail.

Finally, Mauboussin offers advice about how to deal with “tunnel vision,” or the insufficient consideration of alternatives:

  • Explicitly consider alternatives.
  • Seek dissent. (This is very difficult, but highly effective.  Think of Lincoln’s team of rivals.)
  • Keep track of previous decisions. (A decision journal does not cost much, but it can help one over time to make better decisions.)
  • Avoid making decisions while at emotional extremes. (One benefit to meditation—in addition to total calm and rationality—is that it can give you much greater self-awareness.  You can learn to accurately assess your emotional state, and you can learn to postpone important decisions if you’re too emotional or tired.)
  • Understand incentives.

 

THE EXPERT SQUEEZE

In business today, there are many areas where you can get better insights or predictions than what traditional experts can offer.

Mauboussin gives the example of Best Buy forecasting holiday sales.  In the past, Best Buy depended on specialists to make these forecasts.  James Surowiecki, author of The Wisdom of Crowds, went to Best Buy’s headquarters and told them that a crowd could predict better than their specialists could.

Jeff Severts, a Best Buy executive, decided to test Surowiecki’s suggestion.  Late in 2005, Severts set up a location for employees to submit and update their estimates of sales from Thanksgiving to year-end.  In early 2006, Severts revealed that the internal experts had been 93 percent accurate, while the “amateur crowd” was off only one-tenth of one percent.  Best Buy then allocated more resources to its prediction market, and benefited.

Another example of traditional experts being supplanted:  Orley Ashenfelter, wine lover and economist, figured out a simple regression equation that predicts the quality of red wines from France’s Bordeaux region better than most wine experts.  Mauboussin:

With the equation in hand, the computer can deliver appraisals that are quicker, cheaper, more reliable, and without a whiff of snobbishness.

Mauboussin mentions four categories over which we can judge experts versus computers:

Rule based; limited range of outcomes—experts are generally worse than computers. Examples include credit scoring and simple medical diagnosis.

Rule based; wide range of outcomes—experts are generally better than computers.  But this may be changing.  For example, humans used to be better at chess and Go, but now computers are far better than humans.

Probabilistic; limited range of outcomes—experts are equal or worse than collectives.  Examples include admissions officers and poker.

Probabilistic; wide range of outcomes—experts are worse than collectives.  Examples include forecasting any of the following: stock prices, the stock market, interest rates, or the economy.

Regarding areas that are probabilistic, with a wide range of outcomes (the fourth category), Mauboussin comments on economic and political forecasts:

The evidence shows that collectives outperform experts in solving these problems.  For instance, economists are extremely poor forecasters of interest rates, often failing to accurately guess the direction of rate moves, much less their correct level.  Note, too, that not only are experts poor at predicting actual outcomes, they rarely agree with one another.  Two equally credentialed experts may make opposite predictions and, hence, decisions from one another.

Mauboussin notes that experts do relatively well with rule-based problems with a wide range of outcomes because they can be better than computers at eliminating bad choices and making creative connections between bits of information.  A fascinating example: Eric Bonabeau, a physicist, has developed programs that generate alternative designs for packaging using the principles of evolution (recombination and mutation).  But the experts select the best designs at the end of the process, since the computers have no taste.

Yet computers will continue to make big improvements in this category (rule-based problems with a wide range of outcomes).  For instance, many chess programs today can beat any human, whereas there was only one program (IBM’s Deep Blue) that could do this in the late 1990’s.  Also, in October 2015, Google DeepMind’s program AlphaGo beat Fan Hui, the European Go champion.

Note:  We still need experts to make the systems that replace them.  Severts had to set up the prediction market.  Ashenfelter had to find the regression equation.  And experts need to stay on top of the systems, making improvements when needed.

Also, experts are still needed for many areas in strategy, including innovation and creativity.  And people are needed to deal with people.  (Although many jobs will soon be done by robots.)

I’ve written before about how 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/

 

SITUATIONAL AWARENESS

Mauboussin writes about the famous experiment by Solomon Asch.  The subject is shown lines of obviously different lengths.  But in the same room with the subject are shills, who unbeknownst to the subject have already been instructed to say that two lines of obviously different lengths actually have the same length.  So the subject of the experiment has to decide between the obvious evidence of his eyes—the two lines are clearly different lengths—and the opinion of the crowd.  A significant number (36.8 percent) ignored their own eyes and went with the crowd, saying that the two lines had equal length, despite the obvious fact that they didn’t.

(Photo by D-janous, via Wikimedia Commons)

Mauboussin notes that the interesting question about the Solomon Asch experiment is: what’s going on in the heads of people who conform?  Asch himself suggested three possibilities:

Distortion of judgment.  The subjects conclude that their perceptions are wrong and that the group is right.

Distortion of action.  These individuals suppress their own knowledge in order to go with the majority.

Distortion of perception.  This group is not aware that the majority opinion distorts their estimates.

Unfortunately, Asch didn’t have the tools to try to test these possibilities.  Gregory Berns, a neuroscientist, five decades after Asch, used functional magnetic resonance imaging (fMRI) in the lab at Emory University.

For the conforming subjects, the scientists found activity in the areas of the brain that were related to perception of the object.  Also, the scientists did not find a meaningful change in activity in the frontal lobe—an area associated with activities like judgment.  Thus, for conforming subjects, it is a distortion of perception: what the majority claims to see, the subject actually does see.  Remarkable.

What about the people who remained independent when faced with the group’s wrong responses?  Those subjects showed increased activity in the amygdala, a region that signals to prepare for immediate action (fight or flight).  Mauboussin comments: “…while standing alone is commendable, it is unpleasant.”

Priming

Mauboussin:

How do you feel when you read the word ‘treasure’? … If you are like most people, just ruminating on ‘treasure’ gives you a little lift.  Our minds naturally make connections and associate ideas.  So if someone introduces a cue to you—a word, a smell, a symbol—your mind often starts down an associative path.  And you can be sure the initial cue will color a decision that waits at the path’s end.  All this happens outside your perception.

(Subconscious as brain under water, Illustration by Agawa288)

Scientists did the following experiment:

In this test, the researchers placed the French and German wines next to each other, along with small national flags.  Over two weeks, the scientists alternated playing French accordion music and German Bierkeller pieces and watched the results.  When French music played, French wines represented 77 percent of the sales.  When German music played, consumers selected German wines 73 percent of the time… The music made a huge difference in shaping purchases.  But that’s not what the shoppers thought…

While the customers acknowledged that the music made them think of either France or Germany, 86 percent denied that the tunes had any influence on their choice.  This experiment is an example of priming, which psychologists formally define as ‘the incidental activation of knowledge structures by the current situational context.’  In other words, what comes in through our senses influences how we make decisions, even when it seems completely irrelevant in a logical sense.  Priming is by no means limited to music.  Researchers have manipulated behavior through exposure to words, smells, and visual backgrounds.

Mauboussin gives some examples of priming:

  • Immediately after being exposed to words associated with the elderly, primed subjects walked 13 percent slower than subjects seeing neutral words.
  • Exposure to the scent of an all-purpose cleaner prompted study participants to keep their environment tidier while eating a crumbly biscuit.
  • Subjects reviewing Web pages describing two sofa models preferred the more comfortable model when they saw a background with puffy clouds, and favored the cheaper sofa when they saw a background with coins.

The Fault of the Default

While virtually 100 percent of Austrians have consented to be an organ donor, only 12 percent of Germans have.  The difference is due entirely to how the choice is presented.  In Austria, you must opt-out of being an organ donor—being an organ donor is the default choice.  In Germany, you must opt-in to being an organ donor—not being a donor is the default choice.  But this directly translates into many more saved lives in Austria than in Germany.

Illustration by hafakot

Mauboussin makes an important larger point.  We tend to assume that people decide what is best for them independent of how the choice is framed, but in reality, “many people simply go with the default options.”  This includes consequential areas (in addition to organ donation) like savings, educational choice, medical alternatives, etc.

The Power of Inertia

To overcome inertia, Peter Drucker suggested asking: “If we did not do this already, would we, knowing what we now know, go into it?”

Dr. Atul Gawande, author of The Checklist Manifesto, tells the story of Dr. Peter Pronovost, an anesthesiologist and critical-care specialist at the Johns Hopkins Hospital.  Pronovost’s father died due to a medical error, which led Pronovost to dedicate his career to ensuring the safety of patients.  Mauboussin explains:

In the United States, medical professionals put roughly 5 million lines into patients each year, and about 4 percent of those patients become infected within a week and a half.  The added cost of treating those patients is roughly $3 billion per year, and the complications result in twenty to thirty thousand annual preventable deaths.

Pronovost came up with a simple checklist because he observed that physicians in a hurry would often overlook some simple routine that is normally done as a part of safety.  It saved numerous lives and millions of dollars in the first few years at Johns Hopkins Hospital, so Pronovost got the Michigan Health & Hospital Association to try the checklist.  After just three months, the rate of infection dropped by two-thirds.  After eighteen months, the checklist saved 1,500 lives and nearly $200 million.

 

MORE IS DIFFERENT

Mauboussin covers complex adaptive systems such as the stock market or the economy.  His advice, when dealing with a complex adaptive system, is:

  • Consider the system at the correct level.  An individual agent in the system can be very different from one outside the system.
  • Watch for tightly coupled systems.  A system is tightly coupled when there is no slack between items, allowing a process to go from one stage to the next without any opportunity to intervene.  (Examples include space missions and nuclear power plants.)  Most complex adaptive systems are loosely coupled, where removing or incapacitating one or a few agents has little impact on the system’s performance.
  • Use simulations to create virtual worlds.  Simulation is a tool that can help our learning process.  Simulations are low cost, provide feedback, and have proved their value in other domains like military planning and pilot training.

Mauboussin notes that complex adaptive systems often perform well at the system level, despite dumb agents (consider ants or bees).  Moreover, there are often unintended consequences that can lead to failure when well-meaning humans try to manage a complex system towards a particular goal.

 

EVIDENCE OF CIRCUMSTANCE

Decisions that work well in one context can often fail miserably in a different context.  The right answer to many questions that professionals face is: “It depends.”

Mauboussin writes about how most people make decisions based on a theory, even though often they are not aware of it.  Two business professors, Paul Carlile and Clayton Christensen, describe three stages of theory building:

  • The first stage is observation, which includes carefully measuring a phenomenon and documenting the results.  The goal is to set common standards so that subsequent researchers can agree on the subject and the terms to describe it.
  • The second stage is classification, where researchers simplify and organize the world into categories to clarify the differences among phenomena.  Early in theory development, these categories are based predominantly on attributes.
  • The final stage is definition, or describing the relationship between the categories and the outcomes.  Often, these relationships start as simple correlations.

What’s especially important, writes Mauboussin:

Theories improve when researchers test predictions against real-world data, identify anomalies, and subsequently reshape the theory.  Two crucial improvements occur during this refining process.  In the classification stage, researchers evolve the categories to reflect circumstances, not just attributes.  In other words, the categories go beyond what works to when it works.  In the definition stage, the theory advances beyond simple correlations and sharpens to define causes—why it works.  This pair of improvements allows people to go beyond crude estimates and to tailor their choices to the situation they face.

Here is what is often done:  Some successes are observed, some common attributes are identified, and it is proclaimed that these attributes can lead others to success.  This doesn’t work.

By the same logic, a company should not adopt a strategy without understanding the conditions under which it succeeds or fails.  Mauboussin gives the example of Boeing outsourcing both the design and the building of sections of the Dreamliner to its suppliers.  This was a disaster.  Boeing had to pull the design work back in-house.

The Colonel Blotto Game

Each player gets a hundred soldiers (resources) to distribute across three battlefields (dimensions).  The players make their allocations in secret.  Then the players’ choices are simultaneously revealed, and the winner of each battle is whichever army has more soldiers in that battlefield.  The overall winner is whichever player wins the most battles.  What’s interesting is how the game changes as you adjust one of the two parameters (resources, dimensions).

Mauboussin observes that it’s not intuitive how much advantage additional points give to one side in a three-battlefield game:

In a three-battlefield game, a player with 25 percent more resources has a 60 percent expected payoff (the proportion of battles the player wins), and a player with twice the resources has a 78 percent expected payoff.  So some randomness exists, even in contests with fairly asymmetric resources, but the resource-rich side has a decisive advantage.  Further, with low dimensions, the game is largely transitive: if A can beat B and B can beat C, then A can beat C.  Colonel Blotto helps us to understand games with few dimensions, such as tennis.

Things can change even more unexpectedly when the number of dimensions is increased:

But to get the whole picture of the payoffs, we must introduce the second parameter, the number of dimensions or battlefields.  The more dimensions the game has, the less certain the outcome (unless the players have identical resources).  For example, a weak player’s expected payoff is nearly three times higher in a game with fifteen dimensions than in a nine-dimension game.  For this reason, the outcome is harder to predict in a high-dimension game than in a low-dimension game, and as a result there are more upsets.  Baseball is a good example of a high-dimension game…

What may be most surprising is that the Colonel Blotto game is highly nontransitive (except for largely asymmetric, low-dimension situations).  This means that tournaments often fail to reveal the best team.  Mauboussin gives an example where A beats B, B beats C, C beats A, and all of them beat D.  Because there is no best player, the winner of a tournament is simply “the player who got to play D first.”  Mauboussin:

Because of nontransitivity and randomness, the attribute of resources does not always prevail over the circumstance of dimensionality.

Bottom Line on Attributes vs. Circumstances

Mauboussin sums up the  main lesson on attributes versus circumstances:

Most of us look forward to leveraging our favorable experiences by applying the same approach to the next situation.  We also have a thirst for success formulas—key steps to enrich ourselves.  Sometimes our experience and nostrums work, but more often they fail us.  The reason usually boils down to the simple reality that the theories guiding our decisions are based on attributes, not circumstances.  Attribute-based theories come very naturally to us and often appear compelling… However, once you realize the answer to most questions is, ‘It depends,’ you are ready to embark on the quest to figure out what it depends on.

 

PHASE TRANSITIONS—“GRAND AH-WHOOMS”

Just a small incremental change in temperature leads to a change from solid to liquid or from liquid to gas.  Philip Ball, a physicist and author of Critical Mass: How One Thing Leads to Another, calls it a grand ah-whoom.

(Illustration by Designua)

Critical Points, Extremes, and Surprise

In part due to the writings of Nassim Taleb, people are more aware of black swans, or extreme outcomes within a power law distribution.  According to Mauboussin, however, what most people do not yet appreciate is how black swans are caused:

Here’s where critical points and phase transitions come in.  Positive feedback leads to outcomes that are outliers.  And critical points help explain our perpetual surprise at black swan events because we have a hard time understanding how such small incremental perturbations can lead to such large outcomes.

Mauboussin explains critical points in social systems.  Consider the wisdom of crowds: Crowds tend to make accurate predictions when three conditions prevail—diversity, aggregation, and incentives.

Diversity is about people having different ideas and different views of things.  Aggregation means you can bring the group’s information together.  Incentives are rewards for being right and penalties for being wrong that are often, but not necessarily, monetary.

Mauboussin continues:

For a host of psychological and sociological reasons, diversity is the most likely condition to fail when humans are involved.  But what’s essential is that the crowd doesn’t go from smart to dumb gradually.  As you slowly remove diversity, nothing happens initially.  Additional reductions may also have no effect.  But at a certain critical point, a small incremental reduction causes the system to change qualitatively.

Blake LeBaron, an economist at Brandeis University, has done an experiment.  LaBaron created a thousand investors within the computer and gave them money, guidelines on allocating their portfolios, and diverse trading rules.  Then he let the system play out.  As Mauboussin describes:

His model was able to replicate many of the empirical features we see in the real world, including cycles of booms and crashes.  But perhaps his most important finding is that a stock price can continue to rise even while the diversity of decision rules falls.  Invisible vulnerability grows.  But then, ah-whoom, the stock price tumbles as diversity rises again.  Writes LaBaron, ‘During the run-up to a crash, population diversity falls.  Agents begin using very similar trading strategies as their common good performance is reinforced.  This makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilizing impact on the market.’

The Problem of Induction, Reductive Bias, and Bad Predictions

Extrapolating from what we see or have seen, to what will happen next, is a common decision-making mistake.  Nassim Taleb retells Bertrand Russell’s story of a turkey (Taleb said turkey instead of chicken to suit his American audience).  The turkey is fed a thousand days in a row.  The turkey feels increasingly good until the day before Thanksgiving, when an unexpected event occurs.  None of the previous one thousand days has given the turkey any clue about what’s next.  Mauboussin explains:

The equivalent of the turkey’s plight—sharp losses following a period of prosperity—has occurred repeatedly in business.  For example, Merrill Lynch (which was acquired by Bank of America) suffered losses over a two-year period from 2007 to 2008 that were in excess of one-third of the profits it had earned cumulatively in its thirty-six years as a public company….

The term black swan reflects the criticism of induction by the philosopher Karl Popper.  Popper argued that seeing lots of white swans doesn’t prove the theory that all swans are white, but seeing one black swan does disprove it.  So Popper’s point is that to understand a phenomenon, we’re better off focusing on falsification than on verification.  But we’re not naturally inclined to falsify something.

Black swan, Photo by Dr. Jürgen Tenckhoff

Not only does System 1 naturally look for confirming evidence.  But even System 2 uses a positive test strategy, looking for confirming evidence for any hypothesis, rather than looking for disconfirming evidence.

People have a propensity to stick to whatever they currently believe.  Most people rarely examine or test their beliefs (hypotheses).  As Bertrand Russell pointed out:

Most people would rather die than think;  many do.

People are generally overconfident.  Reductive bias means that people tend to believe that reality is much simpler and more predictable than it actually is.  This causes people to oversimplify complex phenomena.  Instead of properly addressing the real questions—however complex and difficult—System 1 naturally substitutes an easier question.  The shortcuts used by System 1 work quite well in simple environments.  But these same shortcuts lead to predictable errors in complex and random environments.

System 2—which can be trained to do logic, statistics, and complex computations—is naturally lazy.  It requires conscious effort to activate System 2 .  If System 1 recognizes a serious threat, then System 2 can be activated if needed.

The problem is that System 1 does not recognize the dangers associated with complex and random environments.  Absent an obvious threat, System 1 will nearly always oversimplify complex phenomena.  This creates overconfidence along with comforting illusions—”everything makes sense” and “everything is fine.”  But complex systems frequently undergo phase transitions, and some of these new phases have sharply negative consequences, especially when people are completely unprepared.

Even very smart people routinely oversimplify and are inclined to trust overly simple mathematical models—for instance, models that assume a normal distribution even when the distribution is far from normal.  Mauboussin argues that Long-Term Capital Management, which blew up in the late 1990’s, had oversimplified reality by relying too heavily on its financial models.  According to their models, the odds of LTCM blowing up—as it did—were astronomically low (1 out of billions).  Clearly their models were very wrong.

Mauboussin spoke with Benoit Mandelbrot, the French mathematician and father of fractal geometry.  Mauboussin asked about the reductive bias.  Mandelbrot replied that the wild randomness of stock markets was clearly visible for all to see, but economists continued to assume mild randomness, largely because it simplified reality and made the math more tractable.  If you assume a normal distribution, the math is much easier than if you tried to capture the wildness and complexity of  reality:

Mandelbrot emphasized that while he didn’t know what extreme event was going to happen in the future, he was sure that the simple models of the economists would not anticipate it.

Mauboussin gives the example of David Li’s formula, which measures the correlation of default between assets.  (The formula is known as a Gaussian copula function.)  Li’s equation could measure the likelihood that two or more assets within a portfolio would default at the same time.  This “opened the floodgates” for financial engineers to create new products, including collateralized debt obligations (bundles of corporate bonds), and summarize the default correlation using Li’s equation “rather than worry about the details of how each corporate bond within the pool would behave.”

Unfortunately, Li’s equation oversimplified a complex world: Li’s equation did not make any adjustments for the fact that many correlations can change significantly.

The failure of Long-Term Capital Management illustrates how changing correlations can wreak havoc.  LTCM observed that the correlation between its diverse investments was less than 10 percent over the prior five years.  To stress test its portfolio, LTCM assumed that correlations could rise to 30 percent, well in excess of anything the historical data showed.  But when the financial crisis hit in 1998, the correlations soared to 70 percent.  Diversification went out the window, and the fund suffered mortal losses.  ‘Anything that relies on correlation is charlatanism,’ scoffed Taleb.  Or, as I’ve heard traders say, ‘The only thing that goes up in a bear market is correlation.’

Music Lab

Duncan Watts, a sociologist, led a trio of researchers at Columbia University in doing a social experiment.  Subjects went to a web site—Music Lab—and were invited to participate in a survey.  Upon entering the site, 20 percent of the subjects were assigned to an independent world and 10 percent each to eight worlds where people could see what other people were doing.

In the independent world, subjects were free to listen to songs, rated them, and download them, but they had no information about what other subjects were doing.  In each of the other eight worlds, the subjects could see how many times other people had downloaded each song.

The subjects in the independent world collectively gave a reasonable indication of the quality of each of the songs.  Thus, you could see for the other eight worlds whether social influence made a difference or not.

Song quality did play a role in the ranking, writes Mauboussin.  A top-five song in the independent world had about a 50 percent chance of finishing in the top five in a social influence world.  And the worst songs rarely topped the charts.  But how would you guess the average song did in the social worlds?

The scientists found that social influence played a huge part in success and failure.  One song, ‘Lockdown’ by the band 52metro, ranked twenty-sixth in the independent world, effectively average.  Yet it was the number one song in one of the social influence worlds, and number forty in another.  Social influence catapulted an average song to hit status in one world—ah-whoom—and relegated it to the cellar in another.  Call it Lockdown’s lesson.

In the eight social worlds, the songs the subjects downloaded early in the experiment had a huge influence on the songs subjects downloaded later.  Since the patterns of download were different in each social world, so were the outcomes.

(Illustration by Mindscanner)

Mauboussin summarizes the lessons:

  • Study the distribution of outcomes for the system you are dealing with.  Taleb defines gray swans as “modelable extreme events,” which are events you can at least prepare for, as opposed to black swans, which are by definition exceedingly difficult to prepare for.
  • Look for ah-whoom moments.  In social systems, you must be mindful of the level of diversity.
  • Beware of forecasters.  Especially for phase transitions, forecasts are generally dismal.
  • Mitigate the downside, capture the upside.  One of the Kelly criterion’s central lessons is that betting too much in a system with extreme outcomes leads to ruin.

 

SORTING LUCK FROM SKILL

In areas such as business, investing, and sports, people make predictable and natural mistakes when it comes to distinguishing skill from luck.  Consider reversion to the mean:

The idea is that for many types of systems, an outcome that is not average will be followed by an outcome that has an expected value closer to the average.  While most people recognize the idea of reversion to the mean, they often ignore or misunderstand the concept, leading to a slew of mistakes in their analysis.

Reversion to the mean was discovered by the Victorian polymath Francis Galton, a cousin of Charles Darwin.  For instance, Dalton found that tall parents tend to have children that are tall, but not as talltheir heights are closer to the mean.  Similarly, short parents tend to have children that are short, but not as shorttheir heights are closer to the mean.

Yet it’s equally true that tall people have parents that are tall, but not as tallthe parents’ heights are closer to the mean.  Similarly, short people have parents that are short, but not as shorttheir heights are closer to the mean.  Thus, Dalton’s crucial insight was that the overall distribution of heights remains stable over time: the proportions of the population in every height category was stable as one looks forward or backward in time.

Skill, Luck, and Outcomes

Mauboussin writes that Daniel Kahneman was asked to offer a formula for the twenty-first century.  Kahneman gave two formulas:

Success = Some talent + luck

Great success = Some talent + a lot of luck

Consider an excellent golfer who scores well below her handicap during the first round.  What do you predict will happen in the second round?  We expect the golfer to have a score closer to her handicap for the second round because we expect there to be less luck compared to the first round.

Illustration by iQoncept

When you think about great streaks in sports like baseball, the record streak always belongs to a very talented player.  So a record streak is a lot of talent plus a lot of luck.

 

TIME TO THINK TWICE

You don’t need to think twice before every decision.  The stakes for most decisions are low.  And even when the stakes are high, the best decision is often obvious enough.

The value of Think Twice is in situations with high stakes where your natural decision-making process will typically lead to a suboptimal choice.  Some final thoughts:

Raise Your Awareness

As Kahneman has written, it is much easier to notice decision-making mistakes in others than in ourselves.  So pay careful attention not only to others, but also to yourself.

It is difficult to think clearly about many problems.  Furthermore, after outcomes have occurred, hindsight bias causes many of us to erroneously recall that we assigned the outcome a much higher probability than we actually did ex ante.

Put Yourself in the Shoes of Others

Embracing the outside view is typically essential when making an important probabilistic decision.  Although the situation may be new for us, there are many others who have gone through similar things.

When it comes to understanding the behavior of individuals, often the situationor specific, powerful incentivescan overwhelm otherwise good people.

Also, be careful when trying to understand or to manage a complex adaptive system, whether an ecosystem or the economy.

Finally, leaders must develop empathy for people.

Recognize the Role of Skill and Luck

When luck plays a significant role, anticipate reversion to the mean: extreme outcomes are followed by more average outcomes.

Short-term investment results reflect a great deal of randomness.

Get Feedback

Timely, accurate, and clear feedback is central to deliberate practice, which is the path to gaining expertise.  The challenge is that in some fields, like long-term investing, most of the feedback comes with a fairly large time lag.

For investors, it is quite helpful to keep a journal detailing the reasons for every investment decision.  (If you have the time, you can also write down how you feel physically and mentally at the time of each decision.)

 

(Photo by Vinay_Mathew)

A well-kept journal allows you to clearly audit your investment decisions.  Otherwise, most of us will lose any ability to recall accurately why we made the decisions we did.  This predictable memory lossin the absence of careful written recordsis often associated with hindsight bias.

It’s essential to identifyregardless of the outcomewhen you have made a good decision and when you have made a bad decision.  A good decision means that you faithfully followed a solid, proven process.

Another benefit of a well-kept investment journal is that you will start to notice other factors or patterns associated with bad investment decisions.  For instance, too much stress or too much fatigue is often associated with poorer decisions.  On the other hand, a good mood is often associated with overconfident decisions.

Mauboussin mentions a story told by Josh Waitzkin about Tigran Petrosian, a former World Chess Champion:

“When playing matches lasting days or weeks, Petrosian would wake up and sit quietly in his room, carefully assessing his own mood.  He then built his game plan for the day based on that mood, with great success.  A journal can provide a structured tool for similar introspection.”

Create a Checklist

Mauboussin:

When you face a tough decision, you want to be able to think clearly about what you might inadvertently overlook.  That’s where a decision checklist can be beneficial.

Photo by Andrey Popov

Mauboussin again:

A good checklist balances two opposing objectives.  It should be general enough to allow for varying conditions, yet specific enough to guide action.  Finding this balance means a checklist should not be too long; ideally, you should be able to fit it on one or two pages.

If you have yet to create a checklist, try it and see which issues surface.  Concentrate on steps or procedures, and ask where decisions have gone off track before.  And recognize that errors are often the result of neglecting a step, not from executing the other steps poorly.

Perform a Premortem

Mauboussin explains:

You assume you are in the future and the decision you made has failed.  You then provide plausible reasons for that failure.  In effect, you try to identify why your decision might lead to a poor outcome before you make the decision.  Klein’s research shows that premortems help people identify a greater number of potential problems than other techniques and encourage more open exchange, because no one individual or group has invested in a decision yet.

…You can track your individual or group premortems in your decision journal.  Watching for the possible sources of failure may also reveal early signs of trouble.

Know What You Can’t Know

  • In decisions that involve a system with many interacting parts, causal links are frequently unclear…. Remember what Warren Buffet said: ‘Virtually all surprises are unpleasant.’  So considering the worst-case scenarios is vital and generally overlooked in prosperous times.
  • Also, resist the temptation to treat a complex system as if it’s simpler than it is…. We can trace most of the large financial disasters to a model that failed to capture the richness of outcomes inherent in a complex system like the stock market.

Mauboussin notes a paradox with decision making: Nearly everyone realizes its importance, but hardly anyone practices (or keeps a journal).  Mauboussin concludes:

There are common and identifiable mistakes that you can understand, see in your daily affairs, and manage effectively.  In those cases, the correct approach to deciding well often conflicts with what your mind naturally does.  But now that you know when to think twice, better decisions will follow.  So prepare your mind, recognize the context, apply the right techniqueand practice.

 

BOOLE MICROCAP FUND

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

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

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

The 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.

Invest Like Sherlock Holmes

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 16, 2018

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

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

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

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

Top investigative journalists follow a similar method.

Outline for this blog post:

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

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

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

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

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

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

 

THE DETECTIVE AND THE INVESTOR

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

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

How can investors develop better habits?  Hagstrom:

The core premise of this book is that the same mental skills that characterize a good detective also characterize a good investor… To say this another way, the analytical methods displayed by the best fictional detectives are in fact high-level decision-making tools that can be learned and applied to the investment world.

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

Hagstrom asks if it is possible to combine the methods of the three Great Detectives.  If so, what would the ideal detective’s approach to investing be?

First, our investor-detective would have to keep an open mind, be prepared to analyze each new opportunity without any preset opinions.  He or she would be well versed in the basic methods of inquiry, and so would avoid making any premature and possibly inaccurate assumptions.  Of course, our investor-detective would presume that the truth might be hidden below the surface and so would distrust the obvious.  The investor-detective would operate with cool calculation and not allow emotions to distract clear thinking.  The investor-detective would also be able to deconstruct the complex situation into its analyzable parts.  And perhaps most important, our investor-detective would have a passion for truth, and, driven by a nagging premonition that things are not what they seem to be, would keep digging away until all the evidence had been uncovered.

 

AUGUSTE DUPIN

(Illustration—by Frédéric Théodore Lix—to The Purloined Letter, via Wikimedia Commons)

The Murders in the Rue Morgue exemplifies Dupin’s skill as a detective.  The case involves Madame L’Espanaye and her daughter.  Madame L’Espanaye was found behind the house in the yard with multiple broken bones and her head almost severed.  The daughter was found strangled to death and stuffed upside down into a chimney.  The murders occurred in a fourth-floor room that was locked from the inside.  On the floor were a bloody straight razor, several bloody tufts of grey hair, and two bags of gold coins.

Several witnesses heard voices, but no one could say for sure which language it was.  After deliberation, Dupin concludes that they must not have been hearing a human voice at all.  He also dismisses the possibility of robbery, since the gold coins weren’t taken.  Moreover, the murderer would have to possess superhuman strength to stuff the daughter’s body up the chimney.  As for getting into a locked room, the murderer could have gotten in through a window.  Finally, Dupin demonstrates that the daughter could not have been strangled by a human hand.  Dupin concludes that Madame L’Espanaye and her daughter were killed by an orangutan.

Dupin places an advertisement in the local newspaper asking if anyone had lost an orangutan.  A sailor arrives looking for it.  The sailor explains that he had seen the orangutan with a razor, imitating the sailor shaving.  The orangutan had then fled.  Once it got into the room with Madame L’Espanaye and her daughter, the orangutan probably grabbed Madame’s hair and was waving the razor, imitating a barber.  When the woman screamed in fear, the orangutan grew furious and killed her and her daughter.

Thus Dupin solves what at first seemed like an impossible case.  The solution is completely unexpected but is the only logical possibility, given all the facts.

Hagstrom writes that investors can learn important lessons from the Great Detective Auguste Dupin:

First, look in all directions, observe carefully and thoughtfully everything you see, and do not make assumptions from inadequate information.  On the other hand, do not blindly accept what you find.  Whatever you read, hear, or overhear about a certain stock or company may not necessarily be true.  Keep on with your research;  give yourself time to dig beneath the surface.

If you’re a small investor, it’s often best to invest in microcap stocks.  (This presumes that you have access to a proven investment process.)  There are hundreds of tiny companies much too small for most professional investors even to consider.  Thus, there is much more mispricing among micro caps.  Moreover, many microcap companies are relatively easy to analyze and understand.  (The Boole Microcap Fund invests in microcap companies.)

 

JONATHAN LAING AND SUNBEAM

(Sunbeam logo, via Wikimedia Commons)

Hagstrom writes that, in the spring of 1997, Wall Street was in love with the self-proclaimed ‘turnaround genius’ Al Dunlap.  Dunlap was asked to take over the troubled Sunbeam Corporation, a maker of electric home appliances.  Dunlap would repeat the strategy he used on previous turnarounds:

[Drive] up the stock price by any means necessary, sell the company, and cash in his stock options at the inflated price.

Although Dunlap made massive cost cuts, some journalists were skeptical, viewing Sunbeam as being in a weak competitive position in a harsh industry.  Jonathan Laing of Barron’s, in particular, took a close look at Sunbeam.  Laing focused on accounting practices:

First, Laing pointed out that Sunbeam took a huge restructuring charge ($337 million) in the last quarter of 1996, resulting in a net loss for the year of $228.3 million.  The charges included moving reserves from 1996 to 1997 (where they could later be recharacterized as income);  prepaying advertising expenses to make the new year’s numbers look better;  a suspiciously high charge for bad-debt allowance;  a $90 million write-off for inventory that, if sold at a later date, could turn up in future profits;  and write-offs for plants, equipment, and trademarks used by business lines that were still operating.

To Laing, it looked very much like Sunbeam was trying to find every possible way to transfer 1997 projected losses to 1996 (and write 1996 off as a lost year, claiming it was ruined by previous management) while at the same time switching 1996 income into 1997…

(Photo by Evgeny Ivanov)

Hagstrom continues:

Even though Sunbeam’s first-quarter 1997 numbers did indeed show a strong increase in sales volume, Laing had collected evidence that the company was engaging in the practice known as ‘inventory stuffing’—getting retailers to place abnormally large orders either through high-pressure sales tactics or by offering them deep discounts (using the written-off inventory from 1996).  Looking closely at Sunbeam’s financial reports, Laing also found a hodgepodge of other maneuvers designed to boost sales numbers, such as delaying delivery of sales made in 1996 so they could go on the books as 1997 sales, shipping more units than the customer had actually ordered, and counting as sales orders that had already been canceled.

The bottom line was simply that much of 1997’s results would be artificial.  Hagstrom summarizes the lesson from Dupin and Laing:

The core lesson for investors here can be expressed simply:  Take nothing for granted, whether it comes from the prefect of police or the CEO of a major corporation.  This is, in fact, a key theme of this chapter.  If something doesn’t make sense to you—no matter who says it—that’s your cue to start digging.

By July 1998, Sunbeam stock had lost 80 percent of its value and was lower than when Dunlap took over.  The board of directors fired Dunlap and admitted that its 1997 financial statements were unreliable and were being audited by a new accounting firm.  In February 2001, Sunbeam filed for Chapter 11 bankruptcy protection.  On May 15, 2001, the Securities and Exchange Commission filed suit against Dunlap and four senior Sunbeam executives, along with their accounting firm, Arthur Andersen.  The SEC charged them with a fraudulent scheme to create the illusion of a successful restructuring.

Hagstrom points out what made Laing successful as an investigative journalist:

He read more background material, dissected more financial statements, talked to more people, and painstakingly pieced together what many others failed to see.

 

TOP INVESTIGATIVE JOURNALISTS

Hagstrom mentions Professor Linn B. Washington, Jr., a talented teacher and experienced investigative reporter.  (Washington was awarded the Robert F. Kennedy Prize for his series of articles on drug wars in the Richard Allen housing project.)  Hagstrom quotes Washington:

Investigative journalism is not a nine-to-five job.  All good investigative journalists are first and foremost hard workers.  They are diggers.  They don’t stop at the first thing they come to but rather they feel a need to persist.  They are often passionate about the story they are working on and this passion helps fuel the relentless pursuit of information.  You can’t teach that.  They either have it or they don’t.

…I think most reporters have a sense of morality.  They are outraged by corruption and they believe their investigations have a real purpose, an almost sacred duty to fulfill.  Good investigative reporters want to right the wrong, to fight for the underdog.  And they believe there is a real responsibility attached to the First Amendment.

(Photo by Robyn Mackenzie)

Hagstrom then refers to The Reporter’s Handbook, written by Steve Weinberg for investigative journalists.  Weinberg maintains that gathering information involves two categories: documents and people.  Hagstrom:

Weinberg asks readers to imagine three concentric circles.  The outmost one is ‘secondary sources,’ the middle one ‘primary sources.’  Both are composed primarily of documents.  The inner circle, ‘human sources,’ is made up of people—a wide range of individuals who hold some tidbit of information to add to the picture the reporter is building.

Ideally, the reporter starts with secondary sources and then primary sources:

At these two levels of the investigation, the best reporters rely on what has been called a ‘documents state of mind.’  This way of looking at the world has been articulated by James Steele and Donald Bartlett, an investigative team from the Philadephia Inquirer.  It means that the reporter starts from day one with the belief that a good record exists somewhere, just waiting to be found.

Once good background knowledge is accumulated from all the primary and secondary documents, the reporter is ready to turn to the human sources…

Photo by intheskies

Time equals truth:

As they start down this research track, reporters also need to remember another vital concept from the handbook:  ‘Time equals truth.’  Doing a complete job of research takes time, whether the researcher is a reporter following a story or an investor following a company—or for that matter, a detective following the evidence at a crime scene.  Journalists, investors, and detectives must always keep in mind that the degree of truth one finds is directly proportional to the amount of time one spends in the search.  The road to truth permits no shortcuts.

The Reporter’s Handbook also urges reporters to question conventional wisdom, to remember that whatever they learn in their investigation may be biased, superficial, self-serving for the source, or just plain wrong.  It’s another way of saying ‘Take nothing for granted.’  It is the journalist’s responsibility—and the investor’s—to penetrate the conventional wisdom and find what is on the other side.

The three concepts discussed above—‘adopt a documents state of mind,’ ‘time equals truth,’ and ‘question conventional wisdom;  take nothing for granted’—may be key operating principles for journalists, but I see them also as new watchwords for investors.

 

EDNA BUCHANAN—PULITZER PRIZE WINNER

Edna Buchanan, working for the Miami Herald and covering the police beat, won a Pulitzer Prize in 1986.  Hagstrom lists some of Buchanan’s principles:

  • Do a complete background check on all the key players.  Find out how a person treats employees, women, the environment, animals, and strangers who can do nothing for them.  Discover if they have a history of unethical and/or illegal behavior.
  • Cast a wide net.  Talk to as many people as you possibly can.  There is always more information.  You just have to find it.  Often that requires being creative.
  • Take the time.  Learning the truth is proportional to the time and effort you invest.  There is always more that you can do.  And you may uncover something crucial.  Never take shortcuts.
  • Use common sense.  Often official promises and pronouncements simply don’t fit the evidence.  Often people lie, whether due to conformity to the crowd, peer pressure, loyalty (like those trying to protect Nixon et al. during Watergate), trying to protect themselves, fear, or any number of reasons.  As for investing, some stories take a long time to figure out, while other stories (especially for tiny companies) are relatively simple.
  • Take no one’s word.  Find out for yourself.  Always be skeptical and read between the lines.  Very often official press releases have been vetted by lawyers and leave out critical information.  Take nothing for granted.
  • Double-check your facts, and then check them again.  For a good reporter, double-checking facts is like breathing.  Find multiples sources of information.  Again, there are no shortcuts.  If you’re an investor, you usually need the full range of good information in order to make a good decision.

In most situations, to get it right requires a great deal of work.  You must look for information from a broad range of sources.  Typically you will find differing opinions.  Not all information has the same value.  Always be skeptical of conventional wisdom, or what ‘everybody knows.’

 

SHERLOCK HOLMES

Image by snaptitude

Sherlock Holmes approaches every problem by following three steps:

  • First, he makes a calm, meticulous examination of the situation, taking care to remain objective and avoid the undue influence of emotion.  Nothing, not even the tiniest detail, escapes his keen eye.
  • Next, he takes what he observes and puts it in context by incorporating elements from his existing store of knowledge.  From his encyclopedic mind, he extracts information about the thing observed that enables him to understand its significance.
  • Finally, he evaluates what he observed in the light of this context and, using sound deductive reasoning, analyzes what it means to come up with the answer.

These steps occur and re-occur in an iterative search for all the facts and for the best hypothesis.

There was a case involving a young doctor, Percy Trevelyan.  Some time ago, an older gentleman named Blessington offered to set up a medical practice for Trevelyan in return for a share of the profits.  Trevelyan agreed.

A patient suffering from catalepsy—a specialty of the doctor—came to the doctor’s office one day.  The patient also had his son with him.  During the examination, the patient suffered a cataleptic attack.  The doctor ran from the room to grab the treatment medicine.  But when he got back, the patient and his son were gone.  The two men returned the following day, giving a reasonable explanation for the mix-up, and the exam continued.  (On both visits, the son had stayed in the waiting room.)

Shortly after the second visit, Blessington burst into the exam room, demanding to know who had been in his private rooms.  The doctor tried to assure him that no one had.  But upon going to Blessington’s room, he saw a strange set of footprints.  Only after Trevelyan promises to bring Sherlock Holmes to the case does Blessington calm down.

Holmes talks with Blessington.  Blessington claims not to know who is after him, but Holmes can tell that he is lying.  Holmes later tells his assistant Watson that the patient and his son were fakes and had some sinister reason for wanting to get Blessington.

Holmes is right.  The next morning, Holmes and Watson are called to the house again.  This time, Blessington is dead, apparently having hung himself.

But Holmes deduces that it wasn’t a suicide but a murder.  For one thing, there were four cigar butts found in the fireplace, which led the policeman to conclude that Blessington had stayed up late agonizing over his decision.  But Holmes recognizes that Blessington’s cigar is a Havana, but the other three cigars had been imported by the Dutch from East India.  Furthermore, two had been smoked from a holder and two without.  So there were at least two other people in the room with Blessington.

Holmes does his usual very methodical examination of the room and the house.  He finds three sets of footprints on the stairs, clearly showing that three men had crept up the stairs.  The men had forced the lock, as Holmes deduced from scratches on it.

Holmes also realized the three men had come to commit murder.  There was a screwdriver left behind.  And he could further deduce (by the ashes dropped) where each man sat as the three men deliberated over how to kill Blessington.  Eventually, they hung Blessington.  Two killers left the house and the third barred the door, implying that the third murderer must be a part of the doctor’s household.

All these signs were visible:  the three sets of footprints, the scratches on the lock, the cigars that were not Blessington’s type, the screwdriver, the fact that the front door was barred when the police arrived.  But it took Holmes to put them all together and deduce their meaning:  murder, not suicide.  As Holmes himself remarked in another context, ‘The world is full of obvious things which nobody by any chance ever observes.’

…He knows Blessington was killed by people well known to him.  He also knows, from Trevelyan’s description, what the fake patient and his son look like.  And he has found a photograph of Blessington in the apartment.  A quick stop at policy headquarters is all Holmes needs to pinpoint their identity.  The killers, no strangers to the police, were a gang of bank robbers who had gone to prison after being betrayed by their partner, who then took off with all the money—the very money he used to set Dr. Trevelyan up in practice.  Recently released from prison, the gang tracked Blessington down and finally executed him.

Spelled out thus, one logical point after another, it seems a simple solution.  Indeed, that is Holmes’s genius:  Everything IS simple, once he explains it.

Hagstrom then adds:

Holmes operates from the presumption that all things are explainable;  that the clues are always present, awaiting discovery. 

The first step—gathering all the facts—usually requires a great deal of careful effort and attention.  One single fact can be the key to deducing the true hypothesis.  The current hypothesis is revisable if there may be relevant facts not yet known.  Therefore, a heightened degree of awareness is always essential.  With practice, a heightened state of alertness becomes natural for the detective (or the investor).

“Details contain the vital essence of the whole matter.” — Sherlock Holmes

Moreover, it’s essential to keep emotion out of the process of discovery:

One reason Holmes is able to see fully what others miss is that he maintains a level of detached objectivity toward the people involved.  He is careful not to be unduly influenced by emotion, but to look at the facts with calm, dispassionate regard.  He sees everything that is there—and nothing that is not.  For Holmes knows that when emotion seeps in, one’s vision of what is true can become compromised.  As he once remarked to Dr. Watson, ‘Emotional qualities are antagonistic to clear reasoning… Detection is, or ought to be, an exact science and should be treated in the same cold and unemotional manner.  You have attempted to tinge it with romanticism, which produces much the same effect as if you worked a love story or an elopement into the fifth proposition of Euclid.’

Image by snaptitude

Holmes himself is rather aloof and even antisocial, which helps him to maintain objectivity when collecting and analyzing data.

‘I make a point of never having any prejudices and of following docilely wherever fact may lead me.’  He starts, that is, with no preformed idea, and merely collects data.  But it is part of Holmes’s brilliance that he does not settle for the easy answer.  Even when he has gathered together enough facts to suggest one logical possibility, he always knows that this answer may not be the correct one.  He keeps searching until he has found everything, even if subsequent facts point in another direction.  He does not reject the new facts simply because they’re antithetical to what he’s already found, as so many others might.

Hagstrom observes that many investors are susceptible to confirmation bias:

…Ironically, it is the investors eager to do their homework who may be the most susceptible.  At a certain point in their research, they have collected enough information that a pattern becomes clear, and they assume they have found the answer.  If subsequent information then contradicts that pattern, they cannot bring themselves to abandon the theory they worked so hard to develop, so they reject the new facts.

Gathering information about an investment you are considering means gather all the information, no matter where it ultimately leads you.  If you find something that does not fit your original thesis, don’t discard the new information—change the thesis.

 

ARTHUR CONAN DOYLE

Arthur Conan Doyle was a Scottish doctor.  One of his professors, Dr. Bell, challenged his students to hone their skills of observation.  Bell believed that a correct diagnosis required alert attention to all aspects of the patient, not just the stated problem.  Doyle later worked for Dr. Bell.  Doyle’s job was to note the patients’ problem along with all possibly relevant details.

Doyle had a very slow start as a doctor.  He had virtually no patients.  He spent his spare time writing, which he had loved doing since boarding school.  Doyle’s main interest was historical fiction.  But he didn’t get much money from what he wrote.

One day he wrote a short novel, A Study in Scarlet, which introduced a private detective, Sherlock Holmes.  Hagstrom quotes Doyle:

I thought I would try my hand at writing a story where the hero would treat crime as Dr. Bell treated disease, and where science would take the place of chance.

Doyle soon realized that he might be able to sell short stories about Sherlock Holmes as a way to get some extra income.  Doyle preferred historical novels, but his short stories about Sherlock Holmes started selling surprisingly well.  Because Doyle continued to emphasize historical novels and the practice of medicine, he demanded higher and higher fees for his short stories about Sherlock Holmes.  But the stories were so popular that magazine editors kept agreeing to the fee increases.

Photo by davehanlon

Soon thereafter, Doyle, having hardly a single patient, decided to abandon medicine and focus on writing.  Doyle still wanted to do other types of writing besides the short stories.  He asked for a very large sum for the Sherlock Holmes stories so that the editors would stop bothering him.  Instead, the editors immediately agreed to the huge fee.

Many years later, Doyle was quite tired of Holmes and Watson after having written fifty-six short stories and four novels about them.  But readers never could get enough.  And the stories are still highly popular to this day, which attests to Doyle’s genius.  Doyle has always been credited with launching the tradition of the scientific sleuth.

 

HOLMES ON WALL STREET

Sherlock Holmes is the most famous Great Detective for good reason.  He is exceptionally thorough, unemotional, and logical.

Holmes knows a great deal about many different things, which is essential in order for him to arrange and analyze all the facts:

The list of things Holmes knows about is staggering:  the typefaces used by different newspapers, what the shape of a skull reveals about race, the geography of London, the configuration of railway lines in cities versus suburbs, and the types of knots used by sailors, for a few examples.  He has authored numerous scientific monographs on such topics as tattoos, ciphers, tobacco ash, variations in human ears, what can be learned from typewriter keys, preserving footprints with plaster of Paris, how a man’s trade affects the shape of his hands, and what a dog’s manner can reveal about the character of its owner.

(Illustration of Sherlock Holmes with various tools, by Elena Kreys)

Consider what Holmes says about his monograph on the subject of tobacco:

“In it I enumerate 140 forms of cigar, cigarette, and pipe tobacco… It is sometimes of supreme importance as a clue.  If you can say definitely, for example, that some murder has been done by a man who was smoking an Indian lunkah, it obviously narrows your field of search.”

It’s very important to keep gathering and re-gathering facts to ensure that you haven’t missed anything.  Holmes:

“It is a capital mistake to theorize before you have all the evidence.  It biases the judgment.”

“The temptation to form premature theories upon insufficient data is the bane of our profession.”

Although gathering all facts is essential, at the same time, you must be organizing those facts since not all facts are relevant to the case at hand.  Of course, this is an iterative process. You may discard a fact as irrelevant and realize later that it is relevant.

Part of the sorting process involves a logical analysis of various combinations of facts.  You reject combinations that are logically impossible.  As Holmes famously said:

“When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”

Often there is more than one logical possibility that is consistent with the known facts.  Be careful not to be deceived by obvious hypotheses.  Often what is ‘obvious’ is completely wrong.

Sometimes finding the solution requires additional research.  Entertaining several possible hypotheses may also be required.  Holmes:

“When you follow two separate chains of thought you will find some point of intersection which should approximate to the truth.”

But be careful to keep facts and hypotheses separate, as Holmes asserts:

“The difficulty is to detach the frame of absolute undeniable facts from the embellishments of theorists.  Then, having established ourselves upon this sound basis, it is our duty to see what inferences may be drawn and what are the special points upon which the whole mystery turns.”

For example, there was a case involving the disappearance of a valuable racehorse.  The chief undeniable fact was that the dog did not bark, which meant that the intruder had to be familiar to the dog.

Sherlock Holmes As Investor

How would Holmes approach investing?  Hagstrom:

Here’s what we know of his methods:  He begins an examination with an objective mind, untainted by prejudice.  He observes acutely and catalogues all the information, down to the tiniest detail, and draws on his broad knowledge to put those details into context.  Then, armed with the facts, he walks logically, rationally, thoughtfully toward a conclusion, always on the lookout for new, sometimes contrary information that might alter the outcome.

It’s worth repeating that much of the process of gathering facts can be tedious and boring.  This is the price you must pay to ensure you get all the facts.  Similarly, analyzing all the facts often requires patience and can take a long time.  No shortcuts.

 

FATHER BROWN

Hagstrom opens the chapter with a scene in which Aristide Valentin—head of Paris police and the most famous investigator in Europe—is chasing Hercule Flambeau, a wealthy and famous French jewel thief.  Both Valentin and Flambeau are on the same train.  But Valentin gets distracted by the behavior of a very short Catholic priest with a round face.  The priest is carrying several brown paper parcels, and he keeps dropping one or the other, or dropping his umbrella.

When the train reaches London, Valentin isn’t exactly sure where Flambeau went.  So Valentin decides to go systematically to the ‘wrong places.’  Valentin ends up at a certain restaurant that caught his attention.  A sugar bowl has salt in it, while the saltcellar contains sugar.  He learns from a waiter that two clergymen had been there earlier, and that one had thrown a half-empty cup of soup against the wall.  Valentin inquires which way the priests went.

Valentin goes to Carstairs Street.  He passes a greengrocer’s stand where the signs for oranges and nuts have been switched.  The owner is still upset about a recent incident in which a parson knocked over his bin of apples.

Valentin keeps looking and notices a restaurant that has a broken window.  He questions the waiter, who explains to him that two foreign parsons had been there.  Apparently, they overpaid.  The waiter told the two parsons of their mistake, at which point one parson said, ‘Sorry for the confusion.  But the extra amount will pay for the window I’m about to break.’  Then the parson broke the window.

Valentin finally ends up in a public park, where he sees two men, one short and one tall, both wearing clerical garb.  Valentin approaches and recognizes that the short man is the same clumsy priest from the train.  The short priest suspected all along that the tall man was not a priest but a criminal.  The short priest, Father Brown, had left the trail of hints for the police.  At that moment, even without turning around, Father Brown knew the police were nearby ready to arrest Flambeau.

Father Brown was invented by G. K. Chesterton.  Father Brown is very compassionate and has deep insight into human psychology, which often helps him to solve crimes.

He knows, from hearing confessions and ministering in times of trouble, how people act when they have done something wrong.  From observing a person’s behavior—facial expressions, ways of walking and talking, general demeanor—he can tell much about that person.  In a word, he can see inside someone’s heart and mind, and form a clear impression about character…

His feats of detection have their roots in this knowledge of human nature, which comes from two sources:  his years in the confessional, and his own self-awareness.  What makes Father Brown truly exceptional is that he acknowledges the capacity for evildoing in himself.  In ‘The Hammer of God’ he says, ‘I am a man and therefore have all devils in my heart.’

Because of this compassionate understanding of human weakness, from both within and without, he can see into the darkest corners of the human heart.  The ability to identify with the criminal, to feel what he is feeling, is what leads him to find the identity of the criminal—even, sometimes, to predict the crime, for he knows the point at which human emotions such as fear or jealousy tip over from acceptable expression into crime.  Even then, he believes in the inherent goodness of mankind, and sets the redemption of the wrongdoer as his main goal.

While Father Brown excels in understanding human psychology, he also excels at logical analysis of the facts.  He is always open to alternative explanations.

(Frontispiece to G. K. Chesterton’s The Wisdom of Father Brown, Illustration by Sydney Semour Lucas, via Wikimedia Commons)

Later the great thief Flambeau is persuaded by Father Brown to give up a life of crime and become a private investigator.  Meanwhile, Valentin, the famous detective, turns to crime and nearly gets away with murder.  Chesterton loves such ironic twists.

Chesterton was a brilliant writer who wrote in an amazing number of different fields.  Chesterton was very compassionate, with a highly developed sense of social justice, notes Hagstrom.  The Father Brown stories are undoubtedly entertaining, but they also deal with questions of justice and morality.  Hagstrom quotes an admirer of Chesterton, who said:  ‘Sherlock Holmes fights criminals;  Father Brown fights the devil.’  Whenever possible, Father Brown wants the criminal to find redemption.

Hagstrom lists what could be Father Brown’s investment guidelines:

  • Look carefully at the circumstances;  do whatever it takes to gather all the clues.
  • Cultivate the understanding of intangibles.
  • Using both tangible and intangible evidence, develop such a full knowledge of potential investments that you can honestly say you know them inside out.
  • Trust your instincts.  Intuition is invaluable.
  • Remain open to the possibility that something else may be happening, something different from that which first appears; remember that the full truth may be hidden beneath the surface.

Hagstrom mentions that psychology can be useful for investing:

Just as Father Brown’s skill as an analytical detective was greatly improved by incorporating the study of psychology with the method of observations, so too can individuals improve their investment performance by combining the study of psychology with the physical evidence of financial statement analysis.

 

HOW TO BECOME A GREAT DETECTIVE

Hagstrom lists the habits of mind of the Great Detectives:

Auguste Dupin

  • Develop a skeptic’s mindset;  don’t automatically accept conventional wisdom.
  • Conduct a thorough investigation.

Sherlock Holmes

  • Begin an investigation with an objective and unemotional viewpoint.
  • Pay attention to the tiniest details.
  • Remain open-minded to new, even contrary, information.
  • Apply a process of logical reasoning to all you learn.

Father Brown

  • Become a student of psychology.
  • Have faith in your intuition.
  • Seek alternative explanations and re-descriptions.

Hagstrom argues that these habits of mind, if diligently and consistently applied, can help you to do better as an investor over time.

Furthermore, the true hero is reason, a lesson directly applicable to investing:

As I think back over all the mystery stories I have read, I realize there were many detectives but only one hero.  That hero is reason.  No matter who the detective was—Dupin, Holmes, Father Brown, Nero Wolfe, or any number of modern counterparts—it was reason that solved the crime and captured the criminal.  For the Great Detectives, reason is everything.  It controls their thinking, illuminates their investigation, and helps them solve the mystery.

Illustration by yadali

Hagstrom continues:

Now think of yourself as an investor.  Do you want greater insight about a perplexing market?  Reason will clarify your investment approach.

Do you want to escape the trap of irrational, emotion-based action and instead make decisions with calm deliberation?  Reason will steady your thinking.

Do you want to be in possession of all the relevant investment facts before making a purchase?  Reason will help you uncover the truth.

Do you want to improve your investment results by purchasing profitable stocks?  Reason will help you capture the market’s mispricing.

In sum, conduct a thorough investigation.  Painstakingly gather all the facts and keep your emotions entirely out of it.  Skeptically question conventional wisdom and ‘what is obvious.’  Carefully use logic to reason through possible hypotheses.  Eliminate hypotheses that cannot explain all the facts.  Stay open to new information and be willing to discard the best current hypothesis if new facts lead in a different direction.  Finally, be a student of psychology.

 

BOOLE MICROCAP FUND

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

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

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

The 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.

Kahneman and Tversky

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 2, 2018

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

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

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

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

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

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

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

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

(Illustration by Alain Lacroix)

 

INTRODUCTION

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

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

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

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

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

 

MAN BOOBS

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

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

Lewis continues:

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

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

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

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

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

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

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

(Illustration by fotomek)

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

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

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

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

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

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

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

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

 

THE OUTSIDER

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

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

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

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

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

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

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

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

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

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

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

Lewis continues:

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

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

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

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

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

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

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

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

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

 

THE INSIDER

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(Transitivity illustration by Thuluviel, Wikimedia Commons)

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

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

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

This line of thinking led to some interesting insights:

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

 

ERRORS

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

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

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

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

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

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

Illustration by intheskies

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

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

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

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

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

 

THE COLLISION

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

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

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

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

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

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

Were human beings good intuitive statisticians?

(Image by Honina, Wikimedia Commons)

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

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

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

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

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

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

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

Lewis later writes:

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

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

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

 

THE MIND’S RULES

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

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

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

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

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

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

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

(Algorithm illustration by Blankstock)

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

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

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

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

“We were sharing a mind.”

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

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

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

(Image by Argus)

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

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

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

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

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

 

THE RULES OF PREDICTION

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

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

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

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

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

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

As Amos said:

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

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

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

Image by Zerophoto

 

GOING VIRAL

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

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

[…]

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

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

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

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

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

Photo by airdone

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

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

Amos and Redelmeier ended up doing a paper:

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

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

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

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

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

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

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

 

BIRTH OF THE WARRIOR PSYCHOLOGIST

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

THE ISOLATION EFFECT

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

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

Which of the following do you prefer?

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

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

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

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

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

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

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

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

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

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

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

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

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

Which of the two programs would you favor?

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

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

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

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

 

THIS CLOUD OF POSSIBILITY

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

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

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

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

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

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

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

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

Which of the two alternatives is more probable?

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

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

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

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

Lewis:

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

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

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

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

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

 

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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.)

August 19, 2018

Shoe Dog is the autobiography of Phil Knight, the creator of Nike.  Bill 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.”

After the introduction, Knight has a chapter for each year, starting in 1962 and going through 1980.

 

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.

(Sweet Sixteen Syracuse vs. Gonzaga, March 25, 2016, Photo by Ryan Dickey, Wikimedia Commons)

Knight continues:

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.

(Runner silhouette, Illustration by Msanca)

Knight:

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.

 

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.

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.

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?

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.

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.’

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…

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.

(Emerald Buddha at Wat Phra Kaew, Image by J. P. Swimmer, Wikimedia Commons)

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, Lead 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.

(Great Sphinx of Giza, Photo by Johnny 201, Wikimedia Commons)

Then 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.

(The Louvre, Photo by Pipiten, Wikimedia Commons)

Then to 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.

Next, 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.

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.

(Temple of Athena Nike, Photo by Steve Swayne, Wikimedia Commons)

 

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.

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.

(Statue of Bill Bowerman, Photo by Diane Lee Jackson, Wikimedia Commons)

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.

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.

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.

(Illustration by Lkeskinen0)

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 2018 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…’

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.’

Knight ordered $3,400 worth of shoes [about $26,000 in 2018 dollars].

(Mount Fuji, Photo by Wipark Kulnirandorn)

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…

Eventually Johnson realized he loved shoes and running more than anthropology or social work.

(Monk meditating, Photo by Ittipon)

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…

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 2018 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.

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.

(First National Bank of Oregon, Photo by Steve Morgan, Wikimedia Commons)

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.

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.

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.

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.” 

(Winston Churchill in 1944, Wikimedia Commons)

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.

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…

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.

(Jeff Johnson, Employee Number One)

Johnson’s apartment was 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 2018 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.

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.

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.

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.”

(Bob Woodell 1967)

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.

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.

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.  Knight met a man named Fujimoto at the picnic.  It turned out to be another life-altering partnership.

…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.

(Cherry trees in Japan, Photo by Nathapon Triratanachat)

 

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 what 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 checked 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?

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.

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.

(Nike logo, Timidonfire, Wikimedia Commons)

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.”

(Nike logo, Wikimedia Commons)

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 takes 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…

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.

 

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.’

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.’

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.’

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.

(Steve Prefontaine)

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.

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.

 

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?

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.

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.

(Law library, Photo by Spiroview Inc.)

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.

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…

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.

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.

(Federal courthouse in Portland, Oregon, Wikimedia Commons)

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.”

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 trial 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.

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.

Demand was always greater than sales, so Knight concluded his approach was reasonable.  There was a new manager at Nissho’s Portland office, Tadayuki Ito, 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.

(Illustration by Lkeskinen0)

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 2018), 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.

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.

(Samurai, Photo by Esolex)

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.

(Nike 1976 waffle trainer)

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.

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.

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.

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.

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.

(Photo by Chris Dorney)

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…

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.

(Photo by Ian Wilson)

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.

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.

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.”

 

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.

 

BOOLE MICROCAP FUND

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

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

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

The 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.