There’s Always Something to Do

(Image:  Zen Buddha Silence by Marilyn Barbone.)

March 18, 2018

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

Here is an outline for this blog post:

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



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

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

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

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

We do liquidation analysis and liquidation analysis only.



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

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

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



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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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



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

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



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

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



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

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

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



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

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

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

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

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



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

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

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

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



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

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

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

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

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

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

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

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



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

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

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

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

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

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

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



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

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

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

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



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


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


Patience, patience, and more patience…


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


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


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


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


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


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


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


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



Here are some of the terms.


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

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


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


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

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


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


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


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

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


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

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

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

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


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

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

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


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

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

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


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


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

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

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


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

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


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


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


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


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


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


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


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

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

We do liquidation analysis and liquidation analysis only.

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

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

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


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

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



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:

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:




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

The Art of Value Investing

(Image:  Zen Buddha Silence by Marilyn Barbone.)

March 11, 2018

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

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

  • Margin of Safety
  • Humility, Flexibility, and Patience
  • “Can’t Lose”: Shorting the U.S. Stock Market
  • “Can’t Lose”: Shorting the Japanese Yen
  • Courage
  • Cigar-Butt’s
  • Opportunities in Micro Caps
  • Predictable Human Irrationality
  • Long-Term Time Horizon
  • Screening and Quantitative Models



(Ben Graham, by Equim43)

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

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

Value investing legend Seth Klarman:

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

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

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



(Image by Wilma64)

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

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

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

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

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

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

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

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

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

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



(Illustration by Eti Swinford)

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

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

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

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

However, no one has ever been able to predict the stock market.  But if you follow the advice of most great value investors, you just focus on investing in individual businesses that you can understand.  There’s no need to try to predict the unpredictable.

That’s not to say there won’t be a large drop in the S&P 500 Index at some point.  But Napier was arguing—starting even before 2012—that the S&P 500 Index was overvalued at levels around 1200-1500 and that it would fall possibly as low as 400.  It’s now roughly six years later and the S&P 500 Index has recently exceeded 2700-2800.  Moreover, Jeremy Grantham, an expert on bubbles and fully aware of arguments by bears like Napier, has recently suggested the S&P 500 Index could exceed 3400-3700 before any serious break.

If the market exceeds 3400 or 3700 and then falls to 1700-2000, Napier still wouldn’t be right because he originally suggested a fall from 1200-1500 towards levels near 400.  Napier is one of the smartest market historians in the world.  This demonstrates that no one has ever been able to predict the stock market.  That’s what great value investors—including Ben Graham, Henry Singleton, Warren Buffett, Charlie Munger, Peter Lynch, and Seth Klarman—have always maintained.

The basic reason the stock market can’t be predicted is that the economy changes and evolves over time.

  • For example, Fed policy in recent decades has been to keep interest rates quite low for years in order to prevent deflation.  Very low rates cause stocks to be much higher than otherwise.
  • Profit margins are arguably higher to the extent that software (and related technologies) has become much more important in the U.S. and global economy.  The five largest U.S. companies are Google, Apple, Microsoft, Facebook, and Amazon, all technology companies.  Lower corporate taxes are likely giving a further boost to profit margins.

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

Recently, in June 2017, Grantham has revised his view again.  See:—i-do-indeed-believe-the-us-market-will-revert-toward-its-old-means-just-very-slowly

Grantham says mean reversion for profit margins and for the CAPE (cyclically adjusted P/E) is likely, but will probably take 20 years rather than 7 years (which previously was sufficient for mean reversion).  That’s because the factors that support margins and the CAPE are themselves changing very slowly.  Those factors include Fed policy including moral hazard, lower interest rates, an aging population, slower growth, productivity, and increased political and monopoly power for corporations.

In January 2018, Grantham updated his view yet again:—bracing-yourself-for-a-possible-near-term-melt-up.pdf?sfvrsn=4

Grantham now asserts that a market melt-up is likely over the next 6 months to 2 years.  Grantham suggests that the S&P 500 Index will exceed 3400 or 3700.  Prices are already high, but few of the usual signs of euphoria are present, which is why Grantham thinks the S&P 500 Index is not quite back to bubble territory.

The historian has to emphasize the big picture: In general are investors getting clearly carried away?  Are prices accelerating?  Is the market narrowing?  And, are at least some of the other early warnings from the previous great bubbles falling into place?

(Image by joshandandreaphotography)

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

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

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

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

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

In 1963, Graham gave a lecture, “Securities in an Insecure World.”  Link:

In the lecture, Graham admits that the Graham P/E—based on ten-year average earnings of the Dow components—was much too conservative.  Graham:

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

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

Similar logic can be applied to the S&P 500 Index today—at just over 2783.  Fed policy including moral hazard, lower interest rates, an aging population, slower growth, productivity, and increased political and monopoly power for corporations are all factors in the S&P 500 being quite high.  But Grantham is most likely right that there won’t be a true bubble until there are more signs of investors getting carried away.  Grantham reminds readers that a bubble is “Excellent Fundamentals Euphorically Extrapolated.”  Now that the global economy is doing nicely, this condition for a true bubble is now in place.

None of this suggests that an investor should attempt market timing.  Value investors can still find individual stock that are undervalued, even though there are fewer today than a few years ago.  But trying to time the market itself has almost never worked except by luck.  This has not only been observed by Graham.  But it’s also been pointed out by Peter Lynch, Seth Klarman, Henry Singleton, and Warren Buffett.  Peter Lynch is one of the best investors.  Klarman is even better.  Buffett is arguably the best.  And Singleton was even smarter than Buffett.

(Illustration by Maxim Popov)

Peter Lynch:

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

Seth Klarman:

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

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

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

There are always naysayers making bearish predictions.  But anyone who owned an S&P 500 index fund from 2007 to present (early 2018) would have done dramatically better than most of those who listened to naysayers.  Buffett:

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

Buffett himself made a 10-year wager against a group of talented hedge fund (and fund of hedge fund) managers.  The S&P 50 Index fund trounced the super-smart hedge funds.  See:

Some very able investors have stayed largely in cash since 2011-2012.  The S&P 500 Index has more than doubled since then.  Moreover, many have tried to short the U.S. stock market since 2011-2012.  Some are down 50 percent or more, while the S&P 500 Index has more than doubled.  The net result of that combination is to be at only 15-25% of the S&P 500’s current value.

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

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

Warren Buffett puts it best:

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



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

(Illustration by Shalom3)

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

Seth Klarman on humility:

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

Klarman on the vital importance of doubt:

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

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

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

Spencer Davidson:

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

Jeffrey Bronchick:

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

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

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



(Courage concept by Travelling-light)

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

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

Graham again:

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

Or as Carlo Cannell says:

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

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

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

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

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



(Photo by Leung Cho Pan)

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

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

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

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

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



(Illustration by Mopic)

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

James Vanasek on the opportunity in micro caps:

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

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

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

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

Robert Robotti adds:

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



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

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

Quantitative value investor James O’Shaugnessy:

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

Bryan Jacoboski:

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

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

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

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

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

(Image by Aleksey Vanin)

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

Invert, always invert.

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

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

When it comes to checklists, it’s helpful to have a list of cognitive biases.  Here’s my list:

Munger’s list is more comprehensive:

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

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

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

John Dorfman on investors overreacting to recent news:

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



(Illustration by Marek)

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

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

Mario Cibelli:

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

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

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

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

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

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

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


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

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

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

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

Whitney George:

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

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

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



(Word cloud by Arloofs)

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

Will Browne:

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

Stephen Goddard:

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

Carlo Cannell:

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

For some time now, it has been clear that simple quant models outperform experts in a wide variety of areas:

Quantitative value investor James O’Shaugnessy:

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

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

Buffett maintains (correctly) that the vast majority of investors, large or small, should invest in low-cost broad market index funds:

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

Will Browne:

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



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:

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.

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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.

The Innovator’s Solution

(Image: Zen Buddha Silence, by Marilyn Barbone)

February 25, 2018

The Innovator’s Dilemma is a business classic by Clayten M. Christensen.  Good companies frequently fail precisely because they are good.  Good companies invest in sustaining technologies, which are generally high-functioning, high-margin, and demanded by customers, instead of disrupting technologies, which start out relatively low-functioning, low-margin, and not demanded by customers.

The Innovator’s Solution, by Clayton Christensen and Michael Raynor, aims at presenting solutions to the innovator’s dilemma.

(Illustration by Rapeepon Boonsongsuwan)


  • The Growth Imperative
  • How Can We Beat Our Most Powerful Competitors?
  • What Products Will Customers Want to Buy?
  • Who Are the Best Customers For Our Products?
  • Getting the Scope of the Business Right
  • How to Avoid Commoditization
  • Is Your Organization Capable of Disruptive Growth?
  • Managing the Strategy Development Process
  • There is Good Money and There is Bad Money
  • The Role of Senior Executives in Leading New Growth



As companies grow larger, it becomes more difficult to grow.  But shareholders demand growth.  Many companies invest aggressively to try to create growth, but most fail to do so.  Why is creating growth so hard for larger companies?

(Image by Bearsky23)

Christensen and Raynor note three explanations that seem plausible but are wrong:

  • Smarter managers could have succeeded.  But when it comes to sustaining growth that creates shareholder value, 90 percent of all publicly traded companies have failed to create it for more than a few years.  Are 90 percent of all managers are below average?
  • Managers become risk-averse.  But here again, the facts don’t support the explanation.  Managers frequently bet billion-dollar companies on one innovation.
  • Creating new-growth businesses is inherently unpredictable.  The odds of success are low, as reflected by how venture capitalists invest.  But there’s far more to the process of creating growth than just luck.

The innovator’s dilemma causes good companies to invest in high-functioning, high-margin products that their current customers want.  This can be seen in the process companies follow to fund ideas:

The process of sorting through and packaging ideas into plans that can win funding… shapes those ideas to resemble the ideas that were approved and became successful in the past.  The processes have in fact evolved to weed out business proposals that target markets where demand might be small.  The problem for growth-seeking managers, of course, is that the exciting growth markets of tomorrow are small today.

A dearth of good ideas is rarely the core problem in a company that struggles to launch exciting new-growth businesses.  The problem is in the shaping process.  Potentially innovative new ideas seem inexorably to be recast into attempts to make existing customers still happier.

It’s possible to gain greater understanding of how companies create profitable growth.  If we can develop a better theory, then we can make better predictions.  There are three stages in theory-building, say Christensen and Raynor:

  • Describe the phenomena in question.
  • Classify the phenomena into categories.
  • Explain what causes the phenomena, and under what circumstances.

Building a theory is iterative.  Scientists keep improving their descriptions, classifications, and causal explanations.

Frequently there is not enough understanding of the circumstances under which businesses succeed.

To know for certain what circumstances they are in, managers also must know what circumstances they are not in.  When collectively exhaustive and mutually exclusive categories of circumstances are defined, things get predictable: We can state what will cause what and why, and can predict how that statement of causality might vary by circumstance.



(Illustration by T. L. Furrer)

Compared to existing products, disruptive innovations start out simpler, more convenient, and less expensive.

Once the disruptive product gains a foothold in new or low-end markets, the improvement cycle begins.  And because the pace of technological progress outstrips customers’ ability to use it, the previously not-good-enough technology eventually improves enough to intersect with the needs of more demanding customers.  When that happens, the disruptors are on a path that will ultimately crush the incumbents.

Most disruptive innovations are launched by entrants.  A good example is minimills disrupting integrated steel companies.

Minimills discovered that by melting scrap metal, they could make steel at 20 percent lower cost than the integrated steel mills.  But the quality of steel the minimills initially produced was low due to the use of scrap metal.  Their steel could only be used for concrete reinforcing bar (rebar).

The rebar market was naturally more profitable for the minimills, due to their lower cost structure.  The integrated steel mills were happy to give up what for them was a lower-margin business.  The minimills were profitable as long as they were competing against integrated steel mills that were still supplying the rebar market.  Once there were no integrated steel mills left, the price of the rebar dropped 20 percent to reflect the lower cost structure of minimills.

This pattern kept repeating.  The minimills looked up-market again.  The minimills expanded their capacity to make angle iron, and thicker bars and rods.  The minimills reaped significant profits as long as they were competing against integrated steel mills still left in the market for bar and rod.  Meanwhile, integrated steel mills gradually abandoned this market because it was lower-margin for them.  After the last integrated steel mill dropped out, the price of bar and rod dropped 20 percent to reflect the costs of minimills.

So the mimimills looked up-market again to structural beams.  Most experts thought minimills wouldn’t be able to roll structural beams.  But the minimills were highly motivated and came up with very clever innovations.  Once again, the minimills experienced nice profits as long as they were competing against integrated steels mills.  But when the last integrated steel mill dropped out of the structural beam market, the price dropped 20 percent.

(Image by Megapixie, via Wikimedia Commons)

Christensen and Raynor add:

The sequence repeated itself when the leading minimill, Nucor, attacked the steel sheet business.  Its market capitalization now dwarfs that of the largest integrated steel company, U.S. Steel.  Bethlehem Steel is bankrupt as of the time of this writing.

This is not a history of bungled steel company management.  It is a story of rational managers facing the innovator’s dilemma: Should we invest to protect the least profitable end of our business, so that we can retain our least loyal, most price-sensitive customers?  Or should we invest to strengthen our position in the most profitable tiers of our business, with customers who reward us with premium prices for better products?

The authors note that these patterns hold for all companies, not just technology companies.  Also, they define “technology” as “the process that any company uses to convert inputs of labor, materials, capital, energy, and information into outputs of greater value.”  Christensen and Raynor:

Disruption does not guarantee success, but it sure helps: The Innovator’s Dilemma showed that following a strategy of disruption increased the odds of creating a successful growth business from 6 percent to 37 percent.

New-market disruptions relate to consumers who previously lacked the money or skills to buy and use the product, or they relate to different situations in which the product can be used.  New-market disruptions compete with “nonconsumption.”

Low-end disruptions attack the least profitable and most overserved customers in the original market.

Examples of new-market disruptions:

The personal computer and Sony’s first battery-powered transistor pocket radio were new-market disruptions, in that their initial customers were new consumers — they had not owned or used the prior generation of products and services.  Canon’s desktop photocopiers were also a new-market disruption, in that they enabled people to begin conveniently making their own photocopies around the corner from their offices, rather than taking their originals to the corporate high-speed photocopy center where a technician had to run the job for them.

The authors then explain low-end disruptions:

…Disruptions such as steel minimills, discount retailing, and the Korean automakers’ entry into the North American market have been pure low-end disruptions in that they did not create new markets — they were simply low-cost business models that grew by picking off the least attractive of the established firms’ customers.

Many disruptions are a hybrid of new-market and low-end.

Christensen and Raynor suggest three sets of questions to determine if an idea has disruptive potential.  The first set of questions relates to new-market potential:

  • Is there a large population of people who historically have not had the money, equipment, or skill to do this thing for themselves, and as a result have gone without it altogether or have needed to pay someone with more expertise to do it for them?
  • To use the product or service, do customers need to go to an inconvenient, centralized location?

The second set of questions concerns low-end disruptions:

  • Are there customers at the low-end of the market who would be happy to purchase a product with less (but good enough) performance if they could get it at a lower price?
  • Can we create a business model that enables us to earn attractive profits at the discount prices required to win the business of these overserved customers at the low end?

A final question is a litmus test:

  • Is the innovation disruptive to all of the significant incumbent firms in the industry?  If it appears to be sustaining to one or more significant players in the industry, then the odds will be stacked in that firm’s favor, and the entrant is unlikely to win.



Christensen and Raynor:

All companies face the continual challenge of defining and developing products that customers will scramble to buy.  But despite the best efforts of remarkably talented people, most attempts to create successful new products fail.  Over 60 percent of all new-product development efforts are scuttled before they ever reach the market.  Of the 40 percent that do see the light of day, 40 percent fail to become profitable and are withdrawn from the market.

(Photo by Kirill Ivanov)

The authors stress that customers “hire” products to do “jobs.”  We need to think about what customers are trying to do and the circumstances involved.

…This is how customers experience life.  Their thought processes originate with an awareness of needing to get something done, and then they set out to hire something or someone to do the job as effectively, conveniently, and inexpensively possible… In other words, the jobs that customers are trying to get done or the outcomes that they are trying to achieve constitute a circumstance-based categorization of markets.

The authors give the example of milkshakes.  What are the jobs that people “hire” milkshakes for?  Nearly half of all milkshakes are bought early the morning.  Often these customers want to have a less boring commute.  Also, a morning milkshake helps to avoid feeling hungry at 10:00.  At other times of day, parents were observed buying milkshakes for their children as a way to calm them down.  Armed with this knowledge, milkshake sellers can improve the milkshakes they sell at specific times of day.

The key here is observing what people are trying to accomplish.  Develop and test hypotheses accordingly.  Then develop products rapidly and get fast feedback.

It’s often much easier to figure out how to develop a low-end disruption.  That’s because the market already exists.  The goal is to move gradually up-market.

Why do many executives, instead of following jobs-to-be-done segmentation, focus on market segments not aligned with how customers live their lives?  Christensen and Raynor say there are at least four reasons:

  • Fear of focus.
  • Senior executives’ demand for quantification of opportunities.
  • The structure of channels.
  • Advertising economics and brand strategies.

The first two reasons relate to resource allocation.  The second two reasons concern the targeting of customers rather than circumstances.

Focus is scary — until you realize that it only means turning your back on markets you could never have anyway.  Sharp focus on jobs that customers are trying to get done holds the promise of greatly improving the odds of success in new-product development.

(Photo by Creativefire)

Rather than understand how customers and markets work, most market research is focused on defining the size of the opportunity.  This is the mistake of basing research on the available data instead of finding out about the jobs customers are trying to do.

When they frame the customer’s world in terms of products, innovators start racing against competitors by proliferating features, functions, and flavors of products that mean little to customers.  Framing markets in terms of customer demographics, they average across several different jobs that arise in customers’ lives and develop one-size-fits-all products that rarely leave most customers fully satisfied.  And framing markets in terms of an organization’s boundaries further restricts innovators’ abilities to develop products that will truly help their customers get the job done perfectly.

Regarding the structure of channels:

Many retail and distribution channels are organized by product categories rather than according to the jobs that customers need to get done.  This channel structure limits innovators’ flexibility in focusing their products on jobs that need to be done, because products need to be slotted into the product categories to which shelf space has been allocated.

Christensen and Raynor give the example of a manufacturer of power tools.  It learned that when workers were hanging a door, they used seven different tools, none of which was specific to the task.  The manufacturer invented a new tool that noticeably simplified the job.  But retail chains refused to sell the new tool because they didn’t have pre-existing shelf space for it.

Brands should be based on jobs to be done.

If a brand’s meaning is positioned on a job to be done, then when the job arises in a customer’s life, he or she will remember the brand and hire the product.  Customers pay significant premiums for brands that do a job well.

Some executives worry that a low-end disruption might harm their established brand.  But they can avoid this issue by properly naming each product.



As long as a business can profit using discount prices, the business can do well selling a low-end innovation.  It’s much harder to find new-market customers.  How do you determine if nonconsumers will become consumers of a given product?  Once again, the job-to-be-done perspective is crucial.

(Illustration by Alexmillos)

The authors continue:

A new-market disruption is an innovation that enables a larger population of people who previously lacked the money or skill now to begin buying and using a product and doing the job for themselves.  From this point forward, we will use the terms nonconsumers and nonconsumption to refer to this type of situation, where the job needs to get done but a good solution historically has been beyond reach.

Christensen and Raynor identify four elements in new-market disruption:

  • The target customers are trying to get a job done, but because they lack the money or skill, a simple, inexpensive solution has been beyond reach.
  • These customers will compare the disruptive product to having nothing at all.  As a result, they are delighted to buy it even though it may not be as good as other products available at high prices to current users with deeper expertise in the original value network.  The performance hurdle required to delight such new-market customers is quite modest.
  • The technology that enables the disruption might be quite sophisticated, but disruptors deploy it to make the purchase and use of the product simple, convenient, and foolproof.  It is the “foolproofedness” that creates new growth by enabling people with less money and training to begin consuming.
  • The disruptive innovation creates a whole new value network.  The new consumers typically purchase the product through new channels and use the product in new venues.

When disruptions come, established firms must take two key steps: First, when it comes to resource allocation, identify the disruption as a threat.  Second, those charged with building a new technology as a response should view their task as an opportunity.  This group should be an independent entity within the overall company.

Disruptive channels are often required to reach new-market customers:

…A company’s channel includes not just wholesale distributors and retail stores, but any entity that adds value to or creates value around the company’s product as it wends its way toward the hands of the end user…

We use this broader definition of channel because there needs to be symmetry of motivation across the entire chain of entities that add value to the product on its way to the end user.  If your product does not help all of these entities do their fundamental job better — which is to move up-market along their own sustaining trajectory toward higher-margin business — then you will struggle to succeed.  If your product provides the fuel that entities in the channel need to move toward improved margins, however, then the energy of the channel will help your new venture succeed.



It’s often advised to stick to your core competence.  The trouble is that something that doesn’t seem core today may turn out to be critical tomorrow.

Consider, for example, IBM’s decision to outsource the microprocessor for its PC business to Intel, and its operating system to Microsoft.  IBM made these decisions in the early 1980s in order to focus on what it did best — designing, assembling, and marketing computer systems… And yet in the process of outsourcing what it did not perceive to be core to the new business, IBM put into business the two companies that subsequently captured most of the profit in the industry.

The solution starts again with the jobs-to-be-done approach.  If the current products are not good enough, integration is best.  If the current products are more than good enough, outsourcing makes sense.

(Photo by Marek Uliasz)

Christensen and Raynor explain product architecture and interfaces:

An architecture is interdependent at an interface if one part cannot be created independently of the other part — if the way one is designed and made depends on the way the other is being designed and made.  When there is an interface across which there are unpredictable interdependencies, then the same organization must simultaneously develop both of the components if it hopes to develop either component.

Interdependent architectures optimize performance, in terms of functionality and reliability.  By definition, these architectures are proprietary because each company will develop its own interdependent design to optimize performance in a different way…

In contrast, a modular interface is a clean one, in which there are no unpredictable interdependencies across components or stages of the value chain.  Modular components fit and work together in well-understood and highly defined ways.  A modular architecture specifies the fit and function of all elements so completely that it doesn’t matter who makes the components or subsystems, as long as they meet the specifications…

Modular architectures optimize flexibility, but because they require tight specification, they give engineers fewer degrees of freedom in design.  As a result, modular flexibility comes at the sacrifice of performance.

The authors point out that most products fall between the two extremes of interdependence and pure modularity.

When product functionality and reliability are not yet good enough, firms that build their products around proprietary, interdependent architectures have a competitive advantage.  That’s because competitors with product architectures that are modular have less freedom and so cannot optimize performance.

The authors mention RCA, Xerox, AT&T, Standard Oil, and U.S. Steel:

These firms enjoyed near-monopoly power.  Their market dominance was the result of the not-good-enough circumstance, which mandated interdependent product or value chain architectures and vertical integration.  But their hegemony proved only temporary, because ultimately, companies that have excelled in the race to make the best possible products find themselves making products that are too good.

Eventually customers evolve in what they want.  They become willing to pay for speed, convenience, and customization.  Product architecture evolves towards more modular design.  This deeply impacts industry structure.  Independent, nonintegrated organizations become able to sell components and subsystems.  Industry standards develop that specify modular interfaces.



Many think commoditization is inevitable, no matter how good the innovation.  Christensen and Raynor reached a different conclusion:

One of the most exciting insights from our research about commoditization is that whenever it is at work somewhere in a value chain, a reciprocal process of de-commoditization is at work somewhere else in the value chain.  And whereas commoditization destroys a company’s ability to capture profits by undermining differentiability, de-commoditization affords opportunities to create and capture potentially enormous wealth.

Companies that position themselves at a place in the value chain where performance is not yet good enough will earn the profits when a disruption is occurring.  Just as Wayne Gretsky sought to skate to where the puck would be (not where it is), companies should position themselves where the money will be (not where it is).

(Photo of Wayne Gretzky by Rick Dikeman, via Wikimedia Commons)

When products are not yet good enough, companies with interdependent, proprietary architecture have strong advantages in differentiation and in cost structures.

This is why, for example, IBM, as the most integrated competitor in the mainframe computer industry, held a 70 percent market share but made 95 percent of the industry’s profits: It had proprietary products, strong cost advantages, and high entry barriers… Making highly differentiable products with strong cost advantages is a license to print money, and lots of it.

Of course, as a company seeks to outdo competitors, eventually it overshoots on the reliability and functionality that customers can use.  This leads to a change in the basis of competition.  There’s evolution towards modular architectures.  This process starts at the bottom of the market, where functionality overshoots first, and then moves gradually up-market.

Christensen and Raynor comment that “industry” itself is usually a faulty categorization.  Value chains evolve as the processes of commoditization and de-commoditization gradually repeat over time.

What’s fascinating — it’s the innovator’s dilemma — is that as innovators are moving up the value chain, established firms gradually abandon their lower-margin products and focus on their higher-margin products.  Established firms repeatedly focus on areas that increase their ROIC (return on invested capital) in the short term.  But these same decisions move established firms away from where the profits will be in the future.

Brands are most valuable when products aren’t yet good enough.  A brand can signal to potential customers that the products they seek will meet their standards.  When the performance of the products becomes more than good enough, the power of brands diminishes.  Christensen and Raynor:

The migration of branding power in a market that is composed of multiple tiers is a process, not an event.  Accordingly, the brands of companies with proprietary products typically create value mapping upward from their position on the improvement trajectory — toward those customers who still are not satisfied with the functionality and reliability of the best that is available.  But mapping downward from the same point — toward the world of modular products where speed, convenience, and responsiveness drive competitive success — the power to create powerful brands migrates away from the end-use product, toward the subsystems and the channel.

This has happened in heavy trucks.  There was a time when the valuable brand, Mack, was on the truck itself.  Truckers paid a significant premium for Mack the bulldog on the hood.  Mack achieved its preeminent reliability through its interdependent architecture and extensive vertical integration.  As the architectures of large trucks have become more modular, however, purchasers have come to care far more whether there is a Cummins or Caterpillar engine inside than whether the truck is assembled by Paccar, Navistar, or Freightliner.



Many innovations fail because the managers or corporations lack the capabilities to create a successful disruption.  Often the very skills that cause a leading company to succeed — through sustaining innovations — cause the same company to fail when it comes to disruptive growth.

The authors define capability by what they call the RPV framework — resources, processes, and values.

Resources are usually people, or things such as technology and cash.  What most often causes failure in disruptive growth is the wrong choice of managers.  It’s often thought that right-stuff attributes, plus a string of uninterrupted successes, is the best way to choose leaders of a disruptive venture.

But the skills needed to run an established firm are quite different from the skills needed to manage a disruptive venture.

In order to be confident that managers have developed the skills required to succeed at a new assignment, one should examine the sorts of problems they have wrestled with in the past.  It is not as important that managers have succeeded with the problem as it is for them to have wrestled with it and developed the skills and intuition for how to meet the challenge successfully the next time around.  One problem with predicting future success from past success is that managers can succeed for reasons not of their own making — and we often learn far more from our failures than our successes.  Failure and bouncing back from failure can be critical courses in the school of experience.  As long as they are willing and able to learn, doing things wrong and recovering from mistakes can give managers an instinct for better navigating through the minefield the next time around.

(Photo by Yuryz)

Successful companies have good processes in place: “Processes include the ways that products are developed and made and the methods by which procurement, market research, budgeting, employee development and compensation, and resource allocation are accomplished.”

Processes evolve as ways to complete specific tasks.  Effective organizations tend to have processes that are aligned with tasks.  But processes are not flexible and they’re not meant to be.  You can’t take processes that work for an established firm and expect them to work in a new-growth venture.

The most important processes usually relate to market research, financial projections, and budgeting and reporting.  Some processes are hard to observe.  But it makes sense to look at whether the organization has faced similar issues in the past.


An organization’s values are the standards by which employees make prioritization decisions — those by which they judge whether an order is attractive or unattractive, whether a particular customer is more important or less important than another, whether an idea for a new product is attractive or marginal, and so on.

Employees at every level make prioritization decisions.  At the executive tiers, these decisions often take the form of whether or not to invest in new products, services, and processes.  Among salespeople, they consist of on-the-spot, day-to-day decisions about which customers they will call on, what products to push with those customers, and which products not to emphasize.  When an engineer makes a design choice or a production scheduler puts one order ahead of another, it is a prioritization decision.

This brings up a crucial point:

Whereas resources and processes are often enablers that define what an organization can do, values often represent constraints — they define what the organization cannot do.  If, for example, the structure of a company’s overhead costs requires it to achieve gross profit margins of 40 percent, a powerful value or decision rule will have evolved that encourages employees not to propose, and senior managers to kill, ideas that promise gross margins below 40 percent.  Such an organization would be incapable of succeeding in low-margin businesses — because you can’t succeed with an endeavor that cannot be prioritized.  At the same time, a different organization’s values, shaped around a very different cost structure, might enable it to accord high priority to the very same project.  These differences create the asymmetries of motivation that exist between disruptors and disruptees.

Acceptable gross margins and cost structures co-evolve.  Another issue is how big a business opportunity has to be.  A huge company may not consider interesting opportunities if they’re too small to move the needle.  However, a wisely run large company will set up small business units for which smaller opportunities are still meaningful.

In the start-up stage, resources are important, especially people.  A few key people can make all the difference.

(Photo by Golloween)

But over time, processes and values become more important.  Many hot, young companies fail because the founders don’t create the processes and values needed to continue to create successful innovations.

As processes and values become almost subconscious, they come to represent the culture of the organization.  When a few people are still important, it’s far easier for the company to change in response to new problems.  But it becomes much more difficult when processes and values are established, and more difficult still when the culture is widespread.

Executives who are building new-growth businesses therefore need to do more than assign managers who have been to the right schools of experience to the problem.  They must ensure that responsibility for making the venture successful is given to an organization whose processes will facilitate what needs to be done and whose values can prioritize those activities.



In every company, there are two strategy-making processes — deliberate and emergent.  Deliberate strategies are conscious and analytical.

Emergent strategy… is the cumulative effect of day-to-day prioritization and investment decisions made by middle managers, engineers, salespeople, and financial staff.  These tend to be tactical, day-to-day operating decisions that are made by people who are not in a visionary, futuristic, or strategic state of mind.  For example, Sam Walton’s decision to build his second store in another small town near his first one in Arkansas for purposes of logistical and managerial efficiency, rather than building it in a large city, led to what became Wal-Mart’s brilliant strategy of building in small towns discount stores that were large enough to preempt competitors’ ability to enter.  Emergent strategies result from managers’ responses to problems or opportunities that were unforeseen in the analysis and planning stages of the deliberate strategy-making process.

(Photo by Alain Lacroix)

If an emergent strategy proves effective, it can be transformed into a deliberate strategy.

Emergent processes should dominate in circumstances in which the future is hard to read and in which it is not clear what the right strategy should be.  This is almost always the case during the early phases of a company’s life.  However, the need for emergent strategy arises whenever a change in circumstances portends that the formula that worked in the past may not be as effective in the future.  On the other hand, the deliberate strategy process should be dominant once a winning strategy has become clear, because in those circumstances effective execution often spells the difference between success and failure.

Initiatives that receive resources are strategic actions, and strategies evolve based on the results of strategic actions.  Resource allocation decisions are especially influenced by a company’s cost structure — which determines gross profit margins — and by the size of a given opportunity.  A great opportunity for a small company — or a small unit — might not move the needle for a large company.

Additional influences on resource allocation include the sales force’s incentive compensation system.  Salespeople decide which customers to focus on and what products to emphasize.  Customers, by their preferences, have significant influence on the resource allocation process.  Competitors’ actions are also important.

The resource allocation process, in other words, is a diffused, unruly, and often invisible process.  Executives who hope to manage the strategy process effectively need to cultivate a subtle understanding of its workings, because strategy is determined by what comes out of the resource allocation process, not by the intentions and proposals that go into it.

(Illustration by Amir Zukanovic)

In 1971, by chance Intel invented the microprocessor during a funded development project for a Japanese calculator company, Busicom.  But DRAMs, not microprocessors, continued to represent the bulk of the company’s sales through the 1970s.  By the early 1980s, DRAMs had the lowest profit margins of Intel’s products.

Microprocessors, by contrast, because they didn’t have much competition, earned among the highest gross profit margins.  The resource allocation process systematically diverted manufacturing resources away from DRAMs and into microprocessors.  This happened automatically, without any explicit management decisions.  Senior management continued putting two-thirds of the R&D budget into DRAM research.  By 1984, senior management realized that Intel had become a microprocessor company.

Intel needed both emergent and deliberate strategies:

A viable strategic direction had to coalesce from the emergent side of the process, because nobody could foresee clearly enough the future of microprocessor-based desktop computers.  But once the winning strategy became apparent, it was just as critical to Intel’s ultimate success that the senior management then seized control of the resource allocation process and deliberately drove the strategy from the top.

It’s essential for start-ups to be flexible and adaptive:

Research suggests that in over 90 percent of all successful new businesses, historically, the strategy that the founders had deliberately decided to pursue was not the strategy that ultimately led to the business’s success.  Entrepreneurs rarely get their strategies exactly right the first time… One of the most important roles of senior management during a venture’s early years is to learn from emergent sources what is working and what is not, and then to cycle that learning back into the process through the deliberate channel.

Once managers hit upon a strategy that works, then they must focus on executing that strategy aggressively.

The authors highlight three points of executive leverage on the strategy process.  Managers must:

  • Carefully control the initial cost structure of a new-growth business, because this quickly will determine the values that will drive the critical resource allocation decisions in that business.
  • Actively accelerate the process by which a viable strategy emerges by insuring that business plans are designed to test and confirm critical assumptions using tools such as discovery-driven planning.
  • Personally and repeatedly intervene, business by business, excercising judgment about whether the circumstance is such that the business needs to follow an emergent or deliberate strategy-making process.  CEOs must not leave the choice about strategy process to policy, habit, or culture.

Managers have to pay particular attention to the initial cost structure of the business:

The only way that a new venture’s managers can compete against nonconsumption with a simple product is to put in place a cost structure that makes such customers and products financially attractive.  Minimizing major cost commitments enables a venture to enthusiastically pursue the small orders that are the initial lifeblood of disruptive businesses in their emergent years.



The type and amount of money determines investor expectations, which in turn heavily influence the markets and channels the venture can and cannot target.  Many potentially disruptive ideas get turned into sustaining innovations, which generally leads to failure.

Christensen and Raynor hold that the best money in early years is patient for growth but impatient for profit.  Disruptive markets start out small, which is why patience for growth is important.  Once a viable strategy has been identified, then impatience for growth makes sense.

Impatience for profit is important so that managers will test ideas as quickly as possible.

(Image by Vpublic)

It’s crucial to keep costs low for both low-end and new-market disruptive strategies.  This determines the type of customers that are attractive.

Financial results do not signal potential stall points well.  Financial results are the fruit of investments made years ago.  Financial results tell you how healthy the business was, not how healthy the business is.  Reliable data generally are about the past.  They only help with planning if the future resembles the past, which is often only true to a limited extent.

Christensen and Raynor suggest three policies for keeping the growth engine running:

  • Launch new growth businesses regularly when the core is still healthy — when it can still be patient for growth — not when financial results signal the need.
  • Keep dividing business units so that as the corporation becomes increasingly large, decisions to launch growth ventures continue to be made within organizational units that can be patient for growth because they are small enough to benefit from investing in small opportunities.
  • Minimize the use of profit from established businesses to subsidize losses in new-growth businesses.  Be impatient for profit: There is nothing like profitability to ensure that a high potential business can continue to garner the funding it needs, even when the corporation’s core business turns sour.



Christensen and Raynor:

The senior executives of a company that seeks repeatedly to create new waves of disruptive growth have three jobs.  The first is a near-term assignment: personally to stand astride the interface between disruptive growth businesses and the mainstream businesses to determine through judgment which of the corporation’s resources and processes should be imposed on the new business, and which should not.  The second is a longer-term responsibility: to shephard the creation of a process that we call a “disruptive growth engine,” which capably and repeatedly launches successful growth businesses.  The third responsibility is perpetual: to sense when the circumstances are changing, and to keep teaching others to recognize these signals.  Because the effectiveness of any strategy is contingent on the circumstance, senior executives need to look to the horizon (which often is at the low end of the market or in nonconsumption) for evidence that the basis of competition is changing, and then initiate projects and acquisitions to ensure that the corporation responds to the changing circumstance as an opportunity for growth and not as a threat to be defended against.

The personal involvement of a senior executive is one of the most crucial things for a disruptive business.  Often the most important improvements for the entire corporation begin as disruptions.

The vast majority of companies that successfully caught a disruptive innovation are companies still run by founders.

We suspect that founders have an advantage in tackling disruption because they not only wield the requisite political clout but also have the self-confidence to override established processes in the interests of pursuing disruptive opportunities.  Professional managers, on the other hand, often seem to find it difficult to push in disruptive directions that seem counterintuitive to most other people in the organization.




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:

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:




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 Innovator’s Dilemma

(Image: Zen Buddha Silence, by Marilyn Barbone)

February 18, 2018

The Innovator’s Dilemma is a business classic by Clayten M. Christensen.  Why do so many good companies consistently fail to deal with certain kinds of technological change?  Precisely because good companies are good, explains Christensen.  Good companies invest in sustaining technologies, which are generally high-functioning, high-margin, and demanded by customers, instead of disrupting technologies, which start out relatively low-functioning, low-margin, and not demanded by customers.


…Companies stumble for many reasons, of course, among them bureaucracy, arrogance, tired executive blood, poor planning, short-term investment horizons, inadequate skills and resources, and just plain bad luck.  But this book is not about companies with such weaknesses: It is about well-managed companies that have their competitive antennae up, listen astutely to their customers, invest aggressively in new technologies, and yet still lose market dominance.

Such seemingly unaccountable failures happen in industries that move fast and in those that move slow; in those built on electronics technology and those built on chemical and mechanical technology; in manufacturing and in service industries.

Christensen gives the example of Sears Roebuck.  At one point, more than 2 percent of all retail sales went to Sears.  Sears pioneered important innovations in retailing, such as supply chain management, store brands, catalogue retailing, and credit card sales.

At the very time Sears was being praised as one of the best-managed companies in the world — in the mid 1960’s — the company was ignoring the rise of discount retailing and home centers.  Sears also let Visa and MasterCard chip away at the huge lead Sears had in the use of credit cards in retailing.

Christensen offers more examples:

In some industries this pattern of leadership failure has been repeated more than once.  Consider the computer industry.  IBM dominated the mainframe market but missed by years the emergence of minicomputers, which were technologically much simpler than mainframes.  In fact, no other major manufacturer of mainframe computers became a significant player in the minicomputer business.  Digital Equipment Corporation created the minicomputer market and was joined by a set of other aggressively managed companies: Data General, Prime, Wang, Hewlett-Packard, and Nixdorf.  But each of these companies in turn missed the desktop personal computer market.  It was left to Apple Computer, together with Commodore, Tandy, and IBM’s stand-alone PC division, to create the personal-computing market.  Apple, in particular, was uniquely innovative in establishing the standard for user-friendly computing.  But Apple and IBM lagged five years behind the leaders in bringing portable computers to market.  Similarly, the firms that built the engineering workstation market — Apollo, Sun, and Silicon Graphics — were all newcomers to the industry.

Christensen observes that many of these top computer manufacturers were at one point regarded as among the best-managed companies in the world.  Yet they failed to invest in disruptive technologies precisely because these leaders focused on the high-performing, high-margin products their customers wanted.  Why wouldn’t you focus on the most popular and profitable products?

Christensen says Xerox missed huge growth and profit opportunities in the market for small tabletop photocopiers.  And not a single integrated steel company had by 1995 built a plant using minimill technology, even though steel minimalls just two years later captured 40 percent of the North American steel market.  Finally, of the thirty manufacturers of cable-actuated power shovels, only four survived the multi-decade transition to hydraulic excavation technology.  Christensen comments:

As we shall see, the list of leading companies that failed when confronted with disruptive changes in technology and market structure is a long one.  At first glance, there seems to be no pattern in the changes that overtook them.  In some cases the new technologies swept through quickly; in others, the transition took decades.  In some, the new technologies were complex and expensive to develop.  In others, the deadly technologies were simple extensions of what the leading companies already did better than anyone else.  One theme common to all of these failures, however, is that the decisions that led to failure were made when the leaders in question were widely regarded as among the best companies in the world.

Christensen asks: Were these firms never well-managed?  Quite the opposite:

…in the cases of well-managed firms such as those cited above, good management was the most powerful reason they failed to stay atop their industries.  Precisely because these firms listened to their customers, invested aggressively in new technologies that would provide their customers more and better products of the sort they wanted, and because they carefully studied market trends and systematically allocated investment capital to innovations that promised the best returns, they lost their positions of leadership.

Here’s the lesson:

There are times at which it is right not to listen to customers, right to invest in developing lower-performance products that promise lower margins, and right to aggressively pursue small, rather than substantial, markets.

Christensen defines “technology” broadly as “the processes by which an organization transforms labor, capital, materials, and information into products and services of greater value.”

Part One, chapters 1 through 4, explains why seemingly good decisions lead to failure when it comes to disrupting technologies.  Part Two, chapters 5 through 10, offers potential solutions to the innovator’s dilemma — how managers can do the best thing for their company’s near-term health while also investing sufficient resources in potentially disruptive technologies.



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:

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:




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 One Device

(Image: Zen Buddha Silence, by Marilyn Barbone)

February 11, 2018

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

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

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

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

(Photo by Pavel Ševela, Wikimedia Commons)



The iPhone is the bestselling product of all time:

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

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

(Photo by Olena Golubova)

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

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

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

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

Merchant again:

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

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

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

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



(Photo by Peshkova)

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

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

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

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

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

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

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

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

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

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

(Image by Willtron, Wikimedia Commons)

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

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

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

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



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

(Photo by Bcos47, Wikimedia Commons)

Merchant quotes history of technology scholar Carolyn Marvin:

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

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

Merchant sums it up:

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

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



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

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

(Photo of Cerro Rico by Mhwater, Wikimedia Commons)

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

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

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

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

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

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

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

Silicon makes up 6 percent of the phone.

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

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



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

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

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

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

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

(Illustration by Artsiom Kusmartseu)



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

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

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

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

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

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

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

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

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

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

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

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

Merchant comments:

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

(Illustration by Onyxprj)



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

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

(Image by BP22Heber, Wikimedia Commons)

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

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



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

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

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

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

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

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

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

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



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

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

Merchant explains:

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

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

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



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

(Coriolis effect, Wikimedia Commons)


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

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

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

(Photos of proximity sensor by Hyderabaduser, Wikimedia Commons)

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

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



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

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

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

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

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

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

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

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

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

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

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

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

Merchant describes the evolution of apps for the iPhone:

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

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

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

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

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

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

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

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

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

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

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



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

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

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

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

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

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

(Photo by Sergey Gavrilichev)

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

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

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

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

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

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

(Photo by Mohamed Soliman)




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

The history of artificial intelligence is quite fascinating.  I wrote about that and related topics here:

(Photo by Christian Lagereek)

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

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

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

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



Merchant writes about his visit to China:

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

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

(Wikimedia Commons)

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

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

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

Merchant continues:

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

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

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

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

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

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

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

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



Merchant writes:

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

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

(2010 Photo by Matthew Yohe)

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

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




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

(Huaqiangbei electronics market, Photo by Lzf)

Merchant, a bit later:

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

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

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

Obvious counterfeits don’t last long:

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

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

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




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

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

(Photo by Rafal Olechowski)

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

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

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

Then there was hardware.  Merchant spoke with Tony Fadell:

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

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

(Apollo program insignia, by NASA, Wikimedia Commons)

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

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

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

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

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



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:

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:




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

Cheap, Solid Microcaps Far Outperform the S&P 500

(Image: Zen Buddha Silence, by Marilyn Barbone)

January 28, 2018

The wisest long-term investment for most investors is an S&P 500 index fund.  It’s just simple arithmetic, as Warren Buffett and Jack Bogle frequently observe:

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:

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:

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.



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.



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:



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:  (Jason Bond)



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:

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:




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

Common Stocks and Common Sense

(Image:  Zen Buddha Silence by Marilyn Barbone)

Januuary 21, 2018

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

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

(Image by Wilma64)

The simple truth is that the vast majority of us should invest in broad market low-cost index funds.  Buffett has maintained this argument for a long time:

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

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

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

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

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

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

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

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

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

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

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

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

Outline for this blog post:

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

(Photo by Lsaloni)



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

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

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

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

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

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

(Photo by Terry Mason)

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

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

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

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

Positive developments can include:

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

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

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

Wachenheim disagrees with growth investing as a strategy:

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

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

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

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



(Photo by Marijus Auruskevicius)

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

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

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

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

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

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



(Image by Alain Lacroix)

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

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

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

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

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



(Photo by Jacek Dudzinski)


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

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

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

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



(IBM Watson by Clockready, Wikimedia Commons)

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

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

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

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

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

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

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



(Photo of a bakery by Mohylek, Wikimedia Commons)

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

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

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

Next Wachenheim examines the business fundamentals:

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

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

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

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

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



(Photo by Dwight Burdette, Wikimedia Commons)

Wachenheim describes his use of screens:

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

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

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

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



(Photo by Steven Pavlov, Wikimedia Commons)

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

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

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

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

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

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



(Photo by Slambo, Wikimedia Commons)

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

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

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

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

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

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

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

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

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

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

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

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

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

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



(AIG Corporate, Photo by AIG, Wikimedia Commons)

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

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

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

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

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

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

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

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

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



(Photo by Miosotis Jade, Wikimedia Commons)

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

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

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

After gathering more information, Wachenheim revised his earnings model:

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

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

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

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

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

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



(Photo by Steven Pavlov, Wikimedia Commons)

Wachenheim does not believe in the Efficient Market Hypothesis:

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

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

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

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

Regarding Whirlpool:

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

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

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

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

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

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



(Photo by José A. Montes, Wikimedia Commons)

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

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

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

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

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

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

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

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

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

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

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

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

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



(Photo by Eddie Maloney, Wikimedia Commons)

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

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

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

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



(Photo of Marcus Goldman, Wikimedia Commons)

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

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

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

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

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

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

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

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

Wachenheim loves his job:

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



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:

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:




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

More Than You Know

(Image: Zen Buddha Silence, by Marilyn Barbone)

January 14, 2018

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

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

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

Here’s an outline:

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

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



(Image by Amir Zukanovic)

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

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

Mauboussin also writes:

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

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

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

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

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

Rubin again:

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



(Photo by Shawn Hempel)


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

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

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

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



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

(Image by Johannes Gerhardus Swanepoel)

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

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

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

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

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

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

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

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

(Image by Marrishuanna)

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



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

(Illustration by lbreakstock)

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

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

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



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

(Illustration by Marek)

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

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



(Illustration by Travelling-light)

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

  • Learning
  • Teaching
  • Self-awareness
  • Capital allocation

Mauboussin asserts:

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

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

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

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

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

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

Mauboussin quotes Warren Buffett:

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

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

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

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



(Image by Andreykuzmin)

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

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

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

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

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

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

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

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



(Photo by Marek Uliasz)

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

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

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



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

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

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

Mauboussin continues:

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

(Illustration by Trueffelpix)

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

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

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



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

(Photo by Leerobin)

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

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


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



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

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

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

(Photo by lbreakstock)

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



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

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

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

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

(Photo by Michele Lombardo)

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

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

Mauboussin sums it up:

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



(Image: Innovation concept, by Daniil Peshkov)

Mauboussin quotes Andrew Hargadon’s How Breakthroughs Happen:

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

Mauboussin adds:

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

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

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



(Photo: Drosophila Melanogaster, by Tomatito26)

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

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

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

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

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

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

(Image by Marek Uliasz)

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



(Photo by Michael Maggs, via Wikimedia Commons)

Mauboussin notes the lessons emphasized by chess master Bruce Pandolfini:

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

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

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



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


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

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

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

Mauboussin remarks that there are three types of fitness landscape:

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

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

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

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



Bradford Cornell:

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

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

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

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

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

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

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

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



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

(Illustration by Teguh Jati Prasetyo)

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

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

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



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

Mauboussin quotes Robert Axelrod’s The Complexity of Cooperation:

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

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

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

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



Mauboussin quotes Robert D. Hanson’s Decision Markets:

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

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

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

(Illustration: Swarm Intelligence, by Farbentek)

Mauboussin again:

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



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

Mauboussin tells of an experiment by Francis Galton:

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

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

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



(Illustration by Acadac, via Wikimedia Commons)

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

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

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

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

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

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



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

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

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



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:

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:




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

Buffett’s Best: Microcap Cigar Butts

(Image:  Zen Buddha Silence by Marilyn Barbone)

December 31, 2017

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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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


(Photo by Sky Sirasitwattana)

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

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

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

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



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

(Photo by Digikhmer)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Buffett “pulled all the levers” at Dempster…



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

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

(Illustration by Maxim Popov)

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

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

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

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

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

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

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

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

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



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

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

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

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

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

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

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

As an alternative to net nets, you could implement a group approach using one of O’Shaugnessy’s composite measures—such as low P/B, P/E, P/S, P/CF, EV/EBITDA.  Applying this to micro caps can produce 15-20% annual returns.  Generally not as good as net nets, but much easier to apply consistently.

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

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

Consider this comment by Charlie Munger:

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

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

(Illustration by Nadoelopisat)

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

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

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

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

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

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

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

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

Here’s Ben Graham explaining mean reversion:

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

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

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

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

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



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

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

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

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

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

Regarding individual net nets, Graham admitted a danger:

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

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

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

(Image by Preecha Israphiwat)

Value investor Seth Klarman warns:

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

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

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

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

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

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

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



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

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

(Illustration by Sangoiri)

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

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

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

Mihaljevic explains:

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

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

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

A good current example is Ensco plc (NYSE: ESV), an offshore oil driller.  Having just completed its acquisition of Atwood Oceanics (NYSE: ATW), Ensco is now a leading offshore driller with a high-specification, globally diverse fleet.  The company also has one of the lowest cost structures, and relatively low debt levels (with the majority of debt due in 2024 or later).  Ensco—like Atwood—has a long history of operational excellence and safety.  Ensco has been rated #1 for seven consecutive years in the leading independent customer satisfaction survey.

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

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

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

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

Are offshore oil drillers in a cyclical or a secular decline?  It’s likely that oil will return to $60-70, at least in the next 5-10 years.  But no one knows for sure.

Ongoing improvements in technology allow oil producers to get more oil—more cheaply—out of existing fields.  Also, growth in transport demand for oil will slow significantly at some point, due to ongoing improvements in fuel efficiency.  See:

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

But even if oil never returns to $60+, oil will be needed for many decades.  At least some offshore drilling will still be needed, and Ensco will be a survivor.

Full Disclosure:

  • The Boole Fund had an investment in Atwood Oceanics. With the acquisition of Atwood by Ensco now completed, the Boole Fund currently owns shares in Ensco plc.
  • The Boole Fund holds positions for 3 to 5 years. The fund doesn’t sell an investment that is still cheap, even if the stock in question is no longer a micro cap.



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

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

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



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:

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:




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

The Essays of Warren Buffett

(Image:  Zen Buddha Silence by Marilyn Barbone.)

December 17, 2017

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

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

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


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

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

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

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

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



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

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

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



Buffett explains:

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

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

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

Buffett offers three suggestions for investors.  He says:

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

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

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

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

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

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

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

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

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

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

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

Buffett then remarks:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Buffett also covers the topic of executive pay:

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

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

The power of this simple math is often ignored by companies to the detriment of their shareholders.  Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings – i.e., earnings withheld from owners…  (page 67)

Buffett points out that ten-year, fixed-price options ignore the fact that earnings automatically build value, and that carrying capital has a cost.  Managers in this situation profit just as they would if they had an option on the savings account that automatically was building value.

Buffett repeatedly emphasizes that excellent management performance should be rewarded.  Indeed, says Buffett, exceptional managers nearly always get less than they should.  But that means you have to measure return on capital versus cost of capital.  Buffett does admit, however, that some managers he admires enormously disagree with him regarding fixed-price options.

Buffett designs Berkshire’s employment contracts with managers based on returns on capital employed versus the cost of that capital.  If the return on capital is high, the manager is rewarded.  If return on capital is sub-standard, then the manager is penalized.  Fixed-price options, by contrast, besides not usually being adjustable for the cost of capital, also fall short in that they reward managers on the upside without penalizing them on the downside.  (Buffett does adjust manager contracts based on the economic characteristics of the business, however.  A regulated business will have lower but still acceptable returns, for instance.)

Regarding reputation, Buffett has written for over 30 years:

We can’t be perfect but we can try to be…

We can afford to lose money – even a lot of money.  But we can’t afford to lose reputation – even a shred of reputation.  

Most auditors, observes Buffett, see that the CEO and CFO pay their fees.  So the auditors are more worried about offending the CEO than they are about accurate reporting.  Buffett suggests that audit committees ask the following four questions of auditors:

  1. If the auditor were solely responsible for the preparation of the company’s financial statements, would they in any way have been prepared differently from the manner selected by management?  This question should cover both material and nonmaterial differences.  If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed.  The audit committee should then evaluate the facts.
  2. If the auditor were an investor, would he have received – in plain English – the information essential to his understanding the company’s financial performance during the reporting period?
  3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO?  If not, what are the differences and why?
  4. Is the auditor aware of any actions – either accounting or operational – that have had the purpose and effect of moving revenues or expenses from one reporting period to another?  (page 79)

Buffett remarks that this procedure would save time and expense, in addition to focusing auditors on their duty.



Buffett discusses his purchase of a farm in Nebraska in 1986, a few years after a bubble in Midwest farm prices had popped.  First, he learned from his son how many bushels of corn and of soybeans would be produced, and what the operating expenses would be.  Buffett determined that the normalized return from the farm would be 10%, and that productivity and prices were both likely to increase over time.  Three decades later, the farm had tripled its earnings and Buffett’s investment had grown five times in value.

Buffett also mentions buying some real estate next to NYU shortly after a bubble in commercial real estate had popped.  The unlevered current yield was 10%.  Earnings subsequently tripled and annual distributions soon exceeded 35% of the original equity investment.

Buffett says these two investments illustrate certain fundamentals of investing, which he spells out as follows:

  • You don’t need to be an expert in order to achieve satisfactory investment returns.  But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well.  Keep things simple and don’t swing for the fences.  When promised quick profits, respond with a quick ‘no.’
  • Focus on the future productivity of the asset you are considering.  If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on.  No one has the ability to evaluate every investment possibility.  But omniscience isn’t necessary;  you only need to understand the actions you undertake.
  • If you instead focus on the prospective price change of a contemplated purchase, you are speculating.  There is nothing improper about that.  I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so… And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
  • With my two small investments, I thought only of what the property would produce and cared not at all about their daily valuations.  Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.  If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
  • Forming macro opinions or listening to the macro or market opinions of others is a waste of time.  Indeed, it is dangerous because it may blur your vision of the facts that are truly important…
  • My two purchases were made in 1986 and 1993.  What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments.  I can’t remember what the headlines or pundits were saying at the time.  Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

Many long-term investors make the mistake of feeling good when stock prices rise.  Buffett says that if you’re going to be a long-term investor and regularly add to your investments, you should prefer stock prices to fall rather than rise.  Eventually, stock prices follow business results.  And it’s safe to assume the U.S. economy will continue to grow over the long term.  But between now and then, if you’re a net buyer of stocks, you’re better off if stock prices fall before they rise.  Buffett:

So smile when you read a headline that says ‘Investors lose as market falls.’  Edit it in your mind to ‘Disinvestors lose as market falls – but investors gain.’  (page 89)

Buffett advises most investors to invest in index funds:

But for a handful of investors who can understand some businesses, it’s better to patiently wait for the fattest pitches.  Buffett gives an analogy:

If my universe of business opportunities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business;  second, assess the quality of the people in charge of running it;  and, third, try to buy into a few of the best operations at a sensible price.  I certainly would not wish to own an equal part of every business in town.  Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies?  And since finding great businesses and outstanding managers is so difficult, why should we discard proven products?  (page 102)

Buffett then quotes the economist and investor John Maynard Keynes:

‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.  It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.  One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.’ – J. M. Keynes

Here are details on Keynes as an investor:

Buffett explains Berkshire’s equity investment strategy by quoting its 1977 annual report:

We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety.  We want the business to be one (a) that we can understand;  (b) with favorable long-term prospects;  (c) operated by honest and competent people;  and (d) available at a very attractive price.  (page 106)

Buffett then notes that, due to Berkshire’s much larger size as well as market conditions, they would now substitute ‘an attractive price’ for ‘a very attractive price.’  How do you decide what’s ‘attractive’?  Buffett quotes The Theory of Investment Value, by John Burr Williams:

‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’

Buffett comments:

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value…

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.  The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.  Unfortunately, the first type of business is very hard to find…

Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future ‘coupons.’  At Berkshire, we attempt to deal with this problem in two ways.  First, we try to stick to businesses we believe we understand.  That means they must be relatively simple and stable in character.  If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.  Incidentally, that shortcoming doesn’t bother us.  What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.  An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price.  If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying.  We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.  (pages 107-108)

At another point, Buffett explains concentrated, buy-and-hold investing:

Inactivity strikes us as intelligent behavior.  Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market.  Why, then, should we behave differently with our minority positions in wonderful businesses?  The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries.  In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management.  Thereafter, you need only monitor whether these qualities are being preserved.

When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio.  This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars.  A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream.  To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate this portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.  (page 111)

Buffett reiterates that he and Charlie, when buying subsidiaries or common stocks, focus on businesses and industries unlikely to change much over time:

…The reason for that is simple:  Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now.  A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.

I should emphasize that, as citizens, Charlie and I welcome change:  Fresh ideas, new products, innovative processes and the like cause our country’s standard of living to rise, and that’s clearly good.  As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration:  We applaud the endeavor but prefer to skip the ride.

Obviously all businesses change to some extent.  Today, See’s is different in many ways from what it was in 1972 when we bought it:  It offers a different assortment of candy, employs different machinery and sells through different distribution channels.  But the reasons why people today buy boxed chocolates, and why they buy them from us rather than from someone else, are virtually unchanged from what they were in the 1920s when the See family was building the business.  Moreover, these motivations are not likely to change over the next 20 years, or even 50.

Buffett goes on to discuss Coca-Cola and Gillette, labeling companies like Coca-Cola ‘The Inevitables.’  Buffett points out that he’s not downplaying the important work these companies must continue to do in order to maximize their results over time.  He’s merely saying that all sensible observers agree that Coke will dominate worldwide over an investment lifetime.  This degree of brand strength – reflected in sustainably high returns on capital – is very rare.  Buffett:

Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables.  But I would rather be certain of a good result than hopeful of a great one.  (page 112)

The main danger for a great company is getting sidetracked from its wonderful core business while acquiring other businesses that are mediocre or worse.

Unfortunately, that is exactly what transpired years ago at Coke.  (Would you believe that a few decades back they were growing shrimp at Coke?)  Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding.  All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.  (page 113)


Buffett (again) recommends index funds for most investors:

Most investors, both individual and institutional, will find that the best way to own common stocks is through an index fund that charges minimal fees.  Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

For those investors seeking to pick individual stocks, the notion of circle of competence is crucial.  Buffett and Munger are well aware of which companies they can evaluate and which they can’t.  Buffett:

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter.  Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.  If others claim predictive skill in those industries – and seem to have their claims validated by the behavior of the stock market – we neither envy nor emulate them.  Instead, we just stick with what we understand.  (page 115)

Mistakes of the First 25 Years

Buffett first notes that the lessons of experience are not always helpful.  But it’s still good to review past mistakes ‘before committing new ones.’  To that end, Buffett lists mistakes of the twenty-five years up until 1989:

** My first mistake, of course, was in buying control of Berkshire.  Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap.  Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the ‘cigar butt’ approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish.  First, the original ‘bargain’ price probably will not turn out to be such a steal after all.  In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns…

** That leads right into a related lesson:  Good jockeys will do well on good horses, but not on broken-down nags…

I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact…

** A further related lesson:  Easy does it.  After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems.  What we have learned is to avoid them.  To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.  On occasion, tough problems must be tackled.  In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO…

** My most surprising discovery:  the overwhelming importance in business of an unseen force that we might call ‘the institutional imperative.’  In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world.  I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions.  But I learned over time that isn’t so.  Instead, rationality frequently wilts when the institutional imperative comes into play.

For example:  (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction;  (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds;  (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops;  and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

** After some mistakes, I learned to go into business only with people I like, trust, and admire… We’ve never succeeded in making a good deal with a bad person.

** Some of my worst mistakes were not publicly visible.  These were stock and business purchases whose virtues I understood and yet didn’t make… For Berkshire’s shareholders, myself included, the cost of this thumb-sucking has been huge.

** Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not.  In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged.  Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good.  Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.

We wouldn’t have liked those 99:1 odds – and never will.  A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.  If your actions are sensible, you are certain to get good results;  in most such cases, leverage just moves things along faster.  Charlie and I have never been in a big hurry:  We enjoy the process far more than the proceeds – though we have learned to live with those also.  (pages 117-120)



Buffett in 2011:

Investment possibilities are both many and varied.  There are three major categories, however, and it’s important to understand the characteristics of each.  So let’s survey the field.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments.  Most of these currency-based investments are thought of as ‘safe.’  In truth they are among the most dangerous of assets.  Their beta may be zero but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal.  This ugly result, moreover, will forever recur.  Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation.  From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire.  It takes no less than $7 today to buy what $1 did at that time.  Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power.  Its managers would have been kidding themselves if they thought of any portion of that interest as income.  (pages 123-124)

Buffett then notes that it’s even worse for tax-paying investors, who would have needed 5.7% annually to hold their ground.  In other words, an invisible ‘inflation tax’ has consumed 4.3% per year.  Given that interest rates today (mid-2017) are very low, currency-based investments are not attractive for the long term (decades).

The second major category of investments involves assets that will never produce anything, but that are purchased in the hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future.  Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further.  Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful).  Gold, however, has two significant shortcomings, being neither of much use nor procreative.  True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production.  Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce of gold at its end.

Today, the world’s gold stock is about 170,000 metric tons.  If all of this gold were melded together, it would form a cube of about 68 feet per side.  (Picture it sitting comfortably within a baseball infield.)  At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion.  Call this cube pile A.

Let’s now create a pile B costing an equal amount.  For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus sixteen Exxon Mobiles (the world’s most profitable company, one earning more than $40 billion annually).  After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).  Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be.  Exxon Mobile will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons).  The 170,000 tons of gold will be unchanged in size and still incapable of producing anything.  You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold.  I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Our first two categories enjoy maximum popularity at peaks of fear:  Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse drives investors to sterile assets such as gold.  We heard ‘cash is king’ in late 2008, just when cash should have been deployed rather than held…

My own preference – and you knew this was coming – is our third category:  investment in productive assets, whether businesses, farms, or real estate.  Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.  Farms, real estate, and many businesses such as Coca-Cola, IBM, and our own See’s Candy meet that double-barreled test.  Certain other companies – think of our regulated utilities for example – fail it because inflation places heavy capital requirements on them.  To earn more, their owners must invest more.  Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle.  In the future the U.S. population will move more goods, consume more food, and require more living space than it does now.  People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens… I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined.  More important, it will be by far the safest.  (pages 125-127)


Pessimism creates low prices.  But you cannot be a contrarian blindly:

The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry.  We want to do business in such an environment, not because we like pessimism but because we like the prices it produces.  It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular;  a contrarian approach is just as foolish as a follow-the-crowd strategy.  What’s required is thinking rather than polling.  Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world:  ‘Most men would rather die than think.  Many do.’  (page 130)



Transaction costs eat up an astonishing degree of corporate earnings every year.  Buffett writes at length – in the 2005 letter – about how this works:

The explanation of how this is happening begins with a fundamental truth: …the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn.  True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B.  And, yes, all investors feel richer when stocks soar.  But an owner can exit only by having someone take his place.  If one investor sells high, another must buy high.  For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of ‘frictional’ costs.  And that’s my point:  These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family.  We’ll call them the Gotrocks.  After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies.  Today that amount is about $700 billion annually.  Naturally, the family spends some of these dollars.  But the portion it saves steadily compounds for its benefit.  In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others.  The Helpers – for a fee, of course – obligingly agree to handle these transactions.  The Gotrocks still own all of corporate America;  the trades just rearrange who owns what.  So the family’s annual gain in wealth dimishes, equalling the earnings of American business minus commissions paid.  The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers.  This fact is not lost upon these broker-Helpers:  Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new ‘beat-my-brother’ game.  Enter another set of Helpers.  These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family.  The suggested cure:  ‘Hire a manager – yes, us – and get the job done professionally.’  These manager-Helpers continue to use the broker-Helpers to execute trades;  the managers may even increase their activity so as to permit the brokers to prosper still more.  Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family’s disappointment grows.  Each of its members is now employing professionals.  Yet overall, the group’s finances have taken a turn for the worse.  The solution?  More help, of course.

It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers.  The befuddled family welcomes this assistance.  By now its members know they can pick neither the right stocks nor the right stock-pickers.  Why, one might ask, should they expect success in picking the right consultant?  But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair.  But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers –  appears.  These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions…

The new arrivals offer a breathtakingly simple solution:  Pay more money.  Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY.  The new Helpers, however, assure the Gotrocks that this change of clothing is all-important… Calmed by this explanation, the family decides to pay up.

And that’s where we are today:  A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers.  Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).

A sufficient number of the arrangements like this – heads, the Helper takes much of the winnings;  tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.  Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business.  In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius.  But Sir Isaac’s talents didn’t extend to investing:  He lost a bundle in the South Sea Bubble explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’  If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion:  For investors as a whole, returns decrease as motion increases.  (pages 169-172)

For more details, see:



The Oracle of Omaha says:

Of all our activities at Berkshire, the most exhilarating for Charlie and me is the acquisition of a business with excellent economic characteristics and a management that we like, trust, and admire.  Such acquisitions are not easy to make, but we look for them constantly…

In the past, I’ve observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess.  Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations.  Initially, disappointing results only deepen their desire to round up new toads… Ultimately, even the most optimistic manager must face reality.  Standing knee-deep in unresponsive toads, he then announces an enormous ‘restructuring’ charge.  In this corporate equivalent of a Head Start program, the CEO receives the education but the stockholders pay the tuition.  (page 199)

Not only do most acquisitions fail to create value for the acquirer;  many actually destroy value.  However, a few do create value.  Buffett writes:

…many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads.  In fairness, we should acknowledge that some acquisition records have been dazzling.  Two major categories stand out.

The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment.  Such favored business must have two characteristics:  (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accomodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.  Managers of ordinary ability, focusing only on acquisition possibilities meeting these tests, have achieved excellent results in recent decades.  However, very few enterprises possess both characteristics, and competition for those that do has now become fierce to the point of being self-defeating.

The second category involves the managerial superstars – who can recognize the rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise.  (page 201)

Capital allocation decisions, including value-destroying acquisitions, add up over the long term.  Buffett:

Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.  Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally.  The company could, of course, distribute the money to shareholders by way of dividends or share repurchases.  But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense.  That’s like asking your interior decorator whether you need a $50,000 rug.

The acquisition problem is often compounded by a biological bias:  Many CEOs obtain their positions in part because they possess an abundance of animal spirits and ego.  If an executive is heavily endowed with these qualities – which, it should be acknowledged, sometimes have their advantages – they won’t disappear when he reaches the top…

At Berkshire, our managers will continue to earn extraordinary returns from what appear to be ordinary businesses.  As a first step, these managers will look for ways to deploy their earnings advantageously in their businesses.  What’s left, they will send to Charlie and me.  We then will try to use those funds in ways that build per-share intrinsic value.  Our goal will be to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust.  (pages 209-210)

Over the years, Berkshire Hathaway has become the buyer of choice for many private business owners.  Buffett remarks:

Our long-avowed goal is to be the ‘buyer of choice’ for businesses – particularly those built and owned by families.  The way to achieve this goal is to deserve it.  That means we must keep our promises;  avoid leveraging up acquired businesses;  grant unusual autonomy to our managers;  and hold the purchased companies through think and thin (though we prefer thick and thicker).

Our record matches our rhetoric.  Most buyers competing against us, however, follow a different path.  For them, acquisitions are ‘merchandise.’  Before the ink dries on their purchase contracts, these operators are contemplating ‘exit strategies.’  We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.  (pages 221-222)



Buffett writes about Aesop and the Inefficient Bush Theory:

The formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop, and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’  To flesh out this principle, you must answer only three questions.  How certain are you that there are indeed birds in the bush?  When will they emerge and how many will there be?  What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?  If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it.  And, of course, don’t literally think birds.  Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable.  It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants.  And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet.  Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.  Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years…

Alas, though Aesop’s proposition and the third variable – that is, interest rates – are simple, plugging in numbers for the other two variables is a difficult task.  Using precise numbers is, in fact, foolish;  working with a range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached.  Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startingly low in relation to value.  (Let’s call this phenomenon the IBT – Inefficient Bush Theory.)  To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion.  But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed.  This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination.  In cases of this sort, any capital commitment must be labeled speculative.

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.  Nothing sedates rationality like large doses of effortless money.  (pages 223-224)

Here Buffett is talking about the bubble in internet stocks in 1999.  He acknowledges that, overall, much value had been created and there was much more to come.  However, many individual internet companies destroyed value rather than creating it.

As noted earlier, Buffett and Munger love technological progress.  But they generally don’t invest in tech companies because it doesn’t fit their buy-and-hold approach.  It’s just not their game.  Some venture capitalists have excelled at it, but it usually takes a statistical investment approach whereby a few big winners eventually outweigh a large number of losses.

Buffett again:

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises.  We’re not smart enough to do that, and we know it.  Instead, we try to apply Aesop’s 2600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to ‘A girl in the convertible is worth five in the phone book.’)  Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount.  We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.  Even so, we make many mistakes:  I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.  (page 226)

Buffett writes about how to evaluate management:

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.  In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.  (page 237)

This leads to a discussion of economic Goodwill:

…businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.  The capitalized value of this excess return is economic Goodwill.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage.  It was not the fair market value of inventories, receivables or fixed assets that produced the premium rates of return.  Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price.  Consumer franchises are a prime source of economic Goodwill.  Other sources include governmental franchises not subject to profit regulation… and an enduring position as the low cost producer in an industry.  (page 239)

Buffett compares economic Goodwill with accounting Goodwill.  As mentioned, economic Goodwill is when the net tangible assets produce earnings in excess of market rates of return.  By contrast, accounting Goodwill is when company A buys company B, and the price paid is above the fair market value of net tangible assets.  The difference between price paid and net tangible asset value is accounting Goodwill.

In the past, companies would amortize accounting Goodwill, typically over a 40-year period.  But the current rule is that companies periodically test the value of the assets acquired.  If it is determined that the acquired assets have less value than when acquired, then the accounting Goodwill is written down based on an impairment charge.  This new way of measuring accounting Goodwill is what Buffett and Munger suggested (see page 247).

Earlier we saw that the net present value of any business is the discounted value of its future cash flows.  However, when we estimate future cash flows, it’s important to distinguish between earnings and free cash flow.  Buffett uses the the term owner earnings instead of free cash flow.  Buffett on owner earnings:

…These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

Buffett then observes that item (c), capital expenditures, usually requires a guess.  So owner earnings, or free cash flow, must also be an estimate.  Nonetheless, free cash flow is what matters when estimating the intrinsic value of a business.

If a business requires heavy capital expenditures to maintain its competitive position, that’s worth less to an owner.  By the same logic, if a business requires very little capital investment to maintain its competitive position, that’s clearly worth much more.  The capital-light business will generally earn much higher returns on capital.

So, generally speaking, as Buffett points out, when capital expenditure requirements exceed depreciation, GAAP earnings overstate owner earnings.  When capital expenditure requirements are less than depreciation, GAAP earnings understate owner earnings.

Moreover, Buffett offers a warning.  Often marketers of businesses and securities present ‘cash flow’ as simply (a) plus (b), without subtracting (c).  However, looking at cash flows without subtracting capital expenditures can give you a very misleading notion of what the business is worth.  Every business must make some capital expenditures over time to maintain its competitive position.

Buffett sums up the discussion of owner earnings – or free cash flow – with a note on accounting:

Accounting numbers of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress.  Charlie and I would be lost without these numbers:  they invariably are the starting point for us in evaluating our own businesses and those of others.  Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.  (page 254)



Buffett observes that managers should try to report the essential information that investors need:

What needs to be reported is data – whether GAAP, non-GAAP, or extra-GAAP – that helps financially literate readers answer three key questions:  (1) Approximately how much is this company worth?  (2) What is the likelihood that it can meet its future obligations?  and (3) How good a job are its managers doing, given the hand they have been dealt?  (page 259)

In 1998, Buffett observed that it had become common to manipulate accounting statements:

In recent years, probity has eroded.  Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers – CEOs you would be happy to have as spouses for your children or as trustees under your will – have come to the view that it’s OK to manipulate earnings to satisfy what they believe are Wall Street’s desires.  Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.

These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree).  To pump the price, they strive, admirably, for operational excellence.  But when operations don’t produce the result hoped for, these CEOs result to unadmirable accounting strategems.  These either manufacture the desired ‘earnings’ or set the stage for them in the future.

Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals – that is, their stock – is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does.  Once such an everybody’s-doing-it attitude takes hold, ethical misgivings vanish.  Call this behavior Son of Gresham:  Bad accounting drives out good.

The distortion du jour is the ‘restructuring charge,’ an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings.  In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors.  In some case, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations.  In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share.

This dump-everything-into-one-quarter behavior suggests a corresponding ‘bold, imaginative’ approach to – golf scores.  In his first round of the season, a golfer should ignore his actual performance and simply fill his card with atrocious numbers – double, triple, quadruple bogeys – and then turn in a score of, say, 140.  Having established this ‘reserve,’ he should go to the golf shop and tell his pro that he wishes to ‘restructure’ his imperfect swing.  Next, as he takes his new swing onto the course, he should count his good holes, but not his bad ones.  These remnants from his old swing should be charged instead to the reserve established earlier.  At the end of five rounds, then, his record will be 140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92.  On Wall Street, they will ignore the 140 – which, after all, came from a ‘discontinued’ swing – and will classify our hero as an 80 shooter (and one who never disappoints).

For those who prefer to cheat up front, there would be a variant of this strategy.  The golfer, playing alone with a cooperative caddy-auditor, should defer the recording of bad holes, take four 80s, accept the plaudits he gets for such athleticism and consistency, and then turn in a fifth card carrying a 140 score.  After rectifying his earlier scorekeeping sins with this ‘big bath,’ he may mumble a few apologies but will refrain from returning the sums he has previously collected from comparing scorecards in the clubhouse.  (The caddy, need we add, will have acquired a loyal patron.)

Unfortunately, CEOs who use variations of these scoring schemes in real life tend to become addicted to the games they’re playing – after all, it’s easier to fiddle with the scorecard than to spend hours on the practice tee – and never muster the will to give them up.  (pages 272-273)


In discussing pension estimates, Buffett explains why index fund investors will do better  – net of all costs – than active investors:

Naturally, everyone expects to be above average.  And those helpers – bless their hearts – will certainly encourage their clients in this belief.  But, as a class, the helper-aided group must be below average.  The reason is simple:  (1)  Investors, overall, will necessarily earn an average return, minus costs they incur;  (2)  Passive and index investors, through their very inactivity, will earn that average minus costs that are very low;  (3)  With that group earning average returns, so must the remaining group – the active investors.  But this group will incur high transaction, management, and advisory costs.  Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren.  That means that the passive group – the ‘know-nothings’ – must win.  (page 276)



Remarks by Buffett (in early 2015) on Berkshire’s fiftieth anniversary:

At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise.  Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo.  That’s important:  If horses had controlled investment decisions, there would have been no auto industry.

Another major advantage we possess is an ability to buy pieces of wonderful business – a.k.a. common stocks.  That’s not a course of action open to most managements.  Over our history, this strategic alternative has proved to be very helpful;  a broad range of options sharpens decision-making.  The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety.  Additionally, the gains we’ve realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.

In effect, the world is Berkshire’s oyster – a world offering us a range of opportunities far beyond those realistically open to most companies.  We are limited, of course, to businesses whose economic prospects we can evaluate.  And that’s a serious limitation:  Charlie and I have no idea what a great many companies will look like ten years from now.  But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry.  On top of that, we can profitably scale to a far larger size than many businesses that are constrained by the limited potential of the single industry in which they operate.

Berkshire has one further advantage that has become increasingly important over the years:  We are now the home of choice for the owners and managers of many outstanding businesses.  Families that own successful businesses have multiple options when they contemplate sale.  Frequently, the best decision is to do nothing.  There are worse things in life than having a prosperous business that one understands well.  But sitting tight is seldom recommended by Wall Street.  (Don’t ask the barber whether you need a haircut.)

When one part of a family wishes to sell while others wish to continue, a public offering often makes sense.  But, when owners wish to cash out entirely, they usually consider one of two paths.  The first is sale to a competitor who is salivating at the possibility of wringing ‘synergies’ from the combining of the two companies.  The buyer invariably contemplates getting rid of large numbers of the seller’s associates, the very people who have helped the owner build his business.  A caring owner, however – and there are plenty of them – usually does not want to leave his long-time associates sadly singing the old country song:  ‘She got the goldmine, I got the shaft.’

The second choice for sellers is the Wall Street buyer.  For some years, these purchasers accurately called themselves ‘leveraged buyout firms.’  When that term got a bad name in the early 1990s – remember RJR and Barbarians at the Gate? – these buyers hastily relabeled themselves ‘private-equity.’  The name may have changed but that was all:  Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases.  Indeed, the amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company.

Later, if things go well and equity begins to build, leveraged buy-out shops will often seek to re-leverage with new borrowings.  They then typically use part of the proceeds to pay a huge dividend that drives equity sharply downward, sometimes even to a negative figure.  In truth, ‘equity’ is a dirty word for many private-equity buyers;  what they love is debt.  And, these buyers can frequently pay top dollar.  Later the business will be resold, often to another leveraged buyer.  In effect, the business becomes a piece of merchandise.

Berkshire offers a third choice to the business owner who wishes to sell:  a permanent home, in which the company’s people and culture will be retained (though, occasionally, management changes will be needed).  Beyond that, any business we acquire dramatically increases its financial strength and ability to grow.  Its days of dealing with banks and Wall Street analysts are also forever ended.  Some sellers don’t care about these matters.  But, when sellers do, Berkshire does not have a lot of competition.  (pages 289-291)

Buffett also observes that companies are worth more as a part of Berkshire than they would be separately.  Berkshire can move funds between businesses or to new ventures instantly and without tax.  Also, some costs would be duplicated if the businesses were independent entities.  This includes regulatory and administrative expenses.  Moreover, there are tax efficiencies, says Buffett:  Certain tax credits available to Berkshire’s utilities are realizable because Berkshire generates large taxable income in other operations.

Buffett sums it up:

Today Berkshire possesses (1) an unmatched collection of businesses, most of them now enjoying favorable economic prospects;  (2) a cadre of outstanding managers who, with few exceptions, are unusually devoted to both the subsidiary they operate and to Berkshire;  (3) an extraordinary diversity of earnings, premier financial strength and oceans of liquidity that we will maintain under all circumstances;  (4) a first-choice ranking among many owners and managers who are contemplating sale of their businesses;  and (5) in a point related to the preceding item, a culture, distinctive in many ways from that of most large companies, that we have worked 50 years to develop and that is now rock-solid.  These strengths provide us a wonderful foundation on which to build.  (page 292)

For the rest of Buffett’s comments, as well as observations by Charles T. Munger on the history and evolution of Berkshire Hathaway, see pages 34-43 of the 2014 letter:



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:

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.

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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.