Kahneman and Tversky

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 2, 2018

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

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

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

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

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

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

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

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

(Illustration by Alain Lacroix)



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

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

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

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

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



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

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

Lewis continues:

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

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

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

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

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

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

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

(Illustration by fotomek)

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

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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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

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

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

Lewis continues:

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

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

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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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

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

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

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

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

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

(Transitivity illustration by Thuluviel, Wikimedia Commons)

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

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

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

This line of thinking led to some interesting insights:

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



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

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

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

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

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

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

Illustration by intheskies

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

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

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

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

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



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

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

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

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

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

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

Were human beings good intuitive statisticians?

(Image by Honina, Wikimedia Commons)

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

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

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

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

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

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

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

Lewis later writes:

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

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

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



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

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

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

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

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

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

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

(Algorithm illustration by Blankstock)

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

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

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

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

“We were sharing a mind.”

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

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

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

(Image by Argus)

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

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

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

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

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



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

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

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

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

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

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

As Amos said:

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

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

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

Image by Zerophoto



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

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


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

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

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

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

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

Photo by airdone

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

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

Amos and Redelmeier ended up doing a paper:

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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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

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

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

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

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

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



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

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

Which of the following do you prefer?

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

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

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

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

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

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

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

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

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

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

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

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

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

Which of the two programs would you favor?

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

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

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

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



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

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

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

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

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

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

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

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

Which of the two alternatives is more probable?

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

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

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

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


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

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

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

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

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



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

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

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

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


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

My e-mail: jb@boolefund.com




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

Shoe Dog

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 19, 2018

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

After the introduction, Knight has a chapter for each year, starting in 1962 and going through 1980.



Knight introduces his story:

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

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

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

I’d never even been with a girl.

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

I wanted to leave a mark on the world…

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

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

(Sweet Sixteen Syracuse vs. Gonzaga, March 25, 2016, Photo by Ryan Dickey, Wikimedia Commons)

Knight continues:

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

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

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

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

(Runner silhouette, Illustration by Msanca)


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

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



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

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

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

Yes, I told myself, yes.  For lack of a better word, God.

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

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

Knight then adds:

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

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

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

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

The first stop was Honolulu.  After seeing Hawaiian girls, then diving into the warm ocean, Buck told Carter they should stay.  What about the plan?  Plans change.  Carter liked the new idea and grinned.

They got jobs selling Encyclopedias door-to-door.  But their main mission was learning how to surf.  “Life was heaven.”  Except that Buck couldn’t sell encyclopedias.  He thought he was getting shier as he got older.

So he tried a job selling securities.  Specifically, Dreyfus funds for Investors Overseas Services, Bernard Cornfeld’s firm.  Knight had better luck with this.

Eventually, the time came for Buck and Carter to continue on their trip around the world.  However, Carter wasn’t sure.

He’d met a girl.  A beautiful Hawaiian teenager with long brown legs and jet-black eyes, the kind of girl who’d greeted our airplane, the kind I dreamed of having and never would.  He wanted to stick around, and how could I argue?

Buck hesitated, not sure he wanted to continue on alone.  But he decided not to stop his journey.  He bought a plane ticket that was good for one year on any airline going anywhere.

When Knight got to Tokyo, much of the city was black because it still hadn’t been rebuilt after the bombing.

American B-29s.  Superfortresses.  Over a span of several nights in the summer of 1944, waves of them dropped 750,000 pounds of bombs, most filled with gasoline and flammable jelly.  One of the world’s oldest cities, Tokyo was made largely of wood, so the bombs set off a hurricane of fire.  Some three hundred thousand people were burned alive, instantly, four times the number who died in Hiroshima.  More than a million were gruesomely injured.  And nearly 80 percent of the buildings were vaporized.  For long, solemn stretches the cab driver and I said nothing.  There was nothing to say.

Fortunately, Buck’s father knew some people in Tokyo at United Press International.  They advised Buck to talk to two ex-GI’s who ran a monthly magazine, the Importer.

First, Knight spent long periods of time in walled gardens reading about Buddhism and Shinto.  He liked the concept of kensho, or sartori – a flash of enlightenment.

But according to Zen, reality is nonlinear.  No past, no present.  All is now.  That required Knight to change his thinking.  There is no self.  Even in competition, all is one.

Knight decided to mix it up and visited the Tokyo Stock Exchange – Tosho.  All was madness and yelling.  Is this what it’s all about?

Knight sought peace and enlightenment again.  He visited the garden of the nineteenth century emperor Meiji and his empress.  This particular place was thought to possess great spiritual power.  Buck sat beneath the ginkgo trees, beside the gorgeous torii gate, which was thought of as a portal to the sacred.

Next it was Tsukiji, the world’s largest fish market.  Tosho all over again.

Then to the lakes region in the Northern Hakone mountains.  An area that inspired many of the great Zen poets.

Knight went to see the two ex-GI’s.  They told him how they’d fallen in love with Japan during the Occupation.  So they stayed.  They had managed to keep the import magazine going for seventeen years thus far.

Knight told them he liked the Tiger shoes produced by Onitsuka Co. in Kobe, Japan.  The ex-GI’s gave him tips on negotiating with the Japanese:

‘No one ever turns you down, flat.  No one ever says, straight out, no.  But they don’t say yes, either.  They speak in circles, sentences with no clear subject or object.  Don’t be discouraged, but don’t be cocky.  You might leave a man’s office thinking you’ve blown it, when in fact he’s ready to do a deal.  You might leave thinking you’ve closed a deal, when in fact you’ve just been rejected.  You never know.’

Knight decided to visit Onitsuka right away, with the advice fresh in his mind.  He managed to get an appointment, but got lost and arrived late.

When he did arrive, several executives met him.  Ken Miyazaki showed him the factory.  Then they went to a conference room.

Knight had rehearsed this scene his head, just like he used to visualize his races.  But one thing he hadn’t prepared for was the recent history of World War II hanging over everything.  The Japanese had heroically rebuilt, putting the war behind them.  And these Japanese executives were young.  Still, Knight thought, their fathers and uncles had tried to kill his.  In brief, Knight hesitated and coughed, then finally said, “Gentlemen.”

Mr. Miyazaki interrupted, “Mr. Knight.  What company are you with?”

Knight replied, “Ah, yes.  Good question.”  Knight experienced fight or flight for a moment.  A random jumble of thoughts flickered in his mind until he visualized his wall of blue ribbons from track.  “Blue Ribbon… Gentleman, I represent Blue Ribbon Sports of Portland, Oregon.”

Knight presented his basic argument, which was that the American shoe market was huge and largely untapped.  If Onitsuka could produce good shoes and price them below Adidas, it could be highly profitable.  Knight had spent so much time on his research paper at Stanford that he could simply quote it and come across as eloquent.

The Japanese executives started talking excitedly together, then suddenly stood up and left the room.  Knight didn’t know if he had been rejected.  Perhaps he should leave.  He waited.

Then they came back into the room with sketches of different Tiger shoes.  They told him they had been thinking about the American market for some time.  They asked Knight how big he thought the market could be.  Knight tossed out, “$1 billion.”  He doesn’t know where the number came from.

They asked him if Blue Ribbon would be interested in selling Tigers in the United States.  Yes, please send samples to this address, Knight said, and I’ll send a money order for fifty dollars.

Knight considered returning home to get a jump on the new business.  But then he decided to finish his trek around the world.

Hong Kong, then the Phillipines.

I was fascinated by all the great generals, from Alexander the Great to George Patton.  I hated war, but I loved the warrior spirit.  I hated the sword, but loved the samurai.  And of all the great fighting men in history I found MacArthur the most compelling.  Those Ray-Bans, that corncob pipe – the man didn’t lack for confidence.  Brilliant tactician, master motivator, he also went on to head the U.S. Olympic Committee.  How could I not love him?

Of course, he was deeply flawed.  But he knew that…

Bangkok.  He made his way to Wat Phra Kaew, a huge 600-year-old Buddha carved from one hunk of jade.  One of the most sacred statues in Asia.

(Emerald Buddha at Wat Phra Kaew, Image by J. P. Swimmer, Wikimedia Commons)

Vietnam, where U.S. soldiers filled the streets.  Everyone knew a very ugly and different war was coming.

Calcutta.  Knight got sick immediately.  He thinks food poisoning.  He was sure, for one whole day, that he was going to die.  He rallied.  He ended up at the Ganges.  There was a funeral.  Others were bathing.  Others were drinking the same water.

“The Upanishads say, Lead me from the unreal to the real.”  So Knight went to Kathmandu and hiked up the Himalayas.

Back to India.  Bombay.

Kenya.  Giant ostriches tried to outrun the bus, records Knight.  When Masai warriors boarded the bus, a baboon or two would also try to board.

Cairo.  The Giza plateau.  Standing besides desert nomads with their silk-draped camels.  At the foot of the Great Sphinx.

…The sun hammered down on my head, the same sun that hammered down on the thousands of men who built these pyramids, and the millions of visitors who came after.  Not one of them was remembered, I thought.  All is vanity, says the Bible.  All is now, says Zen.  All is dust, says the desert.

(Great Sphinx of Giza, Photo by Johnny 201, Wikimedia Commons)

Then Jerusalem.

…the first century rabbi Eleazar ben Azariah said our work is the holiest part of us.  All are proud of their craft.  God speaks of his work;  how much more should man.

Istanbul.  Turkish coffee.  Lost on the confusing streets of the Bosphorus.  Glowing minarets.  Then the golden labyrinths of Topkapi Palace.

Rome.  Tons of pasta.  And the most beautiful women and shoes he’d ever seen, says Knight.  The Coliseum.  The Vatican.  The Sistine Chapel.

Florence.  Reading Dante.  Milan.  Da Vinci:  One of his obsessions was the human foot, which he called a masterpiece of engineering.

Venice.  Marco Polo.  The palazzo of Robert Browning:  “If you get simply beauty and naught else, you get about the best thing God invents.”

Paris.  The Pantheon.  Rousseau.  Voltaire:  “Love truth, but pardon error.”  Praying at Notre Dame.  Lost in the Louvre.

(The Louvre, Photo by Pipiten, Wikimedia Commons)

Then to where Joyce slept, and F. Scott Fitzgerald.  Walking down the Seine, and stopping where Hemingway and Dos Passos read the New Testament aloud to each other.

Next, up the Champs-Elysees, along the liberators’ path, thinking of Patton:  “Don’t tell people how to do things, tell them what to do and let them surprise you with their results.”

Munich.  Berlin.  East Berlin:

…I looked around, all directions.  Nothing.  No trees, no stores, no life.  I thought of all the poverty I’d seen in every corner of Asia.  This was a different kind of poverty, more willful, somehow, more preventable.  I saw three children playing in the street.  I walked over, took their picture.  Two boys and a girl, eight years old.  The girl – red wool hat, pink coat – smiled directly at me.  Will I ever forget her?  Or her shoes?  They were made of cardboard.

Vienna.  Stalin, Trotsky, Tito, Hitler, Jung, Freud.  All at the same location in the same time period.  A “coffee-scented crossroads.”  Where Mozart walked.  Crossing the Danube.  The spires of St. Stephen’s Church, where Beethoven realized he was deaf.

London.  Buckingham Palace, Speakers’ Corner, Harrods.

Knight asked himself what the highlight of his trip was.

Greece, I thought.  No question.  Greece.

…I meditated on that moment, looking up at those astonishing columns, experiencing that bracing shock, the kind you receive from all great beauty, but mixed with a powerful sense of – recognition?

Was it only my imagination?  After all, I was standing at the birthplace of Western civilization.  Maybe I merely wanted it to be familiar.  But I don’t think so.  I had the clearest thought:  I’ve been here before.

Then, walking up those bleached steps, another thought:  This is where it all begins.

On my left was the Parthenon, which Plato had watched the teams of architects and workmen build.  On my right was the Temple of Athena Nike.  Twenty-five centuries ago, per my guidebook, it had housed a beautiful frieze of the goddess Athena, thought to be the bringer of “nike,” or victory.

It was one of many blessings Athena bestowed.  She also rewarded the dealmakers.  In the Oresteia she says:  ‘I admire… the eyes of persuasion.’  She was, in a sense, the patron saint of negotiators.

(Temple of Athena Nike, Photo by Steve Swayne, Wikimedia Commons)



When Buck got home, his hair was to his shoulders and his beard three inches long.  It had been four months since meeting with Onitsuka.  But they hadn’t sent the sample shoes.  Knight wrote to them to ask why.  They wrote back, “Shoes coming… In a little more days.”

Knight got a haircut and shaved.  He was back.  His father suggested he speak with his old friend, Don Frisbee, CEO of Pacific Power & Light.  Frisbee had an MBA from Harvard.  Frisbee told Buck to get his CPA while he was young, a relatively conservative way to put a floor under his earnings.  Knight liked that idea.  He had to take three more courses in accounting, first, which he promptly did at Portland State.

Then Knight worked at Lybrand, Ross Bros. & Montgomery.  It was a Big Eight national firm, but its Portland office was small.  $500 a month and some solid experience.  But pretty boring.



Finally, twelve pairs of shoes arrived from Onitsuka.  They were beautiful, writes Knight.  He sent two pairs immediately to his old track coach at Oregon, Bill Bowerman.

Bowerman was a genius coach, a master motivator, a natural leader of young men, and there was one piece of gear he deemed crucial to their development.  Shoes.

Bowerman was obsessed with shoes.  He constantly took his runners’ shoes and experimented on them.  He especially wanted to make the shoes lighter.  One ounce over a mile is fifty pounds.

Bowerman would try anything.  Kangaroo.  Cod.  Knight says four or five runners on the team were Bowerman’s guinea pigs.  But Knight was his “pet project.”

It’s possible that everything I did in those days was motivated by some deep yearning to impress, to please, Bowerman.  Besides my father there was no man whose approval I craved more, and besides my father there was no man who gave it less often.  Frugality carried over to every part of the coach’s makeup.  He weighed and hoarded words of praise, like uncut diamonds.

After you’d won a race, if you were lucky, Bowerman might say:  ‘Nice race.’  (In fact, that’s precisely what he said to one of his milers after the young man became one of the very first to crack the mythical four-minute mark in the United States.)  More likely Bowerman would say nothing.  He’d stand before you in his tweed blazer and ratty sweater vest, his string tie blowing in the wind, his battered ball cap pulled low, and nod once.  Maybe stare.  Those ice-blue eyes, which missed nothing, gave nothing.  Everyone talked about Bowerman’s dashing good looks, his retro crew cut, his ramrod posture and planed jawline, but what always got me was that gaze of pure violet blue.

(Statue of Bill Bowerman, Photo by Diane Lee Jackson, Wikimedia Commons)

For his service in World War II, Bowerman received the Silver Star and four Bronze Stars.  Bowerman eventually became the most famous track coach in America.  But he hated being called “coach,” writes Knight.  He called himself, “Professor of Competitive Responses” because he viewed himself as preparing his athletes for the many struggles and competitions that lay ahead in life.

Knight did his best to please Bowerman.  Even so, Bowerman would often lose patience with Knight.  On one occasion, Knight told Bowerman he was coming down with the flu and wouldn’t be able to practice.  Bowerman told him to get his ass out there.  The team had a time trial that day.  Knight was close to tears.  But he kept his composure and ran one of his best times of the year.  Bowerman gave him a nod afterward.

Bowerman suggested meeting for lunch shortly after seeing the Tiger shoes from Onitsuka.  At lunch, Bowerman told Knight the shoes were pretty good and suggested they become business partners.  Knight was shocked.

Had God himself spoken from the whirlwind and asked to be my partner, I wouldn’t have been more surprised.

Knight and Bowerman signed an agreement soon thereafter.  Knight found himself thinking again about his coach’s eccentricities.

…He always went against the grain.  Always.  For example, he was the first college coach in America to emphasize rest, to place as much value on recovery as on work.  But when he worked you, brother, he worked you.  Bowerman’s strategy for running the mile was simple.  Set a fast pace for the first two laps, run the third as hard as you can, then triple your speed on the fourth.  There was a Zen-like quality to this strategy because it was impossible.  And yet it worked.  Bowerman coached more sub-four-minute milers than anybody, ever.

Knight wrote Onitsuka and ordered three hundred pairs of shoes, which would cost $1,ooo.  Buck had to ask his dad for another loan, who asked him, “Buck, how long do you think you’re going to keep jackassing around with these shoes?”  His father told him he didn’t send him to Oregon and Stanford to be a door-to-door shoe salesman.

At this point, Knight’s mother told him she wanted to purchase a pair of Tigers.  This helped convince Knight’s father to give him another loan.

In April 1964, Knight got the shipment of Tigers.  Also, Mr. Miyazaki told him he could be the distributor for Onitsuka in the West.  Knight quit his accounting job to focus on selling shoes that spring.  His dad was horrified, his mom happy, remarks Knight.

After being rejected by a couple of sporting goods stores, Knight decided to travel around to various track meets in the Pacific Northwest.  Between races, he’d talk with the coaches, the runners, the fans.  He couldn’t write the orders fast enough.  Knight wondered how this was possible, given his inability to sell encyclopedias.

…So why was selling shoes so different?  Because, I realized, it wasn’t selling.  I believed in running.  I believed that if people got out and ran a few miles every day, the world would be a better place, and I believed these shoes were better to run in.  People, sensing my belief, wanted some of that belief for themselves.

Belief, I decided.  Belief is irresistable.

(Illustration by Lkeskinen0)

Knight started the mail order business because he started getting letters from folks wanting Tigers.  To help the process along, he mailed some handouts with big type:

‘Best news in flats!  Japan challenges European track shoe domination!  Low Japanese labor costs make it possible for an exciting new firm to offer these shoes at the low, low price of $6.95.’  [Note:  This is close to $54 in 2018 dollars, due to inflation.]

Knight had sold out his first shipment by July 4, 1964.  So he ordered 900 more.  This would cost $3,000.  His dad grudgingly gave him a letter of guarantee, which Buck took to the First National Bank of Oregon.  They approved the loan.

Knight wondered how to sell in California.  He couldn’t afford airfare.  So every other weekend, he’d stuff a duffel bag with Tigers.  He’d don his army uniform and head to the local air base.  The MPs would wave him on to the next military transport to San Francisco or Los Angeles.

When in Los Angeles, he’d save more money by staying with a friend from Stanford, Chuck Cale.  At a meet at Occidental College, a handsome guy approached Knight, introducing himself as Jeff Johnson.  He was a fellow runner whom Knight had run with and against while at Stanford.  At this point, Johnson was studying anthropology and planning on becoming a social worker.  But he was selling shoes – Adidas then – on weekends.  Knight tried to recruit him to sell Tigers instead.  No, because he was getting married and needed stability, responded Johnson.

Then Knight got a letter from a high school wrestling coach in Manhasset, New York, claiming that Onitsuka had named him the exclusive distributor for Tigers in the United States.  He ordered Knight to stop selling Tigers.

Knight contacted his cousin, Doug Houser, who’d recently graduated from Stanford Law School.  Houser found out Mr. Manhasset was a bit of a celebrity, a model who was one of the original Marlboro Men.  Knight:  “Just what I need.  A pissing match with some mythic American cowboy.”

Knight went into a funk for awhile.  Then he decided to go visit Onitsuka in Japan.  Knight bought a new suit and also a book, How to Do Business with the Japanese.

Knight realized he had to remain cool.  Emotion could be fatal.

The art of competition, I’d learned from track, was the art of forgetting, and now I reminded myself of that fact.  You must forget your limits.  You must forget your doubts, your pain, your past.  You must forget that internal voice screaming, begging, ‘Not one more step!’  And when it’s not possible to forget it, you must negotiate with it.  I thought over all the races in which my mind wanted one thing, and my body wanted another, those laps in which I’d had to tell my body, ‘Yes, you raise some excellent points, but let’s keep going anyway…’

After finding a place to stay in Kobe, Knight called Onitsuka and requested a meeting.  He got a call back saying Mr. Miyazaki no longer worked there.  Mr. Morimoto had replaced him, and didn’t want Knight to visit headquarters.  Mr. Morimoto would meet him for tea.  None of this was good.

At the meeting, Knight layed out the arguments.  They had had an agreement.  He also pointed out the very robust sales Blue Ribbon had had thus far.  He dropped the name of his business partner.  Mr. Morimoto, who was about Knight’s age, said he’d get back to him.

Knight thought it was over.  But then he got a call from Morimoto saying, “Mr. Onitsuka… himself… wishes to see you.”

At this meeting, Knight first presented his arguments again to those who were initially present.  Then Mr. Onitsuka arrived.

Dressed in a dark blue Italian suit, with a head of black hair as thick as shag carpet, he filled every man in the conference room with fear.  He seemed oblivious, however.  For all his power, for all his wealth, his movements were deferential… Morimoto tried to summarize my reasons for being there.  Mr. Onitsuka raised a hand, cut him off.

Without preamble, he launched into a long, passionate monologue.  Some time ago, he’d said, he’d had a vision.  A wondrous glimpse of the future.  ‘Everyone in the world wear athletic shoes all the time,’ he said.  ‘I know this day will come.’  He paused, looking around the table at each person, to see if they also knew.  His gaze rested on me.  He smiled.  I smiled.  He blinked twice.  ‘You remind me of myself when I am young,’ he said softly.  His stared into my eyes.  One second.  Two.  Now he turned his gaze to Morimoto.  ‘This about those thirteen western states?’ he said.  ‘Yes,’ Morimoto said.  ‘Hm,’ Onitsuka said.  ‘Hmmmm.’  He narrowed his eyes, looked down.  He seemed to be meditating.  Again he looked up at me.  ‘Yes,’ he said.  ‘Alright.  You have western states.’

Knight ordered $3,400 worth of shoes [about $26,000 in 2018 dollars].

(Mount Fuji, Photo by Wipark Kulnirandorn)

To celebrate, Knight decided to climb to the top of Mount Fuji.  Buck met a girl on the wap up, Sarah, who was studying philosophy at Connecticut College for Women.  It went well for a time.  Many letters back and forth.  A couple of visits.  But she decided Knight wasn’t “sophisticated” enough.  Jeanne, one of Buck’s younger sisters, found the letters, read them, and told Buck, “You’re better off without her.”  Buck then asked his sister – given her interest in mail – if she’d like to help with the mail order business for $1.50 an hour.  Sure.  Blue Ribbon Employee Number One.



Buck got a letter from Johnson.  He’d bought some Tigers and loved them.  Could he become a commissioned salesman for Blue Ribbon?  Sure.  $1.75 for each pair of running shoes, $2 for spikes, were the commissions.

Then the letters from Johnson kept coming:

I liked his energy, of course.  And it was hard to fault his enthusiasm.  But I began to worry he might have too much of each.  With the twentieth letter, or the twenty-fifth, I began to worry that the man might be unhinged.  I wondered why everything was so breathless.  I wondered if he was ever going to run out of things he urgently needed to tell me, or ask me…

…He wrote to say that he wanted to expand his sales territory beyond California, to include Arizona, and possibly New Mexico.  He wrote to suggest that we open a retail store in Los Angeles.  He wrote to tell me that he was considering placing ads in running magazines and what did I think?  He wrote to inform me that he’d placed those ads in running magazines and the response was good.  He wrote to ask why I hadn’t answered any of his previous letters.  He wrote to plead for encouragement.  He wrote to complain that I hadn’t responded to his previous plea for encouragement.

I’d always considered myself a conscientious correspondent… And I always meant to answer Johnson’s letters.  But before I got around to it, there was always another one, waiting.  Something about the sheer volume of his correspondence stopped me…

Eventually Johnson realized he loved shoes and running more than anthropology or social work.

(Monk meditating, Photo by Ittipon)

In his heart of hearts Johnson believed that runners are God’s chosen, that running, done right, in the correct spirit and with the proper form, is a mystical exercise, no less than meditation or prayer, and thus he felt called to help runners reach their nirvana.  I’d been around runners much of my life, but this kind of dewy romanticism was something I’d never encountered.  Not even the Yahweh of running, Bowerman, was as pious about the sport as Blue Ribbon’s Part-Time Employee Number Two.

In fact, in 1965, running wasn’t even a sport.  It wasn’t popular, it wan’t unpopular, it just was.  To go out for a three-mile run was something weirdos did, presumably to burn off manic energy.  Running for exercise, running for pleasure, running for endorphins, running to live better and longer – these things were unheard of.

People often went out of their way to mock runners.  Drivers would slow down and honk their horns.  ‘Get a horse!,’ they’d yell, throwing a beer or soda at the runner’s head.  Johnson had been drenched by many a Pepsi.  He wanted to change all this…

Above all, he wanted to make a living doing it, which was next to impossible in 1965.  In me, in Blue Ribbon, he thought he saw a way.

I did everything I could to discourage Johnson from thinking like this.  At every turn, I tried to dampen his enthusiasm for me and my company.  Besides not writing back, I never phoned, never visited, never invited him to Oregon.  I also never missed an opportunity to tell him the unvarnished truth.  I put it flatly:  ‘Though our growth has been good, I owe First National Bank of Oregon $11,000… Cash flow is negative.’

He wrote back immediately, asking if he could work for me full-time…

Knight just shook his head.  Finally in last summer of 1965, Knight accepted Johnson’s offer.  Johnson had been making $460 as a social worker, so he proposed $400 a month [over $3,000 a month in 2018 dollars].  Knight very reluctantly agreed.  It seemed like a huge sum.  Knight writes:

As ever, the accountant in me saw the risk, the entrepreneur the possibility.  So I split the difference and kept moving forward.

Knight then forgot about Johnson because he had bigger issues.  Blue Ribbon had doubled its sales in one year.  But Knight’s banker said they were growing too fast for their equity.  Knight asked how doubling sales – profitably – can be a bad thing.

In those days, however, commercial banks were quite different from investment banks.  Commercial banks never wanted you to outgrow your cash balance.  Knight tried to explain that growing sales as much as possible – profitably – was essential to convince Onitsuka to stick with Blue Ribbon.  And then there’s the monster, Adidas.  But his banker kept repeating:

‘Mr. Knight, you need to slow down.  You don’t have enough equity for this kind of growth.’

Knight kept hearing the word “equity” in his head over and over.  “Cash,” that’s what it meant.  But he was deliberately reinvesting every dollar – on a profitable basis.  What was the problem?

Every meeting with his banker, Knight managed to hold his tongue and say nothing, basically agreeing.  Then he’d keep doubling his orders from Onitsuka.

Knight’s banker, Harry White, had essentially inherited the account.  Previously, Ken Curry was Knight’s banker, but Curry bailed when Knight’s father wouldn’t guarantee the account in the case of business failure.

Furthermore, the fixation on equity didn’t come from White, but from White’s boss, Bob Wallace.  Wallace wanted to be the next president of the bank.  Credit risks were the main roadblock to that goal.

Oregon was smaller back then.  First National and U.S. Bank were the only banks, and the second one had already turned Blue Ribbon down.  So Knight didn’t have a choice.  Also, there as no such thing as venture capital in 1965.

(First National Bank of Oregon, Photo by Steve Morgan, Wikimedia Commons)

To make matters worse, Onitsuka was always late in its shipments, no matter how much Knight pleaded with them.

By this point, Knight had passed the four parts of the CPA exam.  So he decided to get a job as an accountant.  He invested a good chunk of his paycheck into Blue Ribbon.

In analyzing companies as an accountant, Knight learned how they sold things or didn’t, how they survived or didn’t.  He learned how companies got into trouble and how they got out.

It was while working for the Portland branch of Price Waterhouse that he met Delbert J. Hayes, who was the best accountant in the office.  Knight describes Hayes as a man with “great talent, great wit, great passions – and great appetites.”  Hayes was six-foot-two and three hundred pounds.  He loved food and alcohol.  And he smoked two packs a day.

Hayes looked at numbers the way a poet looks at clouds or a geologist looks at rocks, says Knight.  He could see the beauty of numbers.  Numbers were a secret code.

Every evening, Hayes would insist on taking junior accountants out for a drink.  Hayes would talk nonstop, like he drank.  But while other accountants dismissed Hayes’ stories, Knight always paid careful attention.  In every tale told by Hayes was some piece of wisdom about business.  So Knight would match Hayes, shot for shot, in order to learn as much as he could.

The following morning, Knight was always sick.  But he willed himself to do the work.  Being in the Army Reserves at the same time wasn’t easy.  Meanwhile, the conflict in Vietnam was heating up.  Knight:

I had grown to hate that war.  Not simply because I felt it was wrong.  I also felt it was stupid, wasteful.  I hated stupidity.  I hated waste.  Above all, that war, more than other wars, seemed to be run along the same principles of my bank.  Fight not to win, but to avoid losing.  A surefire losing strategy.

Hayes came to appreciate Knight.  Hayes thought it was a tough time to launch a new company with zero cash balance.  But he did acknowledge that having Bowerman as a partner was a valuable, intangible asset.

Recently, Bowerman and Mrs. Bowerman had visited Onitsuka and charmed everyone.  Mr. Onitsuka told Bowerman about founding his shoe company in the rubble after World War II.

He’d built his first lasts, for a line of basketball shoes, by pouring hot wax from Buddhist candles over his own feet.  Though the basketball shoes didn’t sell, Mr. Onitsuka didn’t give up.  He simply switched to running shoes, and the rest is shoe history.  Every Japanese runner in the 1964 Games, Bowerman told me, was wearing Tigers.

Mr. Onitsuka also told Bowerman that the inspiration for the unique soles on Tigers had come to him while eating sushi.  Looking down at his wooden platter, at the underside of an octopus’s leg, he thought a similar suction cup might work on the sole of a runner’s flat.  Bowerman filed that away.  Inspiration, he learned, can come from quotidian things.  Things you might eat.  Or find lying around the house.

Bowerman started corresponding not only with Mr. Onitsuka, but with the entire production team at the Onitsuka factory.  Bowerman realized that Americans tend to be longer and heavier than the Japanese.  He thought the Tigers could be modified to fit Americans better.  Most of Bowerman’s letters went unanswered, but like Johnson Bowerman just kept writing more.

Eventually he broke through.  Onitsuka made prototypes that conformed to Bowerman’s vision of a more American shoe.  Soft inner sole, more arch support, heel wedge to reduce stress on the Achilles tendon – they sent the prototype to Bowerman and he went wild for it.  He asked for more.

Bowerman also experimented with drinks to help his runners recover.  He invented an early version of Gatorade.  As well, he conducted experiments to make the track softer.  He invented an early version of polyurethane.



Johnson kept inundating Knight with long letters, including a boatload of parenthetical comments and a list of PS’s.  Knight felt he didn’t have time to send the requested words of encouragement.  Also, it wasn’t his style.

I look back now and wonder if I was truly being myself, or if I was emulating Bowerman, or my father, or both.  Was I adopting their man-of-few-words demeanor?  Was I maybe modeling all the men I admired?  At the time I was reading everything I could get my hands on about generals, samurai, shoguns, along with biographies of my three main heroes – Churchill, Kennedy, and Tolstoi.  I had no love of violence, but I was fascinated by leadership, or lack thereof, under extreme conditions…

I wasn’t that unique.  Throughout history men have looked to the warrior for a model of Hemingway’s cardinal virtue, pressurized grace… One lesson I took from all my home-schooling about heroes was that they didn’t say much.  None was a blabbermouth.  None micromanaged.  “Don’t tell people how to do things, tell them what to do and let them surprise you with their results.” 

(Winston Churchill in 1944, Wikimedia Commons)

Johnson never let Knight’s lack of communication discourage him.  Johnson was full of energy, passion, and creativity.  He was going all-out, seven days a week, to sell Blue Ribbon shoes.  Johnson had an index card for each customer including their shoe sizes and preferences.  He sent all of them birthday cards and Christmas cards.  Johnson developed extensive correspondence with hundreds of customers.

Johnson began aggregating customer feedback on the shoes.

…One man, for instance, complained that Tiger flats didn’t have enough cushion.  He wanted to run the Boston Marathon but didn’t think the Tigers would last the twenty-six miles.  So Johnson hired a local cobbler to graft rubber soles from a pair of shower shoes into a pair of Tiger flats.  Voila.  Johnsn’s Frankenstein flat had space-age, full-length, midsole cushioning.  (Today it’s standard in all training shoes for runners.)  The jerry-rigged Johnson sole was so dynamic, so soft, so new, Johnson’s customer posted a personal best in the Boston.  Johnson forwarded me the results and urged me to pass them along to Tiger.  Bowerman had just asked me to do the same with his batch of notes a few weeks earlier.  Good grief, I thought, one mad genius at a time.

Johnson had customers in thirty-seven states.  Knight meant to warn him about encroaching on Malboro Man’s territory.  But he never got around to it.

Knight did write to tell Johnson that if he could sell 3,250 shoes by the end of June 1966, then he could open the retail outlet he’d been asking about.  Knight calculated that 3,250 was impossible, so he wasn’t too worried.

Somehow Johnson hit 3,250.  So Blue Ribbon opened its first retail store in Santa Monica.

He then set about turning the store into a mecca, a holy of holies for runners.  He bought the most comfortable chairs he could find, and afford (yard sales), and he created a beautiful space for runners to hang out and talk.  He built shelves and filled them with books that every runner should read, many of them first editions from his own library.  He covered the walls with photos of Tiger-shod runners, and laid in a supply of silk-screened T-shirts with Tiger across the front, which he handed out to his best customers.  He also stuck Tigers to a black lacquered wall and illuminated them with a strip of can lights – very hip.  Very mod.  In all the world, there had never been a sanctuary for runners, a place that didn’t just sell them shoes but celebrated them and their shoes.  Johnson, the aspiring cult leader of runners, finally had his church.  Services were Monday through Saturday, nine to six.

When he first wrote me about the store, I thought of the temples and shrines I’d seen in Asia, and I was anxious to see how Johnson’s compared.  But there just wasn’t time…

Knight got a heads up that the Marlboro man had just launched an advertising campaign which involved poaching customers of Blue Ribbon.  So Knight flew down to see Johnson.

(Jeff Johnson, Employee Number One)

Johnson’s apartment was one giant running shoe.  There were running shoes seemingly everywhere.  And there were many books – mostly thick volumes on philosophy, religion, sociology, anthropology, and classics in Western literature.  Knight had thought he liked to read.  This was a new level, says Knight.

Johnson told Knight he had to go visit Onitsuka again.  Johnson started typing notes, ideas, lists, which would become a manifesto for Knight to take to Onitsuka.  Knight wired Onitsuka.  They got back to him, but it wasn’t Morimoto.  It was a new guy, Kitami.

Knight told Kitami and other executives about the performance of Blue Ribbon thus far, virtually doubling sales each year and projecting more of the same.  Kitami said they wanted someone more established, with offices on the East Coast.  Knight replied that Blue Ribbon had offices on the East Coast and could handle national distribution.  “Well,” said Kitami, “this changes things.”

The next morning, Kitami awarded Blue Ribbon exclusive distribution rights for the United States.  A three-year contract.  Knight promptly placed an order for 5,000 more shoes, which would cost $20,000 – more than $150,000 in 2018 dollars – that he didn’t have.  Kitami said he would ship them to Blue Ribbon’s East Coast office.

There was only one person crazy enough to move to the East Coast on a moment’s notice….



Knight delayed telling Johnson.  Then he hired John Bork, a high school track coach and a friend of a friend, to run the Santa Monica store.  Bork showed up at the store and told Johnson that he, Bork, was the new boss so that Johnson could go back east.

Johnson called Knight.  Knight told him he’d had to tell Onitsuka that Blue Ribbon had an east coast office.  A huge shipment was due to arrive at this office.  Johnson was the only one who could manage the east coast store.  The fate of the company was on his shoulders.  Johnson was shocked, then mad, then freaked out.  Knight flew down to visit him.

Johnson talked himself into going to the east coast.

The forgiveness Johnson showed me, the overall good nature he demonstrated, filled me with gratitude, and a new fondness for the man.  And perhaps a deeper loyalty.  I regretted my treatment of him.  All those unanswered letters.  There are team players, I thought, and then there are team players, and then there’s Johnson.

Soon thereafter, Bowerman called asking Knight to add a new employee – Geoff Hollister.  A former track guy.  Full-time Employee Number Three.

Then Bowerman called again with yet another employee – Bob Woodell.

I knew the name, of course.  Everyone in Oregon knew the name.  Woodell had been a standout on Bowerman’s 1965 team.  Not quite a star, but a gritty and inspiring competitor.  With Oregon defending its second national championship in three years, Woodell had come out of nowhere and won the long jump against vaunted UCLA.  I’d been there, I’d watched him do it, and I’d come away mighty impressed.

The very next day, during a celebration, there had been an accident.  The float twenty guys were carrying collapsed after someone lost their footing.  It landed on Woodell and crushed one of his vertebra, paralyzing his legs.

Knight called Woodell.  Knight realized it was best to keep it strictly business.  So he told Woodell that Bowerman had recommended him.  Would he like to grab lunch to discuss the possibility of working for Blue Ribbon?  Sure thing, he said.

Woodell had already mastered a special car, a Mercury Cougar with hand controls.  At lunch, they hit it off and Woodell impressed Knight.

I wasn’t certain what Blue Ribbon was, or if it would ever become a thing at all, but whatever it was or might become, I hoped it would have something of this man’s spirit.

Knight offered Woodell a job opening a second retail store, in Eugene, for a monthly salary of $400.  Woodell immediately agreed.  They shook hands.  “He still hand the strong grip of an athlete.”

(Bob Woodell 1967)

Bowerman’s latest experiment was with the Spring Up.  He noticed the outer sole melted, whereas the midsole remained solid.  He convinced Onitsuka to fuse the outer sole to the midsole.  The result looked like the ultimate distance training shoe.  Onitsuka also accepted Bowerman’s suggestion of a name for the shoe, the “Aztec,” in homage to the upcoming 1968 Olympics in Mexico City.  Unfortunately, Adidas had a similar name for one of its shoes and threatened to sue.  So Bowerman changed the name to “Cortez.”

The situation with Adidas reminded Knight of when he had been a runner in high school.  The fastest runner in the state was Jim Grelle (pronounced “Grella”) and Knight had been second-fastest.  So Knight spent many races staring at Grelle’s back.  Then they both went to Oregon, so Knight spent more years staring at Grelle’s back.

Adidas made Knight think of Grelle.  Knight felt super motivated.

Once again, in my quixotic effort to overtake a superior opponent, I had Bowerman as my coach.  Once again he was doing everything he could to put me in position to win.  I often drew on the memory of his old prerace pep talks, especially when we were up against our blood rivals, Oregon State.  I would replay Bowerman’s epic speeches… Nearly sixty years later it gives me chills to recall his words, his tone.  No one could get your blood going like Bowerman, though he never raised his voice.

Thanks to the Cortez, Blue Ribbon finished the year strong.  They had nearly doubled their sales again, to $84,000.  Knight rented an office for $50 a month.  And he transferring Woodell to the “home office.”  Woodell had shown himself to be highly skilled and energetic, and in particular, he was excellent at organizing.

The office was cold and the floor was warped.  But it was cheap.  Knight built a corkboard wall, pinning up different Tiger models and borrowing some of Johnson’s ideas from the Santa Monica store.

Knight thought perhaps he could save even more money by living at his office.  Then he reflected that living at your office was what a crazy person does.  Then he got a letter from Johnson saying he was living at his office.  Johnson had set up shop in Wellesley, a suburb of Boston.

Johnson told Knight how he had chosen the location.  He’d seen people running along country roads, many of them women.  Ali MacGraw look-alikes.  Sold.




I wanted to dedicate every minute of every day to Blue Ribbon… I wanted to be present, always.  I wanted to focus constantly on the one task that really mattered.  If my life was to be all work and no play, I wanted my work to be play.  I wanted to quit Price Waterhouse.  Not that I hated it;  it just wasn’t me.

I wanted what everyone wants.  To be me, full-time.

Even though Blue Ribbon was on track to double sales again, there was never enough cash, certainly not to pay Knight.  Knight found another job he thought might fit better with his desire to focus as much as possible on Blue Ribbon.  Assistant Professor of Accounting at Portland State University.

Knight, a CPA who had worked for two accounting firms, knew accounting pretty well at this point.  But he was restless and twitchy, with several nervous tics – including wrapping rubber banks around his wrist and snapping them.  One of his students was named Penelope Parks.  Knight was captivated by her.

Knight decided to use the Socratic method to teach accounting.  Miss Parks turned out to be the best student in the class.  Soon thereafter, Miss Parks asked if Knight would be her advisor.  Knight then asked her if she’d like a job for Blue Ribbon to help with bookkeeping.  “Okay.”

On Miss Parks’ first day at Blue Ribbon, Woodell gave her a list of things – typing, bookkeeping, scheduling, stocking, filing invoices – and told her to pick two.  Hours later, she’d done every thing on the list.  Within a week, Woodell and Knight couldn’t remember how they’d gotten by without her, recalls Knight.

Furthermore, Miss Parks was “all-in” with respect to the mission of Blue Ribbon.  She was good with people, too.  She had a healing effect on Woodell, who was still struggling to adjust to his legs being paralyzed.

Knight often volunteered to go get lunch for the three of them.  But his head was usually so full of business matters that he would invariably get the orders mixed up.  “Can’t wait to see what I’m eating for lunch today,” Woodell might say quietly.  Miss Parks would hide a smile.

Later on, Knight found out that Miss Parks and Woodell weren’t cashing any of their paychecks.  They truly believed in Blue Ribbon.  It was more than just a job for them.

Knight and Penny started dating.  They were good at communicating nonverbally since they were both shy people.  They were a good match and eventually decided to get married.  Knight felt like she was a partner in life.

Knight made another trip to Onitsuka.  Kitami was very friendly this time, inviting him to the company’s annual picnic.  Knight met a man named Fujimoto at the picnic.  It turned out to be another life-altering partnership.

…I was doing business with a country I’d come to love.  Gone was the initial fear.  I connected with the shyness of the Japanese people, with the simplicity of their culture and products and arts.  I liked that they tried to add beauty to every part of life, from the tea ceremony to the commode.  I liked that the radio announced each day which cherry trees, on which corner, were blossoming, and how much.

(Cherry trees in Japan, Photo by Nathapon Triratanachat)



Knight was able to hire more ex-runners on commission.  Sales in 1968 had been $150,000 and now they were on track for $300,000 for 1969.

Knight was finally able to pay himself a salary.  But before leaving Portland State, he happened to see a starving artist in the hallway and asked if she’d do advertising art part-time.  Her name was Carolyn Davidson, and she said OK.

Bowerman and Knight were losing trust in Kitami.  Bowerman thought he didn’t know much about shoes and was full of himself.  Knight hired Fujimoto to be a spy.  Knight pondered again that when it came to business in Japan, you never knew what a competitor or a partner would do.

Knight was absentminded.  He couldn’t go to the store and return with the one thing Penny asked for.  He misplaced wallets and keys frequently.  And he was constantly bumping into trees, poles, and fenders while driving.

Knight got in the habit of calling his father in the evening.  His father would be in his recliner, while Buck would be in his.  They’d hash things over.

Woodell and Knight began looking for a new office.  They started enjoying hanging out together.  Before parting, Knight would time Woodell on how fast he could fold up his wheelchair and get it and himself into his car.

Woodell was super positive and super energetic, a constant reminder of the importance of good spirits and a great attitude.

Buck and Penny would have Woodell over for dinner.  Those were fun times.  They would take turns describing what the company was and might be, and what it must never be.  Woodell was always dressed carefully and always had on a pair of Tigers.

Knight asked Woodell to become operations manager.  He’d demonstrated already that he was exceptionally good at managing day-to-day tasks.  Woodell was delighted.



Knight visited Onitsuka again.  He discovered that Kitami was being promoted to operations manager.  Onitsuka and Blue Ribbon signed another 3-year agreement.  Knight looked into Kitami’s eyes and noticed something very cold.  Knight never forgot that cold look.

Knight pondered the fact that the shipments from Onitsuka were always late, and sometimes had the wrong sizes or even the wrong models.  Woodell and Knight discovered that Onitsuka always filled its orders from Japanese companies first, and then sent its foreign exports.

Meanwhile, Wallace at the bank kept making things difficult.  Knight concluded that a small public offerings could create the extra cash Blue Ribbon needed.  At the time, in 1970, a few venture capital firms had been launched.  But they were in California and mostly invested in high-tech.  So Knight formed Sports-Tek, Inc., as a holding company for Blue Ribbon.  They tried a small public offering.  It didn’t work.

Friends and family chipped in.  Woodell’s parents were particularly generous.

On June 15, 1970, Knight was shocked to see a Man of Oregon on the cover of Sports Illustrated.  His name was Steve Prefontaine.  He’d already set a national record in high school at the two-mile (8:41).  In 1970, he’d run three miles in 13:12.8, the fastest time on the planet.

Knight learned from a Fortune magazine about Japan’s hyper-aggressive sosa shoga, “trading companies.”  It was hard to see what these trading companies were exactly.  Sometimes they were importers.  Sometimes they were exporters.  Sometimes they were banks.  Sometimes they were an arm of the government.

After being harangued by Wallace at First National about cash balances again, Knight walked out and saw a sign for the Bank of Tokyo.  He was escorted to a back room, where a man appeared after a couple of minutes.  Knight showed the man his financials and said he needed credit.  The man said that Japan’s sixth-largest trading company had an office at the top floor of this same building.  Nissho Iwai was a $100-billion dollar company.

Knight met a man named Cam Murakami, who offered Knight a deal on the spot.  Knight said he had to check with Onitsuka first.  Knight wired Kitami, but heard nothing back at all for weeks.

Then Knight got a call from a guy on the east coast who told him that Onitsuka had approached him about becoming its new U.S. distributor.  Knight checked with Fujimoto, his spy.  Yes, it was true.  Onitsuka was considering a clean break with Blue Ribbon.

Knight invited Kitami to visit Blue Ribbon.



March 1971.  Kitami was on his way.  Blue Ribbon vowed to give him the time of his life.

Kitami arrived with a personal assistant, Hiraku Iwano, who was just a kid.  At one point, Kitami told Knight that Blue Ribbon’s sales were disappointing.  Knight said sales were doubling every year.  “Should be triple some people say,” Kitami replied.  “What people?”, asked Knight.  “Never mind,” answered Kitami.

Kitami took a folder from his briefcase and repeated the charge.  Knight tried to defend Blue Ribbon.  Back and forth.  Kitami had to use the restroom.  When he left the meeting room, Knight looked into Kitami’s briefcase and tried to snag the folder that he thought Kitami had been referring to.

Kitami went back to his hotel.  Knight still had the folder.  He and Woodell opened it up.  They found a list of eighteen U.S. athletic shoe distributors.  These were the “some people” who told Kitami that Blue Ribbon wasn’t performing well enough.

I was outraged, of course.  But mostly hurt.  For seven years we’d devoted ourselves to Tiger shoes.  We’d introduced them to America, we’d reinvented the line.  Bowerman and Johnson had shown Onitsuka how to make a better shoe, and their designs were now foundational, setting sales records, changing the face of the industry – and this was how we were repaid?

At the end of Kitami’s visit, as planned, there was dinner with Bowerman, Mrs. Bowerman, and his friend (and lawyer), Jaqua.  Mrs. Bowerman usually didn’t allow alcohol, but she was making an exception.  Knight and Kitami both liked mai tais, which were being served.

Unfortunately, Bowerman had a few too many mai tais.  It appeared things might get out of hand.  Knight looked at Jaqua, remembering that he’d been a fighter pilot in World World II, and that his wingman, one of his closest friends, had been shot out of the sky by a Japanese Zero.  Knight thought he sensed something starting to erupt in Jaqua.

Kitami, however, was having a great time.  Then he found a guiter.  He started playing it and singing a country Western.  Suddenly, he sang “O Sole Mio.”

A Japanese businessman, strumming a Western guitar, singing an Italian ballad, in the voice of an Irish tenor.  It was surreal, then a few miles past surreal, and it didn’t stop.  I’d never know there were so many verses to “O Sole Mio.”  I’d never known a roomful of active, restless Oregonians could sit still and quite for so long.  When he set down the guitar, we all tried not to make eye contact with each other as we gave him a big hand.  I clapped and clapped and it all made sense.  For Kitami, this trip to the United States – the visit to the bank, the meetings with me, the dinner with the Bowermans – wasn’t about Blue Ribbon.  Nor was it about Onitsuka.  Like everything else, it was all about Kitami.

At a meeting soon thereafter, however, Kitami told Knight that Onitsuka wanted to buy Blue Ribbon.  If Blue Ribbon did not accept, Onitsuka would have to work with other distributors.  Knight knew he still needed Onitsuka, at least for awhile.  So he thought of a stall.  He told Kitami he’d have to talk with Bowerman.  Kitami said OK and left.

Knight sent the budget and forecast to First National.  White informed Knight at a meeting that First National would no longer be Blue Ribbon’s bank.  White was sick about it, the bank officers were divided, but it had been Wallace’s call.  Knight strove straight to U.S. Bank.  Sorry.  No.

Blue Ribbon was finishing 1971 with $1.3 million in sales, but it was in danger of failing.  Fortunately, Bank of Cal gave Blue Ribbon a small line of credit.

Knight went back to Nissho and met Tom Sumeragi.  Sumeragi told Knight that Nissho was willing to take a second position to their banks.  Also, Nissho had sent a delegation to Onitsuka to try to work out a deal on financing.  Onitsuka had tossed them out.  Nissho was embarrased that a $25 million company had thrown out a $100 billion company.  Sumeragi told Knight that Nissho could introduce him to other shoe manufacturers in Japan.

Knight knew he had to find a new shoe factory somewhere.  He found one in Gaudalajara, Mexico.  Knight placed an order for three thousand soccer shoes.  It’s at this point that Knight asked his part-time artist, Carolyn Davidson, to try to design a logo.  “Something that evokes a sense of motion.”  She came back two weeks later and her sketches had a theme.  But Knight was wondering what the theme was, “…fat lightning bolts?  Chubby check marks?  Morbidly obese squiggles?…”

Davidson returned later.  Same theme, but better.  Woodell, Johnson, and a few others liked it, saying it looked like a wing or a whoosh of air.  Knight wasn’t thrilled about it, but went along because they were out of time and had to send it to the factory in Mexico.

(Nike logo, Timidonfire, Wikimedia Commons)

They also needed a name.  Falcon.  Dimension Six.  These were possibilities they’d come up with.  Knight liked Dimension Six mostly because he’d come up with it.  Everyone told him it was awful.  It didn’t mean anything.  Bengal.  Condor.  They debated possibilities.

It was time to decide.  Knight still didn’t know.  Then Woodell told him that Johnson had had a dream and then woke up with the name clearly in mind:  “Nike.”

Knight reminisced…  “The Greek goddess of victory.  The Acropolis.  The Parthenon.  The Temple…”

Knight had to decide.  He hated having to decide under time pressure.  He’s not sure if it was luck or spirit or something else, but he chose “Nike.”  Woodell said, “Hm.”  Knight replied, “Yeah, I know.  Maybe it’ll grow on us.”

(Nike logo, Wikimedia Commons)

Meanwhile, Nissho was infusing Blue Ribbon with cash.  But Knight wanted a more permanent solution.  He conceived of a public offering of convertible debentures.  People bought them, including Knight’s friend Cale.

The factory in Mexico didn’t produce good shoes.  Knight talked with Sumeragi, who knew a great deal about shoe factories around the world.  Sumeragi also offered to introduce Knight to Jonas Senter, “a shoe dog.”

Shoe dogs were people who devoted themselves wholly to the making, selling, buying, or designing of shoes.  Lifers used the phrase cheerfully to describe other lifers, men and women who had toiled so long and hard in the shoe trade, they thought and talked about nothing else.  It was an all-consuming mania… But I understood.  The average person takes seventy-five hundred steps a day, 274 million steps over the course of a long life, the equivalent of six times around the globe – shoe dogs, it seemed to me, simply wanted to be part of that journey.  Shoes were their way of connecting with humanity…

Senter was the “knockoff king.”  He’d been behind a recent flood of knockoff Adidas.  Senter’s protege was a guy named Sole.

Knight wasn’t sure partnering with Nissho was the best move.  Jaqua suggested Knight meet with his brother-in-law, Chuck Robinson, CEO of Marcona Mining, which had many joint ventures.  Each of the big eight Japanese trading firms was a partner in at least one of Marcona’s mines, records Knight.  Chuck to Buck:  “If the Japanese trading company understands the rules from the first day, they will be the best partners you’ll ever have.”

Knight went to Sumeragi and said:  “No equity in my company.  Ever.”  Sumeragi consulted a few folks, came back and said:  “No problem.  But here’s our deal.  We take four percent off the top, as a markup on product.  And market interest rates on top of that.”  Done.

Knight met Sole, who mentioned five factories in Japan.

A bit later, Bowerman was eating breakfast when he noticed the waffle iron’s gridded pattern.  This gave him an idea and he started experimenting.

…he took a sheet of stainless steel and punched it with holes, creating a waffle-like surface, and brought this back to the rubber company.  The mold they made from that steel sheet was pliable, workable, and Bowerman now had two foot-sized squares of hard rubber nubs, which he brought home and sewed to the sole of a pair of running shoes.  He gave these to one of his runners.  The runner laced them on and ran like a rabbit.

Bowerman phoned me, excited, and told me about his experiment.  He wanted me to send a sample of his waffle-soled shoes to one of my new factories.  Of course, I said.  I’d send it right away – to Nippon Rubber.

I look back over decades and see him toiling in his workshop, Mrs. Bowerman carefully helping, and I get goosebumps.  He was Edison in Menlo Park, Da Vinci in Florence, Tesla in Wardenclyffe.  Divinely inspired.  I wonder if he knew, if he had any clue, that he was the Daedalus of sneakers, that he was making history, remaking an industry, transforming the way athletes would run and stop and jump for generations.  I wonder if he could conceive in that moment all he’d done.  All that would follow.



The National Sporting Goods Association Show in Chicago in 1972 was extremely important for Blue Ribbon because they were going to introduce the world to Nike shoes.  If sales reps liked Nike shoes, Blue Ribbon had a chance to flourish.  If not, Blue Ribbon wouldn’t be back in 1973.

Right before the show, Onitsuka announced its “acquisition” of Blue Ribbon.  Knight had to reassure Sumeragi that there was no acquisition.  At the same time, Knight couldn’t break from Onitsuka just yet.

As Woodell and Johnson prepared the booth – with stacks of Tigers and also with stacks of Nikes – they realized the Nikes from Nippon Rubber weren’t as high-quality as the Tigers.  The swooshes were crooked, too.

Darn it, this was no time to be introducing flawed shoes.  Worse, we had to push these flawed shoes on to people who weren’t our kind of people.  They were salesmen.  They talked like salesmen, walked like salesmen, and they dressed like salesmen – tight polyester shirts, Sansabelt slacks.  They were extroverts, we were introverts.  They didn’t get us, we didn’t get them, and yet our future depended on them.  And now we’d have to persuade them, somehow, that this Nike thing was worth their time and trust – and money.

I was on the verge of losing it, right on the verge.  Then I saw Johnson and Woodell were already losing it, and I realized that I couldn’t afford to… ‘Look fellas, this is the worst the shoes will ever be.  They’ll get better.  So if we can just sell these… we’ll be on our way.’

The salesmen were skeptical and full of questions about the Nikes.  But by the end of the day, Blue Ribbon had exceeded its highest expectations.  Nikes had been the smash hit of the show.

Johnson was so perplexed that he demanded an answer from the representative of one his biggest accounts.  The rep explained:

‘We’ve been doing business with you Blue Ribbon guys for years and we know that you guys tell the truth.  Everyone else bullshits, you guys always shoot straight.  So if you say this new shoe, this Nike, is worth a shot, we believe.’

Johnson came back to the booth and said, “Telling the truth.  Who knew?”  Woodell laughed.  Johnson laughed.  Knight laughed.

Two weeks later, Kitami showed up without warning in Knight’s office, asking about “this… NEE-kay.”  Knight had been rehearsing for this situation.  He replied simply that it was a side project just in case Onitsuka drops Blue Ribbon.  Kitami seemed placated.

Kitami asked if the Nikes were in stores.  No, said Knight.  Kitami asked when Blue Ribbon was going to sell to Onitsuka.  Knight answered that he still needed to talk with Bowerman.  Kitami then said he had business in California, but would be back.

Knight called Bork in Los Angeles and told him to hide the Nikes.  Bork hid them in the back of the store.  But Kitami, when visiting the store, told Bork he had to use the bathroom.  While in the back, Kitami found stacks of Nikes.

Bork called Knight and told him, “Jig’s up… It’s over.”  Bork ended up quitting.  Knight discovered later that Bork had a new job… working for Kitami.

Kitami demanded a meeting.  Bowerman, Jaqua, and Knight were in attendance.  Jaqua told Knight to say nothing no matter what.  Jaqua told Kitami that he hoped something could still be worked out, since a lawsuit would be damaging to both companies.

Knight called a company-wide meeting to explain that Onitsuka had cut them off.  Many people felt resigned, says Knight, in part because there was a recession in the United States.  Gas lines, political gridlock, rising unemployment, Vietnam.  Knight saw the discouragement in the faces of Blue Ribbon employees, so he told them:

‘…This is the moment we’ve been waiting for.  One moment.  No more selling someone else’s brand.  No more working for someone else.  Onitsuka has been holding us down for years.  Their late deliveries, their mixed-up orders, their refusal to hear and implement our design ideas – who among us isn’t sick of dealing with all that?  It’s time we faced facts:  If we’re going to succeed, or fail, we should do so on our own terms, with our own ideas – our own brand.  We posted two million in sales last year… none of which had anything to do with Onitsuka.  That number was a testament to our ingenuity and hard work.  Let’s not look at this as a crisis.  Let’s look at this as our liberation.  Our Independence Day.’

Johnson told Knight, “Your finest hour.”  Knight replied he was just telling the truth.

The Olympic track-and-field trials in 1972 were going to be in Eugene.  Blue Ribbon gave Nikes to anyone who would take them.  And they handed out Nike T-shirts left and right.

The main event was on the final day, a race between Steve Prefontaine – known as “Pre” – and the great Olympian George Young.  Pre was the biggest thing to hit American track and field since Jesse Owens.  Knight tried to figure out why.  It was hard to say, exactly.  Knight:

Sometimes I thought the secret to Pre’s appeal was his passion.  He didn’t care if he died crossing the finish line, so long as he crossed first.  No matter what Bowerman told him, no matter what his body told him, Pre refused to slow down, ease off.  He pushed himself to the brink and beyond.  This was often a counterproductive strategy, and sometimes it was plainly stupid, and occasionally it was suicidal.  But it was always uplifting for the crowd.  No matter the sport – no matter the human endeavor, really – total effort will win people’s hearts.

(Steve Prefontaine)

Gerry Lindgren was also in this race with Pre and Young.  Lindgren may have been the best distance runner in the world at that time.  Lindgren had beaten Pre when Lindgren was a senior and Pre a freshman.

Pre took the lead right away.  Young tucked in behind him.  In no time they pulled way ahead of the field and it became a two-man affair… Each man’s strategy was clear.  Young meant to stay with Pre until the final lap, then use his superior sprint to go by and win.  Pre, meanwhile, intended to set such a fast pace at the outset that by the time they got to that final lap, Young’s legs would be gone.

For eleven laps they ran a half stride apart.  With the crowd now roaring, frothing, shrieking, the two men entered the final lap.  It felt like a boxing match.  It felt like a joust… Pre reached down, found another level – we saw him do it.  He opened up a yard lead, then two, then five.  We saw Young grimacing and we knew that he would not, could not, catch Pre.  I told myself, Don’t forget this.  Do not forget.  I told myself there was much to be learned from such a display of passion, whether you were running a mile or a company.

Both men had broken the American record.  Pre had broken it by a little bit more.

…What followed was one of the greatest ovations I’ve ever heard, and I’ve spent my life in stadiums.

I’d never witnessed anything quite like that race.  And yet I didn’t just witness it.  I took part in it.  Days later I felt sore in the hams and quads.  This, I decided, this is what sports are, what they can do.  Like books, sports give people a sense of having lived other lives, of taking part in other people’s victories.  And defeats.  When sports are at their best, the spirit of the fan merges with the spirit of the athlete, and in that convergence, in that transference, is the oneness that mystics talk about.



Bowerman had retired from coaching, partly because of the sadness of the terrorist attacks at the 1972 Olympics in Munich.  Bowerman had been able to help hide one Israeli athlete.  Bowerman had immediately called the U.S. consul and shouted, “Send the marines!”  Eleven Israeli athletes had been captured and later killed.  An unspeakable tragedy.  Knight thought of the deaths of the two Kennedys, and Dr. King, and the students at Kent State.

Ours was a difficult, death-drenched age, and at least once every day you were forced to ask yourself:  What’s the point?

Although Bowerman had retired from coaching, he was still coaching Pre.  Pre had finished a disappointing fourth at the Olympics.  He could have gotten silver if he’d allowed another runner to be the front runner and if he’d coasted in his wake.  But, of course, Pre couldn’t do that.

It took Pre six months to re-emerge.  He won the NCAA three-mile for a fourth straight year, with a time of 13:05.3.  He also won in the 5,000 by a good margin with a time of 13:22.4, a new American record.  And Bowerman had finally convinced Pre to wear Nikes.

At that time, Olympic athletes couldn’t receive endorsement money.  So Pre sometimes tended bar and occasionally ran in Europe in exchange for illicit cash from promoters.

Knight decided to hire Pre, partly to keep him from injuring himself by racing too much.  Pre’s title was National Director of Public Affairs.  People often asked Knight what that meant.  Knight would say, “It means he can run fast.”  Pre wore Nikes everywhere and he preached Nike as gospel, says Knight.

Around this time, Knight realized that Johnson was becoming an excellent designer.  The East Coast was running smoothly, but needed reorganization.  So Knight asked Johnson to switch places with Woodell.  Woodell excelled at operations and thus would be a great fit for the East Coast situation.

Although Johnson and Woodell irritated one another, they both denied it.  When Knight asked them to switch places, the two exchanged house keys without the slightest complaint.

In the spring of 1973, Knight held his second meeting with the debenture holders.  He had to tell them that despite $3.2 million in sales, the company had lost $57,000.  The reaction was negative.  Knight tried to explain that sales continue to explode higher.  But the investors were not happy.

Knight left the meeting thinking he would never, ever take the company public.  He didn’t want to deal with that much negativity and rejection ever again.

Onitsuka filed suit against Blue Ribbon in Japan.  So Blue Ribbon had to file against them in the United States.

Knight asked his Cousin Houser to be in charge of the case.  Houser was a fine lawyer who carried himself with confidence.

Better yet, he was a tenacious competitor.  When we were kids Cousin Houser and I used to play vicious, marathon games of badminton in his backyard.  One summer we played exactly 116 games.  Why 116?  Because Cousin Houser beat me 115 straight times.  I refused to quit until I’d won.  And he had no trouble understanding my position.

More importantly, Cousin Houser was able to talk his firm into taking the Blue Ribbon case on contingency.

Knight continued his evening conversations with this father, who believed strongly in Blue Ribbon’s cause.  Knight’s father, who had been trained as a lawyer, spent time studying law books.  He reassured Buck, “we” are going to win.  This support from his father boosted Buck’s spirits at a challenging time.

(Law library, Photo by Spiroview Inc.)

Cousin Houser told Knight one day that he was bringing on a new member of the team, a young lawyer from UC Berkeley School of Law, Rob Strasser.  Not only was Strasser brilliant.  He also believed in the rightness of Blue Ribbon’s case, viewing it as a “holy crusade.”

Strasser was a fellow Oregonian who felt looked down on by folks north and south.  Moreover, he felt like an outcast.  Knight could relate.  Strasser often downplayed his intelligence for fear of alienating people.  Knight could relate to that, too.

Intelligence like Strasser’s, however, couldn’t be hidden for long.  He was one of the greatest thinkers I ever met.  Debator, negotiator, talker, seeker – his mind was always whirring, trying to understand.

When he wasn’t preparing for the trial, Knight was exclusively focused on sales.  It was essential that they sell out every pair of shoes in each order.  The company was still growing fast and cash was always short.

Whenever there was a delay, Woodell always knew what the problem was and could quickly let Knight know.  Knight on Woodell:

He had a superb talent for underplaying the bad, and underplaying the good, for simply being in the moment… throughout the day a steady rain of pigeon poop would fall on Woodell’s hair, shoulders, desktop.  But Woodell would simply dust himself off, casually clear his desk with the side of his hand, and continue with his work.

…I tried often to emulate Woodell’s Zen monk demeanor.  Most days, however, it was beyond me…

Blue Ribbon couldn’t meet demand.  This frustrated Knight.  Supplies were arriving on time.  But in 1973, it seemed that the whole world, all at once, wanted running shoes.  And there were never enough.  This made things precarious, to say the least, for Blue Ribbon:

…We were leveraged to the hilt, and like most people who live from paycheck to paycheck, we were walking the edge of a precipice.  When a shipment of shoes was late, our pair count plummeted.  When our pair count plummeted, we weren’t able to generate enough revenue to repay Nissho and the Bank of California on time.  When we couldn’t repay Nissho and the Bank of California on time, we couldn’t borrow more.  When we couldn’t borrow more we were late placing our next order.

Sales for 1973 hit $4.8 million, up 50 percent from the previous year.  But Blue Ribbon was still on fragile ground, it seemed.  Knight then thought of asking their retailers to sign up for large and unrefundable orders, six months in advance, in exchange for hefty discounts, up to 7 percent.  Such long-term commitments from well-established retailers like Nordstrom, Kinney, Athlete’s Foot, United Sporting Goods, and others, could then be used to get more credit from Nissho and the Bank of California.

Much later, after much protesting, the retailers signed on to the long-term commitments.



The trial.  Federal courthouse in downtown Portland.  Wayne Hilliard was the lead lawyer for the opposition.  He was fiery and eloquent.  Cousin Houser was the lead for Blue Ribbon.  He’d convinced his firm to take the Blue Ribbon case on contingency.  But instead of a few months, it was now two years later.  Houser hadn’t seen a dime and costs were huge.  Moreover, Houser told Knight that his fellow law partners sometimes put a great deal of pressure on Houser to drop the Blue Ribbon case.

(Federal courthouse in Portland, Oregon, Wikimedia Commons)

Houser stuck with the case.  He wasn’t fiery.  But he was prepared and dedicated.  Knight was initially disappointed, but later came to admire him.  “Fire or no, Cousin Houser was a true hero.”

After being questioned by both sides, Knight felt he hadn’t done well at all, a D minus.  Houser and Strasser didn’t disagree.

The judge in the case was the Honorable James Burns.  He called himself James the Just.  Johnson made the mistake of discussing the trial with a store manager after James the Just had expressly forbidden all discussion of the case outside the courtroom.  James the Just was upset.  Knight:

Johnson redeemed himself with his testimony.  Articulate, dazzlingly anal about the tiniest details, he described the Boston and the Cortez better than anyone else in the world could, including me.  Hilliard tried and tried to break him, and couldn’t.

Later on, the testimony of Iwano, the young assistant who’d been with Kitami, was heard.  Iwano testified that Kitami had a fixed plan already in place to break the contract with Blue Ribbon.  Kitami had openly discussed this plan on many occasions, said Iwano.

Bowerman’s testimony was so-so because, out of disdain, he hadn’t prepared.  Woodell, for his part, was nervous.

Mr. Onitsuka said he hadn’t known anything about the conflict between Kitami and Knight.  Kitami, in his testimony, lied again and again.  He said that he had no plan to break the contract with Blue Ribbon.  He also claimed that meeting with other distributors had just been market research.  As well, the idea of acquiring Blue Ribbon “was initiated by Phil Knight.”

James the Just was convinced that Blue Ribbon had been more truthful.  In particular, Iwano seemed truthful, while Kitami didn’t.  On the issue of trademarks, Blue Ribbon would retain all rights to the Boston and the Cortez.

A bit later, Hilliard offered $400,000.  Finally, Blue Ribbon accepted.  Knight was happy for Cousin Houser, who would get half.  It was the largest payment in the history of his firm.

Knight, with help from Hayes, convinced Strasser to come work for Blue Ribbon.  Strasser later accepted.

Japanese labor costs were rising.  The yen was fluctuating.  Knight decided Blue Ribbon needed to find factories outside of Japan.  He looked at Taiwan, but shoe factories there weren’t quite ready.  He looked next at Puerto Rico.

Then Knight went to the east coast to look for possible factories.  The first factory owner laughed in Knight’s face.

The next empty factory Knight visited – with Johnson – the owner was willing to lease the third floor to Blue Ribbon.  He suggested a local guy to manage the factory, Bill Giampietro.  Giampietro turned out to be “a true shoe dog,” said Knight.  All he’d ever done is make shoes, like his father.  Perfect.  Could he get the old Exeter factory up and running?  How much would it cost?  No problem.  About $250,000.  Deal.

Knight asked Johnson to run the new factory.  Johnson said, “…what do I know about running a factory?  I’d be in completely over my head.”

Knight couldn’t stop laughing:  “Over your head?  Over your head!  We’re all in over our heads!  Way over!”

Knight writes that, at Blue Ribbon, it wasn’t that they thought they couldn’t fail.  On the contrary, they thought they would fail.  But they believed they would fail fast, learn from it, and be better for it.

Finishing up 1974, the company was on track for $8 million in sales.  Their contact at Bank of California, Perry Holland, kept telling them to slow down.  So they sped up, as usual.



Knight kept telling Hayes, “Pay Nissho first.”  Blue Ribbon had a line of credit at the bank for $1 million.  They had a second million from Nissho.  That was absolutely essential.

…Grow or die, that’s what I believed, no matter the situation.  Why cut your order from $3 million down to $2 million if you believed in your bones that demand out there was for $5 million?  So I was forever pushing my conservative bankers to the brink, forcing them into a game of chicken.  I’d order a number of shoes that seemed to them absurd, a number we’d need to stretch to pay for, and I’d always just barely pay for them, in the nick of time, and then just barely pay our other monthly bills, at the last minute, always doing just enough, and no more, to prevent the bankers from booting us.  And then, at the end of the month, I’d empty our accounts to pay Nissho and start from zero again.

Demand was always greater than sales, so Knight concluded his approach was reasonable.  There was a new manager at Nissho’s Portland office, Tadayuki Ito, in place of Sumeragi.  (Sumeragi still helped with the Blue Ribbon account, though.)

One day in the spring of 1975, Blue Ribbon was $75,000 short of the $1 million they owed Nissho.  Blue Ribbon would have to completely drain every other account to make up for the shortfall.  Retail stores.  Johnson’s Exeter factory.  All of them.

(Illustration by Lkeskinen0)

In Exeter, a mob of angry workers was at Johnson’s door.  Giampetro drove with Johnson to see an old friend who owned a box company that depended on Blue Ribbon.  Giampetro asked for a loan of $5,000 (more than $25,000 in 2018), which was outrageous.  The man counted out fifty crisp hundred-dollar bills, says Knight.

Then Holland called Knight and Hayes to a meeting at the Bank of California.  The bank would no longer do business with Blue Ribbon.

Knight was worried how Ito and Sumeragi, representing Nissho, would react.  Ito and Sumeragi, after hearing what happened, said they would need to look at Blue Ribbon’s books.

On the weekend, Knight called a company-wide meeting to discuss the situation.  The Exeter factory had been a secret kept from Nissho.  But everyone agreed to give Nissho all information.

During this meeting, two creditors – owed $500,000 and $100,000 – called and were livid.  They were on their way to Oregon to collect and cash out.

On Monday, Ito and Sumeragi arrived at Blue Ribbon’s office.  Without a word, they went through the lobby to the conference room, sat down with the books and got to work.  Then Ito came to information related to the Exeter factory.  He did a slow double-take and then looked up at Knight.  Knight nodded.  Ito smiled.  Knight:

I gave him a weak half smile in return, and in that brief wordless exchange countless fates and futures were decided.

It turned out that Sumeragi had been trying to help Blue Ribbon by hiding Nissho’s invoices in a drawer.  Blue Ribbon had been stressing out trying to pay Nissho on time, but they’d never paid them on time because Sumeragi thought he was helping, writes Knight.

Ito accused Sumeragi of working for Blue Ribbon.  Sumeragi swore on his life that he’d acted independently.  Ito asked why.  Sumeragi answered that he thought Blue Ribbon would be a great success, perhaps a $20 million account.  Ito eventually forgave Blue Ribbon.  “There are worse things than ambition,” he said.

Ito accompanied Knight and Hayes to a meeting with the Bank of California.  Only this time, Ito – whom Knight saw as a “mythic samurai, wielding a jeweled sword” – was on their side.

(Samurai, Photo by Esolex)

According to Knight, Ito opened the meeting and “went all in.”  After confirming that Bank of California no longer wanted to handle Blue Ribbon’s account, Ito said Nissho wanted to pay off Blue Ribbon’s outstanding debt.  He asked for the number and it was the same number he’d learned earlier.  Ito already had a check made out for the amount and slid an envelope with the check across the table.  Ito insisted the check be deposited immediately.

After the meeting, Knight and Hayes bowed to Ito.  Ito remarked:

‘Such stupidity… I do not like such stupidity.  People pay too much attention to numbers.’


Blue Ribbon still needed a bank.  They started calling.  “The first six hung up on us,” recalls Knight.  First State Bank of Oregon didn’t hang up.  They offered one million in credit.

Pre died in a tragic car accident at the age of twenty-four.  At the time of his death, he held every American record from 2,000 to 10,000 meters, from two miles to six miles.  People created a shrine where Pre had died.  They left flowers, letters, notes, gifts.  Knight, Johnson, and Woodell decided that Blue Ribbon would curate Pre’s rock, making it a holy site forever.



Knight had several meetings early in 1976 with Woodell, Hayes, and Strasser about the company’s cash situation.  Nissho was lending Blue Ribbon millions, but to keep up with demand, they needed millions more.  The most logical solution was to go public.  But Knight and the others felt that it just wasn’t who they were.  No way.

They found other ways to raise money, including a million-dollar loan guaranteed by the U.S. Small Business Administration.

Meanwhile, Bowerman’s waffle trainer was getting even more popular.

(Nike 1976 waffle trainer)

With its unique outer sole, and its pillowy midsole cushion, and its below-market price ($24.95), the waffle trainer was continuing to capture the popular imagination like no previous shoe.  It didn’t just feel different, or fit different – it looked different.  Radically so.  Bright red upper, fat white swoosh – it was a revolution in aesthetics.  Its look was drawing hundreds of thousands of new customers into the Nike fold, and its performance was sealing their loyalty.  It had better traction and cushioning than anything on the market.

Watching that shoe evolve in 1976 from popular accessory to cultural artifact, I had a thought.  People might start wearing this thing to class.

And the office.

And the grocery store.

And throughout their everyday lives.

It was a rather grandiose idea… So I ordered the factories to start making the waffle trainer in blue, which would go better with jeans, and that’s when it really took off.

We couldn’t make enough.  Retailers and sales reps were on their knees, pleading for all the waffle trainers we could ship.  The soaring pair counts were transforming our company, not to mention the industry.  We were seeing numbers that redefined our long-term goals, because they gave us something we’d always lacked – an identify.  More than a brand, Nike was now becoming a household word, to such an extent that we would have to change the company name.  Blue Ribbon, we decided, had run its course.  We would have to incorporate as Nike, Inc.

They needed to ramp up production.  Knight realized the time had come to visit Taiwan.  To help with the Taiwan effort, Knight turned to Jim Gorman.  Gorman had been raised in a series of foster homes.  Nike was the family he’d never had.

…In every instance, Gorman had done a fine job and never uttered a sour word.  He seemed the perfect candidate to take on the latest mission impossible – Taiwan.  But first I needed to give him a crash course on Asia.  So I scheduled a trip, just the two of us.

Gorman was full of questions for Knight and took notes on everything.  Knight enjoyed teaching Gorman, partly because Knight himself could learn what he knew even better through the process of teaching.

Taiwan had a hundred smaller factories, whereas South Korea had a few larger ones.  That’s why Nike needed to go to Taiwan at this juncture.  Demand for Nikes was exploding, but their volume was still too low for a giant shoe factory.  However, Knight knew it would be a challenge to get a shoe factory in Taiwan to improve its quality enough to be able to produce Nikes.

During the visit to various Taiwan shoe factories, Jerry Hsieh introduced himself to Knight and Gorman.  Hsieh was a genuine shoe dog, but quite young, twenty-something.  When Knight and Gorman found their way to Hsieh’s office – a room stuffed with shoes everywhere – Hsieh started sharing his deep knowledge of shoes.  Also, Hsieh told them he knew the very best shoe factories in Taiwan and for a small fee, would be happy to introduce them.  They agreed on a commission per pair.

The 1976 Olympic trials, again in Eugene.  In the 10,000 meter race, all top three finishers wore Nikes.  Some top finishers in other qualifying races also wore Nikes.  Meanwhile, Penny created a great number of Nike T-shirts.  People would see other people wearing the Nike T-shirts and want to buy one.  The Nike employees heard people whispering.  “Nike.”  “Nike.”  “Nike.”

At the close of 1976, Nike had doubled its sales to $14 million.  The company still had no cash, though.  Its bank accounts were often at zero.

The company’s biannual retreat was taking place.  People called it Buttface.

Johnson coined the phrase, we think.  At one of our earliest retreats he muttered:  “How many multi-million dollar companies can you yell out, ‘Hey, Buttface,’ and the entire management team turns around?”  It got a laugh.  And then it stuck.  And then it became a key part of our vernacular.  Buttface referred to both the retreat and the retreaters, and it not only captured the informal mood of those retreats, where no idea was too sacred to be mocked, and no person was too important to be ridiculed, it also summed up the company spirit, mission and ethos.

Knight continues:

…The problems confronting us were grave, complex, insurmountable… And yet we were always laughing.  Sometimes, after a really cathartic guffaw, I’d look around the table and feel overcome by emotion.  Camaraderie, loyalty, gratitude.  Even love.  Surely love.  But I also remember feeling shocked that these were the men I’d assembled.  These were the founding fathers of a multi-million dollar company that sold athletic shoes?  A paralyzed guy, two morbidly obese guys, a chain-smoking guy?  It was bracing to realize that, in this group, the one with whom I had the most in common was… Johnson.  And yet, it was undeniable.  While everyone else was laughing, rioting, he’d be the sane one, sitting quietly in the middle of the table reading a book.

A bit later, Knight writes:

Undoubtedly we looked, to any casual observer, like a sorry, motley crew, hopelessly mismatched.  But in fact we were more alike than different, and that gave a coherence to our goals and our efforts.  We were mostly Oregon guys, which was important.  We had an inborn need to prove ourselves, to show the world that we weren’t hicks and hayseeds.  And we were nearly all merciless self-loathers, which kept the egos in check.  There was none of that smartest-guy-in-the-room foolishness.  Hayes, Strasser, Woodell, Johnson, each would have been the smartest guy in any room, but none believed of himself, or the next guy.  Our meetings were defined by contempt, disdain, and heaps of abuse.

(Photo by Chris Dorney)

Knight records:

…Each of us had been misunderstood, misjudged, dismissed.  Shunned by bosses, spurned by luck, rejected by society, short-changed by fate when looks and other natural graces were handed out.  We’d each been forged by early failure.  We’d each given ourselves to some quest, some attempt at validation or meaning, and fallen short.

I identified with the born loser in each Buttface, and vice versa, and I knew that together we could become winners…

Knight’s management style continued to be very hands-off, following Patton’s leadership belief:

Don’t tell people how to do things, tell them what to do and let them surprise you with their results.

Nike’s culture seemed to be working thus far.  Since Bork, no one had gotten really upset, not even what they were paid, which is unusual, notes Knight.  Knight created a culture he himself would have wanted:  let people be, let people do, let people make their own mistakes.



M. Frank Rudy, a former aerospace engineer, and his business partner, Bob Bogert, presented to Nike the idea of putting air in the soles of shoes.  Great cushioning, great support, a wonderful ride.  Knight tried wearing a pair Rudy showed him on a six-mile run.  Unstable, but one great ride.

Strasser, who by this point had become Nike’s negotiator, offered Rudy 10 cents for every pair we sold.  Rudy asked for twenty.  They settled somewhere in the middle.  Knight sent Rudy and his partner back to Exeter, which “was becoming our de facto Research and Development Department.”

Knight calls this time “an odd moment,” saying furthermore that “a second strange shoe dog showed up on our door step.  His name was Sonny Vaccaro…”.  Vaccaro had founded the Dapper Dan Classic, a high school all-star game that had become very popular.  Though it, Vaccaro had gotten to know many coaches.  Knight hired Vaccaro and sent him, with Strasser, to sign up college basketball coaches.  Knight expected them to fail.  But they succeeded.

Knight knew he had to meet again with Chuck Robinson, who’d served with distinction as a lieutenant commander on a battle ship in World War II.  Chuck knew business better than anyone Knight had ever met.  Recently, he’d been the number two guy under Henry Kissinger, so he wasn’t available for meetings.  Now Chuck was free.

Chuck took a look at Nike’s financials and couldn’t stop laughing, saying, “Compositionally, you are a Japanese trading company – 90 percent debt!”

Chuck told Buck, “You can’t live like this.”  The solution was to go public in order to raise a large amount of cash.  Knight invited Chuck to join the board.  Chuck agreed, to Knight’s surprise.

When Knight put the question of going public to a company vote, however, the consensus was still to remain private.

Then they received a letter from the U.S. Customs Service containing a bill for $25 million.  Nike’s competitors, Converse and Keds – plus a few small factories – were behind it.  They had been lobbying in Washington, DC, trying to slow Nike by enforcing the American Selling Price, an old law dating back to protectionist days.

(Photo by Ian Wilson)

ASP – American Selling Price – said that import duties on nylon shoes should be 20 percent of the shoe’s manufacturing cost.  Unless there was a “similar shoe” made by a U.S. competitor.  Then it should be 20 percent of that shoe’s selling price.  Nike’s competitors just needed to make some shoes deemed “similar,” price them very high, and voila – high import duties for Nike.

They’d managed to pull the trick off, raising Nike’s import duties retroactively by 40 percent.

Near the end of 1977, Nike’s sales were approaching $70 million.



Knight calls Strasser the “five-star general” in the battle with the U.S. government.  But they knew they needed “a few good men.”  Strasser suggested a friend of his, a young Portland lawyer, Richard Werschkul.  Stanford undergrad, University of Oregon law.  A sharp guy with a presence.  And an eccentric streak.  Some worried he was too serious and obsessive.  But that seemed good to Knight.  And Knight trusted Strasser.  Werschkul was dispatched to Washington, DC.

Meanwhile, sales were on track for $140 million.  Furthermore, Nike shoes were finally recognized as higher quality than Adidas shoes.  Knight thought Nike had led in quality and innovation for years.

Nike had to start selling clothes, announced Knight at Buttface in 1978.  First, Adidas sold more apparel than shoes.  Second, it would be easier to get athletes into endorsement deals.

Knight decided to hire a young accountant, Bob Nelson, and put him in charge of the new line of Nike apparel.  But Nelson had no sense of style, unfortunately.  When he presented his ideas, they didn’t look good.  Knight decided to transfer him to an accounting position, where he would excel.  Knight writes:

…Then I quietly shifted Woodell to apparel.  He did his typically flawless job, assembling a line that gained immediate attention and respect in the industry.  I asked myself why I didn’t just let Woodell do everything.

Tailwind – a new Nike shoe with air – came out in late 1978.  Then Nike had to recall it due to a design flaw.  Knight concluded they’d learned a valuable lesson.  “Don’t put twelve innovations into one shoe.”

Around this time, many seemed to be suffering from burnout, including Knight.  And back in DC, Werschkul was becoming hyper obsessive.  He’d tried to talk with everyone possible.  They all told him to put something in writing so they could study it.

Werschkul spent months writing.  It became hundreds of pages.  “Without a shred of irony Werschkul called it:  Werschkul on American Selling Price, Volume I.”  Knight:

When you thought about it, when you really thought about it, what really scared you was that Volume I.

Knight sent Strasser to calm Werschkul down.  Knight realized that he himself would have to go to DC.  “Maybe the cure for any burnout… is just to work harder.”



Senators Mark O. Hatfield and Bob Packwood helped Nike deal with the $25 million bill from U.S. Customs.  Knight started the process of looking for a factory in China.



Chuck Robinson suggested to Knight that Nike could go public but have two classes of stock, class A and class B.  Nike insiders would own class A shares, which would allow them to name three-quarters of the board of directors.  The Washington Post Company and a few other companies had done this.

Knight explained the idea – going public with two classes of stock – to colleagues at Nike.  All agreed that it was time to go public to raise badly needed cash.

In China, Knight – with Strasser, Hayes, and others – signed a deal with China’s Ministry of Sports.  Four years later, at the Olympics in Los Angeles, the Chinese track-and-field team entered the stadium wearing Nike shoes and warm-ups.  Before leaving China, Nike signed a deal with two Chinese factories.

Knight then muses about “business”:

It seems wrong to call it “business.”  It seems wrong to throw all those hectic days and sleepless nights, all those magnificent triumphs and desperate struggles, under that bland, generic banner:  business.  What we were doing felt like so much more.  Each new day brought fifty new problems, fifty tough decisions that needed to be made, right now, and we were always acutely aware that one rash move, one wrong decision could be the end.  The margin for error was forever getting narrower, while the stakes were forever creeping higher – and none of us wavered in the belief that “stakes” didn’t mean “money.”  For some, I realize, business is the all-out pursuit of profits, period, full stop, but for us business was no more about making money than being human is about making blood.  Yes, the human body needs blood.  It needs to manufacture red and white cells and platelets and redistribute them evenly, smoothly, to all the right places, on time, or else.  But that day-to-day mission of the human body isn’t our mission as human beings.  It’s a basic process that enables our higher aims, and life always strives to transcend the basic processes of living – and at some point in the late 1970s, I did, too.  I redefined winning, expanded it beyond my original definition of not losing, of merely staying alive.  That was no longer enough to sustain me, or my company.  We wanted, as all great businesses do, to create, to contribute, and we dared to say so aloud.  When you make something, when you improve something, when you add to some new thing or service to the lives of strangers, making them happier, or healthier, or safer, or better, and when you do it all crisply and efficiently, smartly, the way everything should be done but so seldom is – you’re participating more fully in the whole grand human drama.  More than simply alive, you’re helping others to live more fully, and if that’s business, all right, call me a businessman.



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

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

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

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


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

My e-mail: jb@boolefund.com


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



Warren Buffett’s Ground Rules

(Image:  Zen Buddha Silence by Marilyn Barbone.)

July 29, 2018

Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor, is an excellent book by Jeremy C. Miller.  Miller did the book with no input at all from Buffett.  But Buffett has commented quite favorably on the result:

Mr. Miller has done a superb job of researching and dissecting the operation of Buffett Partnership Ltd., and of explaining how Berkshire’s culture has evolved from its BPL origin.  If you are fascinated by investment theory and practice, you will enjoy this book.

Miller has arranged each chapter around a single theme.  Here is a brief summary of these chapters:

  • Orientation—The Principles of Ben Graham
  • Compounding
  • Measuring Up
  • The Partnership—An Elegant Structure
  • The Generals
  • Workouts
  • Controls
  • Dempster Diving—The Asset Conversion Play
  • Conservative versus Conventional
  • Size versus Performance
  • Go-Go or No-Go
  • Toward a Higher Form

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


ORIENTATION—The Principles of Ben Graham

At the beginning of the Buffett Partnership Ltd. (BPL), the small amount of capital Buffett was investing—$100,100—meant that, in a sense, his opportunities were similar to that of any small individual investor.  No companies were too small or obscure to be potential investment opportunities.

Ben Graham, the father of value investing, was Buffett’s teacher and mentor.  Buffett learned several key principles from Graham that are still true today and that still inform Buffett’s investing:

  • Margin of Safety
  • Market Prices
  • Owning Stock is Owning Part of a Business
  • Forecasting

Margin of Safety

Margin of safety means that if you think a stock is worth $20 a share, then you try to buy it at $10 (or lower).  You try to buy well below your estimate of the intrinsic value of the business.

No investor is always right.  Good value investors tend to be right about 60% of the time and wrong 40% of the time.  Sometimes an investor makes a mistake.  Other times an investor gets unlucky.  Luck does play a role, and the future is always unpredictable to an extent.

A margin of safety is meant to help limit losses in those cases where you make a mistake or are unlucky.

Market Prices

Market prices in the shorter term often deviate from intrinsic value.  The intrinsic value of any business is the total cash that can be taken out of the business over time, discounted back to the present.  (For some businesses, liquidation value is the best estimate of intrinsic value.)   Figuring out the intrinsic value of a given business requires careful analysis, which should be done without any input from stock price fluctuations.  Graham notes that many investors make the mistake of thinking that random stock price movements actually represent something fundamental, but they rarely do.

(Illustration by Prairat Fhunta)

It is only over a long period of time that a stock price will approximate the intrinsic value of a business based on the actual business results.  Over shorter periods of time, stock prices can be completely irrational, deviating significantly from the intrinsic value of a given business.

According to Graham, the wise, long-term value investor will buy if the price get irrationally low and will sell if the price gets irrationally high.  Most of the time, however, he will simply ignore the random daily gyrations of stock prices.  Summarizing Graham’s lesson, Buffett wrote:

[A] market quote’s availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgments.

It is only over a period of roughly 3 to 5 years—at a minimum—that the stock price of an individual business can be expected to track intrinsic value.

Owning Stock is Owning Part of a Business

A share of stock is a fractional ownership claim on the entire business.  Thus, if you can value the business—whether based on liquidation value, net asset value, or discounted cash flows—then you can value the stock.

(Illustration by Teguh Jati Prasetyo)

As Miller explains, a company’s shares over the lifetime of a business will necessarily produce a return equal to the returns produced by that business.  Any investor can enjoy the returns of a given business as long as they do not pay too high a price for the stock.

Value investors focus on valuing businesses, and they do not worry about unpredictable shorter term stock prices.  Buffett again:

We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do.  The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right.  In other words, we tend to concentrate on what should happen, not when it should happen.

Buffett stresses these lessons repeatedly.  As Miller writes, stocks are not pieces of paper to trade back and forth.  Stocks are claims on a business, and some of those businesses can be valued.  We cannot predict when a stock price will approximate intrinsic value, but we know that it will in the long run.  The market eventually gets it right.  The proper focus for an investor is finding the right businesses at the right prices, without worrying about when an investment will work.


Buffett learned from Graham that macro variables simply cannot be predicted.  It’s just too hard to forecast the stock market, interest rates, commodity prices, GDP, etc.  Regarding the annual values of macro variables, Buffett was (and still is) extremely consistent in his opinion:

I don’t have the first clue.

All of Buffett’s experience over the past 65+ years has convinced him even more that such variables simply can’t be predicted from year to year with any sort of reliability.  As Buffett wrote in 2014:

Anything can happen anytime in markets.  And no advisor, economist, or TV commentator—and definitely not Charlie nor I—can tell you when chaos will occur.  Market forecasters will fill your ear but will never fill your wallet.

Link: http://berkshirehathaway.com/letters/2014ltr.pdf

(Illustration by Maxim Popov)

Ben Graham:

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.

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.

Finally, Buffett again:

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.

The unpredictability of the stock market from year to year (along with other macro variables) is an extremely important lesson for investors.  History is full of examples of highly intelligent people making these types of predictions, and being wrong.  Miller notes:

Through Buffett’s insights, we learn not to fall victim to the siren songs of these ‘expert’ opinions and churn our portfolios, jumping from guesstimate to guesstimate and allowing what could otherwise be a decent result to be consumed by taxes, commissions, and random chance.

Buffett himself is a good example of how unpredictable the stock market is.  For most of the years when Buffett ran BPL—from the mid-1950’s until 1969—he often commented that he thought stocks were overvalued.  But as a value investor, Buffett focused nearly all his time on finding individual stocks that were undervalued.  He kept writing that the stock market would decline, even though he didn’t know when.  It turned out to take almost a decade from Buffett’s initial warning before the stock market actually did decline.  Because he stayed focused on individual stocks, his track record was stellar.  Had Buffett ever stopped focusing on individual stocks because he was worried about a stock market decline, he would have missed many years of excellent results.

Miller remarks:

A good deal of Buffett’s astonishing success during the Partnership years and beyond has come from never pretending to know things that were either unknowable or unknown.

Miller concludes:

The good news is that the occasional market drop is of little consequence to long-term investors.  Preparing yourself to shrug off the next downturn is an important element of the method Buffett lays out.  While no one knows what the market is going to do from year to year, odds are we will have at least a few 20-30% drops over the next decade or two.  Exactly when these occur is of no great significance.  What matters is where you start and where you end up—shuffle around the order of the plus and minus years and you still come to the same ultimate result in the end.  Since the general trend is up, as long as a severe 25-40% drop isn’t going to somehow cause you to sell out at the low prices, you’re apt to do pretty well in stocks over the long run.  You can allow the market pops and drops to come and go, as they inevitably will.

For the vast majority of investors, it is literally true that they would get the best long-term results if, after buying some decent investments (value investments or index funds), they completely forgot about these holdings.  One study by Fidelity showed that the best performing of all their account holders literally forgot they had portfolios at all.

Graham explained this long ago (as quoted by Miller):

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation.  He need pay attention to it and act upon it only to the extent that it suits his book, and no more.  Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.  That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.



If Buffett skipped a haircut for $10 in 1956 and invested it instead, that $10 would be worth more than $1 million today ($10 compounded at 22% for 60 years).  Being keenly aware of the power of compounding, Buffett has always been exceptionally frugal.

(Photo by Bjørn Hovdal)

Another example of the power of compounding is Ronald Read, a gas station attendant.  As Miller observes, Read ended up with $8 million by consistently investing a small portion of his salary into high-quality dividend-paying stocks.

In Buffett’s case, after becoming the world’s richest man during a few different years, he was able to make the largest private charitable donation in history—to the Gates Foundation, run by his friends Bill and Melinda Gates.  It’s also noteworthy, says Miller, that Buffett is (and has long been) one of the happiest people on earth because he gets to spend the majority of his time doing things he loves doing.

Stocks versus Bonds Today

Miller writes (in 2016):

Today, with bond yields not too far from zero, a 5-6% per annum result over the next 20 to 30 years seems like a reasonable assumption [for stocks].  If we get those kinds of results, the power of compound interest will be just as important, but it will take longer for the effects to gain momentum.

Small costs add up to a very large difference over time.  Probably no one explains this better than Jack Bogle.  See: http://boolefund.com/bogle-index-funds/



One of Buffett’s “Ground Rules” for BPL was Ground Rule #5:

While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance.  It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow.  If any three-year or longer period produces poor results, we should start looking around for other places to have our money.  An exception to the latter statement would be three years covering a speculative explosion in a bull market.

Buffett also set very ambitious goals at the outset of BPL, including beating the Dow by an average margin of 10 percentage points per year.  Buffett explains how his value investing approach could achieve this target:

I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%.  Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur.  The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s.



Incentives drive human conduct.  The vast majority of people underestimate just how important incentives are when trying to predict or explain human behavior.  As Charlie Munger has said:

I think I’ve been in the top 5% of my age cohort almost my entire adult life in understanding the power of incentives, and yet I’ve always underestimated that power.  Never a year passes but I get some surprise that pushes a little further my appreciation of the incentive superpower.

(Image by Ctitze)

Buffett figured that stocks would increase 5-7% per year on average.  He designed the fee structure of BPL with this in mind.  The chief fee structure was as follows:  there would be no flat fee based on assets under management, and there would be no fee on the first 6% increase in any given year.  There would be a fee of 25% of profits above the first 6% increase in any given year.

The 6% would compound from year to year.  Because Buffett’s explicitly stated goal was to beat the Dow by an average of 10% per year, his fee structure was designed accordingly.  Unlike most professional investors, Buffett didn’t charge any flat fee just for having assets under management.  Rather, his entire fee essentially came from beating the market—or beating a 6% increase compounded each year.  If Buffett did much better than the market, then he would be rewarded accordingly.  Yet if Buffett fell behind the market, then it could take some time before he earned any fees, since the 6% level compounded each and every year.

In a nutshell, the incentives were well-designed for Buffett to minimize the downside and maximize the upside.  Because Buffett understood Graham’s value investing approach to be set up in just this way—where minimizing the downside was a part of maximizing the upside—Buffett was incentivized to do value investing as well as he possibly could.

Compare Buffett’s fee structure in BPL to the fee structure of many of today’s hedge funds.  These days, many hedge funds charge “2 and 20,” or a 2% flat fee for assets under management and 20% of all profits.  There are, of course, some hedge funds that have outstanding track records.  Yet there are quite a few hedge funds where the performance, net of all fees, is not very different (and frequently worse) than the S&P 500 Index.  Whereas Buffett’s entire fee was based upon performance above a 6% compounded annual return, there are many hedge funds bringing in huge fees even though their net results are not much different from 6% per year.

In pursuing his investment goals, Buffett used three categories of investments:

  • The Generals
  • Workouts
  • Controls

Miller discusses each category in turn.



Miller begins by highlighting that there are many different approaches to value investing.  You can focus on very cheap stocks, regardless of business quality or fundamentals.  You can instead look for great, well-protected franchise businesses that can compound value over time.  You can focus on tiny, obscure microcap companies that are much too small for most professional investors even to consider.  Or you could find value in mid- or large-cap companies.  And within these categories, you could take a passive approach—like an index fund or a quantitative fund—or you could adopt an active approach of carefully picking each individual stock.

Miller says Buffett essentially used all of these different approaches at one time or another.  Miller:

For Buffett, the Generals were a highly secretive, highly concentrated portfolio of undervalued common stocks that produced the majority of the Partnership’s overall gains.

With one exception, Buffett never revealed the names of the companies in which he was investing.  These were trade secrets.

Using the Moody’s Manuals and other primary sources of statistical data, Buffett scoured the field to find stocks trading at rock-bottom valuations.  Often these were tiny, obscure, and off-the-radar companies trading below their liquidation value.  In the early years especially, the Partnership was small enough to be largely unconstrained, allowing for a go-anywhere, do-anything approach, similar to that of most individual investors today.

Even today, it’s remarkable how many tiny microcap companies are virtually unknown.  They’re simply too small for most professional investors even to consider.  Quite a few have no analyst coverage.

(Photo by Sean824)

Buffett was never concerned about when specific cheap stocks would finally rise toward their intrinsic values.  Buffett:

Sometimes these work out very fast; many times they take years.  It is difficult at the time of purchase to know any specific reason why they should appreciate in price.  However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices.  A lot of value can be obtained for the price paid.

Among the Generals, Buffett had two subdivisions, as Miller explains.

“Generals – Private Owner” were undervalued based on what a private owner would pay—which itself is still based on discounted future cash flows or liquidation value.  But in some cases, these Generals became controlled investments in BPL, meaning Buffett bought enough stock to be able to influence management.

“Generals – Relatively Undervalued” were undervalued stocks that lacked any prospect for BPL or any other private owner to acquire control.  Without the possibility of an activist, these cheap stocks were riskier than “Generals – Private Owner.”

Earlier I mentioned discounted cash flows and liquidation value as two primary ways to value companies.  These two valuation methods can also be referred to as earnings power value and net asset value.  They are linked in that net asset value for a going concern is based on the earnings power of the assets.

Often, however, net asset value is better approximated by liquidation value rather than earnings power.  Buffett referred to these deep value opportunities as cigar butts.  Like a soggy cigar butt found on a street corner, a deep value investment would often give “one free puff.”  Such a cigar butt is disgusting, but that one puff is “all profit.”

One potential problem with Graham’s cigar-butt approach—buying well below liquidation value—is that if a company continues to lose money, then the liquidation value gradually gets eroded.

(Illustration by Preecha Israphiwat)

In these cases, if possible, Buffett would try to buy enough stock in order to influence management.  Thus, a General would become a Control.  Buffett also looked for situations where another investor would take control.  Buffett called this “coattail riding.”

Buffett wrote that deep value cigar butts were central to the great performance of the Buffett Partnership:

… over the years this has been our best category, measured by average return, and has also maintained by far the best percentage of profitable transactions.  This approach was the way I was taught the business, and it formerly accounted for a large proportion of all our investment ideas.  Our total individual profits in this category during the twelve-year BPL history are probably fifty times or more our total losses.

Yet over time, Buffett evolved from primarily a deep value, cigar-butt strategy to an approach focused on higher quality businesses.  Buffett explained the difference in his 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 the qualitative decisions, but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Much later, in his 2014 Berkshire Hathaway Letter to Shareholders, Buffett would explain his evolution from deep value investing to investing in higher quality companies that could be held for a long time.  See page 25: http://berkshirehathaway.com/letters/2014ltr.pdf

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…

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.

In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise.

Miller quotes Charlie Munger:

… having started out as Grahamites—which, by the way, worked fine—we gradually got what I would call better insights.  And we realized that some company that was selling at two or three times book value could still be a hell of a bargain because of the momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.

And once we’d gotten over the hurdle of recognizing that a thing could be based on quantitative measures that would have horrified Graham, we started thinking about better businesses… Buffett Partnership, for example, owned American Express and Disney when they got pounded down.

(Illustration by Patrick Marcel Pelz)

Buffett actually amended the Ground Rules so that he could put 40% of BPL into American Express, which had gotten cheap after a huge, but solvable problem—exposure to the Salad Oil Scandal.  This was the largest position the partnership ever held, both on a percentage and absolute dollar basis.  BPL’s $13 million investment into American Express produced $20 million in profits over the course of a few years, thus creating a large portion of the partnership’s performance during this time.  (In today’s dollars, BPL’s Amex investment was about $90 million, while the profit was about $140 million.)

A high quality company has a high and sustainable return on invested capital (ROIC).  That’s only possible if the business has a sustainable competitive advantage.  Buffett:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.  The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

Any investor who could find a company like See’s Candies—the quintessential high quality business—and buy it at a reasonable price, would do extremely well over time.  But it is exceedingly difficult, even for the smartest investors, to find companies like See’s Candies.

(Photo by Cihcvlss, via Wikimedia Commons)

Buffett and his business partner, Charlie Munger, acquired See’s Candies in 1972.  The company has typically experienced a return on invested capital (ROIC) of over 100 percent, which is extraordinary.  Buffett and Munger purchased See’s Candies for $25 million.  Since then, the business has generated over $2 billion in pre-tax earnings.

Tom Gayner of the Markel Corporation is another investor who has done quite well by buying high quality businesses.  Miller notes:

Tom emphasizes that you have to get only a very small number of these right for this type of strategy to really pay off.  The companies you get right will harness the power of compounding and grow to dwarf the mistakes.  He argues that investors who make twenty or so sound purchases over a lifetime will come to see one or two grow to become a significant percentage of their net worth.

Tom has a great example of this phenomenon that also reminds us not to pigeonhole Ben Graham as purely a deep value investor.  Graham paid up for quality when he bought the insurance company GEICO—he ended up making more profits from that single investment than he did from all his other activities combined.

What Should You Do?

Assume that you are an investor operating with modest sums.  Is it best to follow the deep value, cigar butt approach, or is it best to look for high-quality companies that can compound business value over time?  Miller writes:

One can make a strong case for either method, just as many well-respected investors have done.  Both can work, but what’s right for you will depend on the size of funds you are working with, your personality, your own ability to do good valuation work, and your ability to define objectively the outer edges of your own competence.

Tobias Carlisle, with his 2014 book, Deep Value, comes out as a good example of a Graham purist.  His research shows that the worse a cheap company’s fundamentals, the better the stock is likely to do.  With his deeply quantitative orientation, Tobias has developed something he calls the ‘Acquirer’s Multiple’ to identify and systematically make good investment decisions.  He seems to have found something that he understands and that works well for him.  Note that he literally shuns quality in his approach to finding value.

… While he’s smart to have found something that works for him, he’s even smarter to avoid what doesn’t.  Of course he’d prefer to buy a great business over a poor business if he could be sure that it could maintain its high returns well into the future.  However, he hasn’t yet found a way to identify the companies with the factors needed to protect those high returns from competition, at least systematically, so he avoids them.

As Buffett himself has often written, a quantitative, deep value approach is a much surer source of investment profits than an approach based on finding high quality companies.  Many investors are better off following a cigar-butt approach.  (This is what the Boole Microcap Fund does.)

(Photo by Sensay)

Buffett himself got the highest returns of his career from microcap cigar butts.  See: http://boolefund.com/buffetts-best-microcap-cigar-butts/


Buffett has often observed that only a small handful of investments have been responsible for the vast majority of wealth he’s created over time.  Buffett:

I will only swing at pitches that I really like.  If you do it 10 times in your life, you’ll be rich.  You should approach investing like you have a punch card with 20 punch-outs, one for each trade in your life.

I think people would be better off if they only had 10 opportunities to buy stocks throughout their lifetime.  You know what would happen?  They would make sure that each buy was a good one.  They would do lots and lots of research before they made the buy.  You don’t have to have many 4X growth opportunities to get rich.  You don’t need to do too much, but the environment makes you feel like you need to do something all the time.

Whether you use a deep value approach or a strategy based on higher quality, it is possible to concentrate.

That said, if you use a quantitative approach—which works well for deep value—then having at least 15-20 positions generally works better over time.  Part of the reason is that, when buying a basket of deep value stocks—stocks which are typically very ugly—it is rarely possible to say which ones will be the best performers.  The legendary value investor Joel Greenblatt, who has excelled at both deep value and high-quality value, has readily admitted that the deep value stocks he picks as best often are not the best.  Greenblatt also has said:

In our experience, eliminating the stocks you would obviously not want to own eliminates many big winners.

As Tobias Carlisle so clearly illustrates in Deep Value, the ugliest of the ugly often end up being among the best performers.  Without a fully quantitative strategy—which forces you to buy the cheapest, ugliest stocks—it is easy to miss many big winners.

Tom Gayner’s strategy is almost the opposite of Tobias Carlisle’s but he understands it and it works for him.  Neither one is ‘right’ or ‘wrong’; each has developed a value system that works for him.  What’s right in investing is what works for the individual.



What Buffett called Workouts is now known as merger arbitrage (or risk arbitrage).  When one company announces that it will buy another, the acquisition target stock will move up towards the announced price, but not all the way.

With a sufficient spread and with a high probability of the deal closing, Buffett would take a position in the target company’s stock.  Buffett learned the technique from Graham.  If one were to combine the record of Graham-Newman, BPL, and Berkshire Hathaway through 1988—a total period of 65 years—Buffett calculated that merger arbitrage produced unlevered returns of about 20% per year.  So this was a very profitable category for the Buffett Partnership.

Because Buffett would often use up to 10% margin—and never more than 25%—the actual net returns for BPL were likely higher than 20% per year.  Thus, not only could Workouts do just as well as the Generals—because of the modest leverage used in merger arbitrage—but even more importantly, Workouts were largely uncorrelated (and often negatively correlated) with the overall stock market.  So even when the overall market was flat or down—which often meant that the Generals were flat or down—Workouts could and sometimes did produce a positive return.  As Buffett wrote:

Obviously the workouts (along with controls) saved the day in 1962, and if we had been light in this category that year, our final result would have been much poorer, although still quite respectable considering market conditions during the year.  We could just as well have had a much smaller percentage of our portfolio in workouts that year; availability decided it, not any notion on my part as to what the market was going to do.  Therefore, it is important to realize that in 1962 we were just plain lucky regarding mix of categories.

In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of themselves, resulting in a banner year.  If workouts had been normal, (say, more like 1962) we would have looked much poorer compared to the Dow….

Buffett goes on to note that in 1964, Workouts were a big drag on performance.  So Workouts didn’t work in every year, but they did tend to produce excellent returns over time.  And these returns were uncorrelated or negatively correlated with the returns of the Generals.  Buffett wrote: “In years of market decline, it piles up a big edge for us;  during bull markets, it is a drag on performance.”

Note:  Merger arbitrage has gotten much more difficult and competitive these days based on a much larger number of investors and based on huge computing power.  Thus, merger arbitrage is best not to do for most investors today.  Yet there are other types of investments with low correlation with the overall market that nonetheless can provide good long-term returns.  For instance, privately owned businesses might serve in this role.  Energy-related stocks—if held for at least 5 years—have low correlation with the overall market and also tend to outperform it.  Similarly, many microcap stocks have relatively low correlation with the broad market and outperform it over time.



Controls are situations when Buffett bought enough stock so as to influence management to unlock value.  Miller gives the example of the Sanborn Map Company.  Buffett had more than one-third of the Partnership invested in this stock.  The company published and constantly revised highly detailed maps of all cities in the United States.  Fire insurance companies were the primary users of these maps.  Buffett wrote:

In the early 1950’s a competitive method of underwriting known as ‘carding’ made inroads on Sanborn’s business and after-tax profits of the map business fell from an average level of over $500,000 in the late 1930’s to under $100,000 in 1958 and 1959.  Considering the upward bias in the economy during this period, this amounted to an almost complete elimination of what had been sizable, stable earning power.

However, during the early 1930’s Sanborn had begun to accumulate an investment portfolio.  There were no capital requirements to the business so that any retained earnings could be devoted to this project.  Over a period of time, about $2.5 million was invested, roughly half in bonds and half in stocks.  Thus, in the last decade particularly, the investment portfolio blossomed while the operating map business wilted.

Let me give you some idea of the extreme divergence of these two factors.  In 1938 when the Dow-Jones Industrial Average was in the 100-120 range, Sanborn sold at $110 per share.  In 1958 with the Average in the 550 area, Sanborn sold at $45 per share.  Yet during that same period the value of the Sanborn investment portfolio increased from about $20 per share to $65 per share.  This means, in effect, that the buyer of Sanborn stock in 1938 was placing a positive valuation of $90 per share on the map business ($110 less the $20 value of the investments unrelated to the map business) in a year of depressed business and stock market conditions.  In the tremendously more vigorous climate of 1958 the same map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing.


… The very fact that the investment portfolio had done so well served to minimize in the eyes of most directors the need for rejuvenation of the map business.  Sanborn had a sales volume of about $2 million per year and owned about $7 million worth of marketable securities.  The income from the investment portfolio was substantial, the business had no possible financial worries, the insurance companies were satisfied with the price paid for maps, and the stockholders still received dividends.  However, these dividends were cut five times in eight years although I could never find any record of suggestions pertaining to cutting salaries or director’s and committee fees.

[Most board members owned virtually no stock…]  The officers were capable, aware of the problems of the business, but kept in a subservient role by the Board of Directors.  The final member of our cast was a son of a deceased president of Sanborn.  The widow owned about 15,000 shares of stock.

In late 1958, the son, unhappy with the trend of the business, demanded the top position in the company, was turned down, and submitted his resignation, which was accepted.  Shortly thereafter we made a bid to his mother for her block of stock, which was accepted.  At the time there were two other large holdings, one of about 10,000 shares (dispersed among customers of a brokerage firm) and one of about 8,000.  These people were quite unhappy with the situation and desired a separation of the investment portfolio from the map business as did we.

Buffett continues:

There was considerable opposition on the Board to change of any type, particularly when initiated by an outsider, although management was in complete accord with our plan… To avoid a proxy fight… and to avoid time delay with a large portion of Sanborn’s money tied up in blue-chip stocks which I didn’t care for at current prices, a plan was evolved taking out all stockholders at fair value who wanted out.  The SEC ruled favorably on the fairness of the plan.  About 72% of the Sanborn stock, involving 50% of the 1,600 stockholders, was exchanged for portfolio securities at fair value.  The map business was left with over $1.25 million in government and municipal bonds as a reserve fund, and a potential corporate capital gains tax of over $1 million was eliminated.  The remaining stockholders were left with a slightly improved asset value, substantially higher earnings per share, and an increased dividend rate.

Lessons from Controls

Miller reminds us that investing in a stock is becoming a part owner of the business:

In 1960, one-third of the Partnership was in Sanborn’s stock, meaning one-third of the Partnership was in the business of selling insurance maps and managing a securities portfolio.  In his discussion of Controls, Buffett is teaching us to not think about ‘investing in a stock’ but instead to think about ‘being in a business.’

Miller again:

Whether you are running a business or evaluating one, a singular question remains paramount: what is its value, both in terms of the assets involved and the earnings produced, then, how can it be maximized?  The skill in answering these questions determines the success of investors and business managers like.

Buffett often quotes Ben Graham on this point:

Investment is most intelligent when it is most businesslike and business is most intelligent when it’s most investment-like.

In some cases, a General would languish in price for years, allowing BPL to continue acquiring the stock at cheap prices.  In this way, a General would sometimes become a Control.  A General is attractive as a cheap stock.  When a General becomes a Control, it becomes more attractive to the extent that BPL can actively work to unlock value.

In the case of Controls, Buffett was willing to work actively to unlock value, but it did often require taking actions that would be criticized, as Miller writes:

… he had to threaten Sanborn Map’s board with a proxy fight (legal battle) to get them to act… At Dempster Mill, we’ll see that he had to fire the CEO and bring in his own man, Harry Bottle.  Together they liquidated large parts of the business to restore the economics of the company.  Buffett was vilified in the local newspaper for doing so.  While he saw himself as saving the business by excising the rotten parts, critics only saw the lost jobs.  Early at Berkshire, he had to fire the CEO and hit the brakes on capital expenditures in textiles before redirecting the company’s focus to insurance and banking.  It was never easy and often stressful, but when action was needed, action was taken.  As he said, ‘Everything else being equal, I would much rather let others do the work.  However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.’

The ability to actively unlock value led Buffett naturally to concentrate heavily.  A situation like Sanborn had high upside and a tiny risk of loss, so it made sense to bet big.

With Dempster Mill, Berkshire, and Diversified Retailing Company (DRC), the values had to be estimated by Buffett and confirmed by auditors.  In the case of Dempster and Berkshire, BPL owned so much stock that trying to trade it could dramatically impact the market price.  That is why the year-end values had to be estimated, which Buffett did conservatively based on current value rather than future value.  DRC also had to be valued this way because it was a privately owned business that never had a publicly traded stock.

Correctly valuing the Controls was important.  Not only would it impact the year-end overall performance of BPL—too high of an estimate would inflate the performance, while too low of an estimate would depress the performance.  But also, correctly valuing Controls would impact limited partners who were entering or leaving the Partnership.  Exiting limited partners would benefit at the expense of remaining limited partners if the estimated value of the Controls was too high.  Conversely, new limited partners would benefit at the expense of existing limited partners if the estimated value of the Controls was too low.  Buffett was very careful, and his estimates were audited by the firm that would later become KPMG.

Buffett’s November 1966 letter to partners gives some detail on the appraisal process:

The dominant factors affecting control valuations are earnings power (past and prospective) and asset values.  The nature of our controlled businesses, the quality of the assets involved, and the fact that the Federal Income Tax basis applicable to the net assets substantially exceeds our valuations, cause us to place considerably more weight on the asset factor than is typical in most business valuations…. The Partnership Agreement charges me with the responsibility for establishing fair value for controlling interests, and this means fair to both adding and withdrawing partners at a specific point in time.  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…

It’s worth noting that Sanborn, Dempster, and Berkshire were all cigar butts where net asset value was much higher than the current market price.  They were very cheap businesses, but they were not good businesses, which is part of why valuing them was mostly based on asset value rather than earnings power.

Because Ben Graham relied mostly on the cigar-butt approach, basing his investments on discounts to liquidation value, Buffett had already learned how to value companies based on their assets.  Miller quotes Chapter 43 of Graham and Dodd’s Security Analysis:

The rule in calculating liquidating value is that the liabilities are real but the value of the assets must be questioned. This means that all true liabilities shown on the books must be deducted at their face amount.  The value to be ascribed to the assets, however, will vary according to their character.

Graham advised the following rule of thumb for liquidation analysis: 100 cents on the dollar for cash, 80 cents on the dollar for receivables, 67 cents on the dollar for inventory (with a wide range depending on the business), and 15 cents on the dollar for fixed assets.

In the case of Sanborn, the company had a hidden asset in the form of a large investment portfolio that was not reflected on its balance sheet.  Dempster Mill’s net assets were much higher on the balance sheet than was indicated by the market price.  Buffett had to determine what the assets were really worth.  With Berkshire, part of the value would be determined by redeploying capital into higher return opportunities.  (Buffett’s successful redeployment of Berkshire’s cash formed the foundation for Berkshire Hathaway, now one of the largest and most successful U.S. companies.)

Circle of Competence

A central concept for Buffett and Munger is circle of competence.  For any given company, are you capable of reasonably estimating what the assets are worth?  If not, you can either spend the time required to understand the company and the industry, or you can put it into the TOO HARD pile.

Buffett and Munger have three piles:  IN, OUT, and TOO HARD.  A great many public companies simply go into the TOO HARD pile.  This limitation—sticking with companies you can understand well—has been a key to the excellent long-term performance of Buffett and Munger.

For a value investor managing a smaller sum, who can focus on tiny, obscure microcap companies, there are thousands and thousands of businesses.  When there are so many that you probably can understand well, it makes no sense to spend long periods of time on businesses that are decidedly difficult to understand.

For example, you could spend months gaining an understanding of General Electric, or you could spend that same amount of time gaining a complete understanding of at least a dozen tiny microcap companies.  Many microcap businesses are quite simple.

Here’s the thing:  As Buffett has pointed out, frequently you don’t get paid for degree of difficulty in investing.  If you’re willing to turn over enough rocks, eventually you can find a microcap business that you can easily understand and that is extraordinarily cheap.  You’ll almost certainly do far better with that type of investment than with a mid-cap or large-cap company that’s much harder to understand and probably not nearly as cheap.



Dempster was a tiny micro cap, a family-owned company in Beatrice, Nebraska, that manufactured windmills and farm equipment.

(Photo by Digikhmer)


Much of the fun in investing comes from the hunting process itself… Picture the pulse-quickening moment in 1956 when Buffett, thumbing through the Moody’s Manual, came across a tiny, obscure manufacturing company whose stock had fallen 75% in the previous year.  Realizing that it was now available for a fraction of its net working capital and an even smaller fraction of its book value, he started buying the stock as low as $17 a share.  He got out at $80.

Miller writes that Dempster can serve as a template for valuing businesses using the net asset value approach.  Dempster’s profits were very low, but the stock traded far below its asset value.

Buffett joined the board of directors soon after his first purchase.  He kept buying the stock for the next five years.  A large block of stock from the Dempster family became available for sale in 1961.  By August of that year, BPL owned 70% of Dempster and a few “associates” owned another 10%.  BPL’s average price was $1.2 million ($28/share), roughly a 50% discount to working capital and 66% discount to book value.  Dempster accounted for roughly 20% of BPL’s total assets by year-end.

The situation was challenging at first because the inventories were high and rising.  Buffett tried to work with existing management, but had to throw them out because inventories kept rising.  The company’s bank was threatening to seize the collateral backing the loan.  With 20% of BPL in Dempster, if the company went under it would have a large negative impact on the Partnership.  At Munger’s recommendation, Buffett met and hired an “operating man” name Harry Bottle.

Bottle was a turnaround specialist.  Buffett was so happy with Bottle’s work that in the next year’s letter, Buffett named him “man of the year.”  He cut inventories from $4 million to $1 million, quickly repaid the bank loan, cut administrative and selling expenses in half, and closed five unprofitable branches.  With help from Buffett and Munger, Bottle also raised prices up to 500% on their used equipment.  There was little impact on sales volume.  All of these steps worked together to put Dempster on a healthy economic footing.

Buffett then took an unusual step.  Whereas most managers feel automatically that they must reinvest profits into the business, even if the business is creating low returns, Buffett was more rational.  Miller explains:

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 in windmills.  He immediately stopped the company from putting more capital in and started taking the capital out.

Instead, Buffett invested the capital into the cheapest stocks he could find, those offering the highest potential returns.  In effect, he was converting capital from a low-return business to a high-return business—buying cheap stocks until they rose towards intrinsic value.  Over time, Dempster looked less like a manufacturing company and more like the investment partnership.  Miller observes:

The willingness and ability to see investment capital as completely fungible, whether it is capital tied up in the assets of a business or capital that’s invested in securities, is an exceedingly rare trait.

Dempster initially was worth $35/share in 1961.  By year-end 1962, Dempster was worth $51/share, with market securities worth $35/share and the manufacturing operations worth $16/share.

Buffett also learned from this experience the importance of a high-quality and trustworthy CEO.  Buffett heaped praise on Harry Bottle.  Miller points out that Buffett developed a style like that of Dale Carnegie: Praise by name, criticize by category.

It should also be noted that Dempster’s market value in 1961 was $1.6 million, a tiny microcap company.  This kind of opportunity—including being able to buy control—is open to those investing relatively small sums.  Very often the cheapest stocks can be found among microcap companies.  This high degree of inefficiency results from the fact that most professionals investors never look at micro caps.

Miller sums it up:

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.  Buffett commented, ‘Harry has continued this year to turn under-utilized assets into cash, but in addition, he has made the remaining needed assets productive.’

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.  Raising prices on replacement parts and reducing operating costs pulled levers #1 and #2.  Lever #3 was pulled as inventories (assets) were reduced.  Lever #4 was pulled when Buffett borrowed money to buy more stocks.  Lever #5 was pulled when he avoided a big tax bill by selling all the operating assets of the company.

When profitability goes up and the capital required to produce it goes down, the returns and the value of the business go straight up.  Buffett understood this intrinsically and Dempster is now a powerful example for today’s investors who obsess over (1) and (2) at the expense of (3).  Pulling underutilized assets out of a company not only produces cash to be used elsewhere, it makes the business better and more valuable.  It is a wonderful reminder to individual and professional investors alike to focus their attention first on the balance sheet (there is a reason it comes first in the set of financial statements).  Never lose sight of the fact that without tangible assets, there would be no earnings in the first place.



Although following the crowd made sense in our evolutionary history, and still makes sense in many circumstances, following the crowd kills your ability to outperform the stock market.  Miller explains:

Successful investing requires you to do your own thinking and train yourself to be comfortable going against the crowd.  You could say that good results come primarily from a properly calibrated balance of hubris and humility—hubris enough to think you can have insights that are superior to the collective wisdom of the market, humility enough to know the limits of your abilities and to be willing to change course when errors are recognized.

You’ll have to evaluate facts and circumstances, apply logic and reason to form a hypothesis, and then act when the facts line up, irrespective of whether the crowd agrees or disagrees with your conclusions.  Investing well goes against the grain of social proof; it goes against the instincts that have been genetically programmed into our human nature.  That’s part of what makes it so hard.

Howard Marks, a Buffett contemporary who also has a literary bent, challenges his readers to “dare to be great” in order to dare to be better investors.  As he tells his readers, “the real question is whether you dare to do the things that are necessary in order to be great.  Are you willing to be different, and are you willing to be wrong?  In order to have a chance at great results, you have to be open to being both.”

There are two key ideas in Buffett’s highly independent approach:

  • The best purchases are made when your thinking puts you in opposition to conventional wisdom or popular trends.
  • A concentrated portfolio can actually be more conservative than a diversified one when the right conditions are met.

Conventional, academic thinking equates the riskiness of a stock with its beta, which is a measure of its volatility.  Buffett, later in his career, gave the following example to illustrate the silliness of beta:

The Washington Post Company in 1973 was selling for $80 million in the market.  At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more…

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, it’s beta would have been greater.  And to people who think beta [or, more importantly, downside volatility] measures risk, the cheaper price would have made it look riskier.  This is truly Alice in Wonderland.  I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million….

In the 1970’s, the Washington Post Company was an outstanding, high-return business and remained so for decades.  Of course, like most businesses, its high profitability did not last, in this case because of the internet.

But the point is that if you, as a value investor, buy something at 20% of probable intrinsic value, and the stock then drops 50% and you buy a bunch more, your investment now has 10x upside instead of 5x, and simultaneously, your investment is now probably safer.

Having the expected return from your investment double, while at the same time having the downside risk get cut in half, is completely contrary to what is taught in modern finance theory.  Finance theory says that a higher potential return always requires higher risk.  Yet the experience of many value investors is that quite often an increase in potential return also means a decrease in risk.  Thus, a value investor cheers (and backs up the truck) when his or her best idea keeps going down in price, and this happens routinely.

Thinking for Yourself

The best time to buy is when the crowd is most fearful.  But this requires thinking for yourself.  A good example is when Buffett put 40% of BPL into American Express after the Salad Oil Scandal.  Miller:

The Partnership lessons teach investors that there is only one set of circumstances where you or anyone else should make an investment—when the important facts in a situation are fully understood and when the course of action is as plain as day.  Otherwise, pass.  For instance, in Sanborn, when Buffett realized he was virtually assured to make money in the stock given he was buying the securities portfolio at 70 cents on the dollar with the map company coming for free, he invested heavily.  When he saw Dempster was selling below the value of its excess inventory alone, he loaded up.

Miller quotes Buffett:

When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action is obvious.  In that case—whether conventional or unconventional—whether others agree or disagree—we feel—we are progressing in a conservative manner.

Ben Graham:

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

Buffett again:

You will not be right simply because a large number of people momentarily agree with you.  You will not be right simply because important people agree with you… You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct.

Buffett, once more:

A public opinion poll is no substitute for thought.

Loading Up

Buffett thought it was conservative and rational to put 40% of the Partnership assets into American Express.  Buffett had amended the Ground Rules of the Partnership to include a provision that allowed up to 40% of BPL’s assets to be in a single security under conditions “coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”

Miller notes that Buffett gave the following advice to a group of students in the late 1990s:

If you can identify six wonderful businesses, that is all the diversification you need.  And you will make a lot of money.  And I can guarantee that going into a seventh one instead of putting more money into your first one is going to be a terrible mistake.  Very few people have gotten rich on their seventh best idea.  But a lot of people have gotten rich with their best idea.  So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I [would] probably have half of [it in] what I like best.

Your Best Ideas Define Your Next Choice

If you’re using concentrated value investing, then the simple test for whether to add a new idea to your portfolio is to compare any new idea to your best current ideas.

Successful concentrated value investing requires a great deal of passion, curiosity, patience, and prior experience (i.e., lots of mistakes).  It also often requires a focus on tiny, obscure micro caps, since this is the most inefficient part of the market and it contains many simple businesses.

Buffett explains:

Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year—one somewhat more sour, probably, than if I had diversified more.  While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater.

Buffett in the January 25, 1967, BPL Letter:

Our relative performance in this category [Generals–Relatively Undervalued] was the best we have ever had—due to one holding which was our largest investment at yearend 1965 and also yearend 1966.  This investment has substantially outperformed the general market for us during each year (1964, 1965, 1966) that we have held it.  While any single year’s performance can be quite erratic, we think the probabilities are highly favorable for superior future performance over a three or four year period.  The attractiveness and relative certainty of this particular security are what caused me to introduce Ground Rule 7 in November, 1965 to allow individual holdings of up to 40% of our net assets.  We spend considerable effort continuously evaluating every facet of the company and constantly testing our hypothesis that this security is superior to alternative investment choices.  Such constant evaluation and comparison at shifting prices is absolutely essential to our investment operation.

It would be much more pleasant (and indicate a more favorable future) to report that our results in the Generals—Relatively Undervalued category represented fifteen securities in ten industries, practically all of which outperformed the market.  We simply don’t have that many good ideas…



Miller comments that Buffett, if he were managing a relatively small amount of money, probably would have stayed fully invested even during the speculative peak of the late 1990’s.  This is largely because there are almost always cheap microcap companies that are too small and obscure to be noticed by most investors.  As Buffett said during the late 1990’s:

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

There were times when he was managing BPL when Buffett recognized that more assets under management would increase the Partnership’s ability to do Control investments.  But according to Buffett, it was also sometimes true that less assets under management made it easier to invest in tiny, cheap microcap companies.  So Buffett wrote:

What is more important—the decreasing prospects of profitability in passive investments or the increasing prospects in control investments?  I can’t give a definite answer to this since to a great extent it depends on the type of market in which we are operating.  My present opinion is that there is no reason to think these should not be offsetting factors;  if my opinion should change, you will be told.  I can say, most assuredly, that our results in 1960 and 1961 would not have been better if we had been operating with the much smaller sums of 1956 and 1957.

By 1966, however, when assets under management reached $43 million, Buffett changed his mind.  He wrote his partners:

As circumstances presently appear, I feel substantially greater size is more likely to harm future results than to help them.  This might not be true for my own personal results, but it is likely to be true for your results.

Buffett saw a drag on performance that would probably develop as a result of two factors:  larger assets under management, and a stock market that was high overall, with far fewer opportunities.  It’s important to note again that Buffett did not think a high market would be a factor if he were managing smaller sums.  As Buffett said in 2005, when asked if he could still make 50% per year with smaller sums:

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 could 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.

Ideas versus Capital

The bottom line is simple:  If you have more capital than ideas, then assets are too large and will be a drag on performance.  If you have more ideas than capital, then assets are not a drag and may even be too small.



In 1956, Buffett had told his partners that he thought the stock market was high relative to intrinsic value.  Since he never tried to predict the market, he remained focused on finding tiny microcap companies that were cheap.  Staying focused on finding what was cheapest was central to the 29.8% per year the BPL achieved over the ensuing decade.  Had Buffett ever invested less because he was worried about a stock market decline, his record would have been nowhere near as good.

An expensive stock market says nothing about when a correction will happen.  And an expensive stock market rarely means that there are no obscure, cheap microcap companies.

By 1966, however, because BPL had more assets under management and because Buffett thought the stock market was even more overvalued, Buffett finally decided not to accept any new capital.

Somewhat ironically, BPL had its best year ever in 1968, with a return of 58.8%.  But this also led Buffett to consider closing the Partnership altogether.  Buffett had simply run out of ideas, due to the combination of his assets under management and a stock market that was quite overvalued in his view.

In May 1969, Buffett announced his decision to liquidate the Partnership.  Performance in 1969 was mediocre, and Buffett wrote:

… I would continue to operate the Partnership in 1970, or even 1971, if I had some really first class ideas.  Not because I want to, but simply because I would so much rather end with a good year than a poor one.  However, I just don’t see anything available that gives any reasonable hope of delivering such a good year and I have no desire to grope around, hoping to ‘get lucky’ with other people’s money.  I am not attuned to this market environment and I don’t want to spoil a decent result by trying to play a game I don’t understand just so I can go out a hero.

Go-Go Years – Jerry Tsai

The big bull market run of the 1960s became known as the Go-Go years.  Jerry Tsai’s highly speculative investment style, which produced high returns for some time, was representative of the Go-Go years.  In 1968, Tsai shrewdly sold his Manhattan Fund, which had $500 million under management.  The fund went on to lose 90% of its value over the next several years.



Buffett constantly evolved as an investor.  As Miller writes:

A good deal of this evolution occurred throughout the Partnership years, where we have seen a willingness to concentrate his investments to greater and greater degrees, a steady migration toward quality compounders from statistically cheap cigar butts, and the forging of his highly unique ability to break down the distinction between assets and capital in a way that allows for their fungibility in the pursuit of higher returns.



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

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

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

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


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

My e-mail: jb@boolefund.com




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

You’re deluding yourself

(Image: Zen Buddha Silence, by Marilyn Barbone)

July 15, 2018

You’re deluding yourself.  I’m deluding myself.  Our brains just do this automatically, all the time.  We invent simple stories based on cause and effect.  Often this is harmless.  But sometimes it’s important to recognize that reality is far more unpredictable than we’d like.

We’re not wired to understand probabilities.  As Daniel Kahneman and Amos Tversky have demonstrated, even many professional statisticians are not good “intuitive statisticians.”  They’re usually only good if they slow down and work through the problem at hand step-by-step.  Otherwise, they too tend to create overly simplistic, overly deterministic stories.

(Photo by Wittayayut Seethong)

To develop better mental habits, a good place to start is by recognizing delusions and biases, which are widespread in business, politics, and economics.  To that end, here are four of the best books:

  • Thinking, Fast and Slow (Farrar, Straus and Giroux, 2011), by Daniel Kahneman
  • Poor Charlie’s Almanack (Walsworth, 3rd edition, 2005), by Charles T. Munger
  • The Halo Effect…and Eight Other Business Delusions That Deceive Managers (Free Press, 2007), by Phil Rosenzweig
  • Expert Political Judgment: How Good Is It? How Can We Know? (Princeton University Press, 2006), by Philip Tetlock

Tetlock’s work is particularly important.  He tracked over 27,000 predictions made in real time by 284 experts from 1984 to 2003.  Tetlock found that the expert predictions—on the whole—were no better than chance.  Many of these experts have deep historical knowledge of politics or economics, which can give us important insights and is often a precursor to scientific knowledge.  But it’s not yet science—the ability to make predictions.

Kahneman and Munger both show how our intuition uses mental shortcuts (heuristics) to jump to conclusions.  Often these conclusions are fine.  But not if probabilistic reasoning is needed to reach a good decision.

This blog post focuses on Rosenzweig’s book, which examines delusions in business, with particular emphasis on the Halo Effect.

Outline for this blog post:

  • The Halo Effect
  • Illusions and Delusions
  • How Little We Know
  • The Story of Cisco
  • Up and Down with ABB
  • Halos All Around Us
  • Research to the Rescue?
  • Searching for Stars, Finding Halos
  • The Mother of All Business Questions, Take Two
  • Managing Without Coconut Headsets



Rosenzweig quotes John Kay of the Financial Times:

The power of the halo effect means that when things are going well praise spills over to every aspect of performance, but also that when the wheel of fortune spins, the reappraisal is equally extensive.  Our search for excessively simple explanations, our desire to find great men and excellent companies, gets in the way of the complex truth.

(Image by Ileezhun)

Rosenzweig explains the essence of the Halo Effect:

If you select companies on the basis of outcomes—whether success or failure—and then gather data that are biased by those outcomes, you’ll never know what drives performance.  You’ll only know how high performers or low performers are described.

Rosenzweig describes his book as “a guide for the reflective manager,” a way to avoid delusions and to think critically.  It’s quite natural for us to construct simple stories about why things happen.  But many events—including business success and failure—don’t happen in a straightforward way.  There’s a large measure of uncertainty (chance) involved.

Rosenzweig adds:

Of course, for those who want a book that promises to reveal the secret of success, or the formula to dominate their market, or the six steps to greatness, there are plenty to choose from.  Every year, dozens of new books claim to reveal the secrets of leading companies… Others tell you how to become an innovation powerhouse, or craft a failsafe strategy, or devise a boundaryless organization, or make the competition irrelevant.

But if anything, the world is getting more unpredictable:

In fact, for all the secrets and formulas, for all the self-proclaimed thought leadership, success in business is as elusive as ever.  It’s probably more elusive than ever, with increasingly global competition and technological change moving at faster and faster rates—which might explain why we’re tempted by promises of breakthroughs and secrets and quick fixes in the first place.  Desperate circumstances push us to look for miracle cures.

Rosenzweig explains that business managers are under great pressure to increase profits.  So they naturally look for clear solutions that they can implement right away.  Business writers and experts are happy to supply what is demanded.  However, reality is usually far more unpredictable than is commonly assumed.



Science is the ability to predict things:  if x, then y (with probability z).  (If we’re talking about physics—other than quantum mechanics—then z = 100% in the vast majority of cases.)  But the sciences that deal with human behavior still haven’t discovered enough to make many predictions.  There are specific experiments or circumstances where good predictions can be made—such as where to place specific items in a retailer to maximize sales.  And good research has uncovered numerous statistical correlations.

But on the whole, there’s still much unpredictability in business and in human behavior generally.  There’s still not much scientific knowledge.

Rosenzweig says some of the biggest recent business blockbusters contain several delusions:

For all their claims of scientific rigor, for all their lengthy descriptions of apparently solid and careful research, they operate mainly at the level of storytelling.  They offer tales of inspiration that we find comforting and satisfying, but they’re based on shaky thinking.  They’re deluded.

Rosenzweig explains that most management books seek to understand what leads to high performance.  By contrast, Rosenzweig asks why it is so difficult to understand high performance.  We suffer from many delusions.  Our intuition leads us to construct simple stories to explain things, even when those stories are false.

(Image by Edward H. Adelson, via Wikimedia commons)

Look at squares A and B just above:  Are they the same color?  Or is one square lighter than the other?

A and B are exactly the same color.  However, our visual system automatically uses contrast.  If it didn’t, then as Steven Pinker has pointed out, we would think a lump of coal in bright sunlight was white.  We would think a lump of snow inside a dark house was black.  We don’t make these mistakes because our visual system works in part by contrast.  Kathryn Schulz mentions this in her excellent book, Being Wrong (HarperCollins, 2010).

This use of contrast is a heuristic—a shortcut—used by our visual system.  This happens automatically.  And usually this heuristic helps us, as in Pinker’s examples.

The important point is that our intuition (part of our mental system) is like our visual system Our intuition also uses heuristics.

  • If we are asked a difficult question, our intuition substitutes an easier question and then answers that question.  This happens automatically and without our conscious awareness. 
  • Similarly, our intuition constructs simple stories in terms of cause and effect, even if reality is far more complex and random.  This happens automatically and without our conscious awareness.

(Image by Edward H. Adelson, via Wikimedia Commons)

This second image is the same as the previous one—except this one has two vertical grey bars.  This helps (to some extent) our eyes to see that squares A and B are exactly the same color.

Rosenzweig mentions that some rigorous research of business has been conducted.  But this research often reaches far more modest conclusions than what we seek.  As a result, it’s not popular or well-known.  For instance, there may be a 0.2 correlation between certain approaches of a CEO and business performance.  That’s a huge finding—20% of business performance is based on specific CEO behavior.

But that means 80% of business performance is due to other factors, including chance.  That’s not the type of information people in business want to hear when they’re busy and under pressure.



In January 2004, after a disastrous holiday season, Lego—the Danish toymaker—fired its chief operating officer, Poul Ploughman.  Rosenzweig points out that when a company does well, we tend to automatically think its leaders did the right things and should be praised or promoted.  When a company does poorly, we tend to jump to the conclusion that its leaders did the wrong things and should be replaced.

But reality is far more complex.  Good leadership may represent 20-30% of the reason a company is doing well now, but luck may be an even bigger factor.  Similarly, bad leadership may be responsible for 20-30% of a company’s poor performance, whereas bad luck—unforeseeable events—may be a bigger factor.

(Photo by Marco Clarizia)

As humans, we’re driven to construct stories in which success and failure are completely explainable—without reference to luck—based on the actions of people and systems.  This satisfies our psychological need to see the world as a predictable place.

However, reality is unpredictable to an extent.  We understand far less than we think.  Luck usually plays a large role in business success and failure.

When Lego hired Ploughman, it was seen as a coup.  Ploughman helped Lego expand into electronic toys.  When the initial results of this expansion were not positive, Lego’s CEO Kjeld Kirk Kristiansen lost patience and fired Ploughman.

The business press reported that Lego had “strayed from its core.”  However, the company tried to expand because its traditional operations were not as profitable as before.  If the company’s attempted expansion had been more profitable, the business press would have reported that Lego “wisely expanded.”

(Photo of lego bricks by Benjamin D. Esham)

When it comes to business performance, there are many factors—including luck.  A company may move forward on an absolute basis, but fall behind relative to competitors.  Also, consumer tastes are unpredictable.

  • A company may attempt expansion and fail, but the decision may have been wise based on available information.  Regardless, observers are likely to say the company “unwisely strayed from its core.”
  • Or a company may try to expand and succeed, but it may have been a stupid decision based on available information.  Regardless, observers are likely to claim that the company “brilliantly expanded.”

To understand better how businesses succeed, we should try to understand what factors are involved in good decisions, even though good decisions often don’t work and bad decisions sometimes do.  We want to avoid outcome bias, where our evaluation of the quality of a decision is colored by whether the result was favorable or not.

Science is:  if x, then y (with probability z).  This is a slightly modified definition (I added “with probability z”) Rosenzweig borrowed from physicist Richard Feynman.

In some areas of business, scientists have discovered reliable statistical correlations.  For instance, this set of behaviors—a, b, and c—has a 0.10 correlation with revenues.  If you do a, b, and c—holding all else constant—then revenues will increase approximately 10%.

The difficult thing about studying business is that often you cannot run controlled experiments.  Of course, sometimes you can.  For instance, you can experiment with where to place various items in a store (or chain of stores).  You can compare results and gain good statistical information.  Also, there are promotions and advertising campaigns that you can test.  And you can track consumer behavior online.

But frequently you cannot run controlled experiments.  As Rosenzweig observes, you can’t do 100 acquisitions, and manage half of them one way, the other half another way, and then compare the results.

There’s nothing wrong with stories, which are satisfying explanations we construct about various events.  But stories are not science, and it’s important to keep the distinction straight, especially when we’re trying to understand why things happen.

An even better term than pseudo-science is Feynman’s term, Cargo Cult Science.  Rosenzweig quotes Feynman:

In the South Seas, there is a cult of people.  During the war, they saw airplanes land with lots of materials, and they want the same thing to happen now.  So they’ve arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas—he’s the controller—and they wait for the airplanes to land.  They’re doing everything right.  The form is perfect.  But it doesn’t work.  No airplanes land.  So I call these things Cargo Cult Science, because they follow all the apparent precepts and forms of scientific investigation, but they’re missing something essential, because the planes don’t land.

(Photo of Richard Feynman in 1984, by Tamiko Thiel)

Rosenzweig concludes:

The business world is full of Cargo Cult Science, books and articles that claim to be rigorous scientific research but operate mainly at the level of storytelling.  In later chapters, we’ll look at some of this research—some that meet the standard of science but aren’t satisfying as stories, and some that offer wonderful stories but are doubtful as science.  As we’ll see, some of the most successful business books of recent years, perched atop the bestseller list for months on end, cloak themselves in the mantle of science, but have little more predictive power than a pair of coconut headsets on a tropical island.

It’s not that stories have nothing to teach us.  For instance, experts may develop deep historical knowledge that offers us useful insights into human behavior.  And such knowledge is often an antecedent to scientific knowledge.

But we have to be careful not to confuse stories with science.  Otherwise, it’s very easy and natural to delude ourselves that we understand something scientifically, when in fact we don’t.  Our intuition creates simple stories of cause and effect just as automatically as our visual system is unable to avoid optical illusions.

(Holy grail or two girls, by Micka)



Rosenzweig tells the story of Cisco.  Sandra K. Lerner and Leonard Bosack met in graduate school, fell in love, and got married.  After graduating, they each took jobs managing computer networks at different corners of the Stanford campus.  They wanted to communicate, and they invented a multiprotocol router.  Rosenzweig:

Like many start-ups, Cisco began by operating out of a basement and at first sold its wares to friends and professional acquaintances.  Once revenues approached $1 million, Lerner and Bosack went in search of venture capital.  The man who finally said yes was Donald Valentine at Sequoia Capital, the seventy-seventh moneyman they approached, who invested $2.5 million for a third of the stock and management control.  Valentine began to professionalize Cisco’s management, bringing in as CEO an industry veteran, John Morgridge.  Sales grew rapidly, from $1.5 million in 1987 to $28 million in 1989, and in February 1990, Cisco went public.

Valentine and Morgridge brought on John Chambers as a sales executive in 1991.  Chambers had worked at IBM and Wang Labs, and was ready to work at a smaller company where he might have more of an impact.  Chambers came up with a plan for Cisco to dominate the market for computer infrastructure.  Over the next three years, Cisco acquired two dozen companies.

(Cisco Logo, via Wikimedia Commons)

Chambers became CEO in 1995 and Cisco continued acquiring companies.  Cisco’s revenues reached $4 billion in 1997.  Rosenzweig:

Cisco rode the crest of the internet wave in 1998… Cisco had a 40 percent share of the $20 billion data-networking equipment industry—routers, hubs, and devices that made up the so-called plumbing of the Internet—and a massive 80 percent share of the high-end router market.  But Cisco wasn’t just growing revenues.  It was profitable, too.  At a time when even the most admired Internet start-ups, like Amazon.com, were losing money, Cisco posted operating margins of 60 percent.  This wasn’t some dot-com with a business plan, way out there in the blue, riding on a smile and a shoeshine.  It wasn’t panning for Internet gold, it was selling picks and shovels to miners who were lining up around the corner to buy them…

Cisco reached $100 billion market capitalization in just twelve years.  It had taken Microsoft twenty years (the previous record).

Accounts explaining Cisco’s success nearly always gave credit to John Chambers.  He’d overcome dyslexia to go to law school.  And Chambers said he learned from working at IBM and Wang that if you don’t react to shifts in technology, your work will be lost and the lives of employees disrupted.  Cisco wouldn’t make that mistake, Chambers declared.

Cisco had a disciplined, detailed process for making acquisitions, and an even more disciplined process for integrating acquisitions into Cisco’s operations.  Cisco had made “a science” of acquisitions.  And it cared a lot about the human side—turnover rate for acquired employees was only 2.1% versus an industry average of 20%.

After the Internet stock bubble burst, business reporters completely reversed their opinion of Cisco on every major point:

  • Customer service—from excellent to poor
  • Forecasting ability—from outstanding to terrible
  • Innovation—from nearly perfect to visibly flawed
  • Acquisitions—from scientific process to binge buying
  • Senior leadership—from amazing to arrogant

Business reporters recalled that Chambers had claimed that Cisco “was faster, smarter, and just plain better than competitors.”  Rosenzweig says this is fascinating because only business reporters had said this when Cisco was doing well.  Chambers himself never said it, but now business writers seemed to recall that he had.

Rosenzweig points out that it was possible that Cisco had changed.  But that’s not what business reporters were saying.  They viewed Cisco through an entirely different lens, now that the company was struggling.

The essence of the Halo Effect: If a company is performing well, then it’s easy to view virtually everything it does through a positive lens.  If a company is doing poorly, then it’s natural to view virtually everything it does through a negative lens.  The story of Cisco certainly fits this pattern.

As Rosenzweig remarks, the fundamental problem is twofold:

  • We have little scientific knowledge of what leads to business success or failure.
  • But we do know about revenues, profits, and the stock price.  If these observable measures are positive, we intuitively jump to the conclusion that the company must be doing many things well.  If these observable measures are declining, we conclude that the company must be doing many things poorly.



ABB is a Swedish-Swiss industrial company that was created in 1988 by the merger of two leading engineering companies, Sweden’s ASEA and Switzerland’s Brown Boveri.

(ABB Logo, via Wikimedia Commons)

Rosenzweig thought it would be interesting to look at a non-American, non-Internet company.  The Halo Effect is still clearly visible in the accounts of ABB’s rise and fall.

When it came to ABB’s rise, from the late 1980’s to the late 1990’s, we see that business experts drew similar conclusions.  First, the CEO, Percy Barnevik, was widely and highly praised.  Rosenzweig describes Barnevik as a “Scandinavian who combined old world manners and language skills with American pragmatism and an orientation for action.”  Barnevik was described in the press as very driven, but also unpretentious and accessible.  He met frequently with all levels of ABB management.  He was a speed reader and highly analytical.  Away from work, he climbed mountains and went for long jogs (lasting up to 10 hours).  On top of all this, Barnevik was viewed as humble, not arrogant.  By 1993, Barnevik had become a legend.

Another explanation for ABB’s success was its culture.  Despite its conservative Swedish and Swiss roots, ABB had a strong bias for action.  Barnevik said so on several occasions, asserting that the only unacceptable thing was to do nothing.  He claimed that if you do 50 things, and 35 are in the right direction, that is enough.

A third explanation was that the company was designed to be globally efficient, but still able to compete in local markets.  Barnevik wanted people in different locations to be able to launch new products, make design changes, or alter production methods.  ABB had a matrix structure, with fifty-one business areas and forty-one country managers.  This resulted in 5,000 profit centers, with each one empowered to achieve high performance and accountable to do so.

In 1996, ABB was named Europe’s Most Respected Company for the third year in a row by the Financial Times.  Kevin Barham and Claudia Heimer, of Ashridge Management Centre in England, published a 382-page book about ABB.  They identified five reasons for ABB’s success:  customer focus, connectivity, communication, collegiality, and convergence.  They placed ABB in the same category as Microsoft and General Electric.

In 1997, Barnevik stepped down as CEO, replaced by Goran Lindahl.  Then the company transitioned towards businesses based on intellectual capital.  ABB entered new areas, like financial services.  It exited the trains and trams business, as well as the nuclear fuels business.  Rosensweig asks if ABB was “straying from its core.”  Not at all because ABB was still seen as a success.  Lindahl was CEO of the year in 1999 according to the American publication, Industry Week.  Lindahl was the first European to get this award.

In November 2000, Lindahl abruptly stepped down, saying he wanted to be replaced by someone with more expertise in IT.  Jürgen Centerman became the new CEO.

ABB’s performance entered a steep decline.  Centerman was replaced by Jürgen Dormann in September 2002.  Dormann sold the company’s petrochemicals business and its structured finance business.  ABB focused on automation technologies and power technologies.  But the company’s market cap dipped below $4 billion, down from a peak of $40 billion.

When ABB was on the rise in terms of performance, it was described as bold and daring because of its bias for action and experimentation.  Now, with performance being poor, ABB was described as impulsive and foolish.  Moreover, whereas ABB’s decentralized strategy had been praised when ABB was rising, now the same strategy was criticized.  As for Barnevik, while he had previously been described as bold and visionary, now he was called arrogant and imperial.

Most interesting of all, notes Rosenzweig, is that neither the company nor Barnevik was thought to have changed.  It was only how they were characterized that had changed—clear examples of the Halo Effect.

Rosenzweig writes:

…one of the main reasons we love stories is that they don’t simply report disconnected facts but make connections about cause and effect, often ascribing credit or blame to individuals.  Our most compelling stories often place people at the center of events… Once widely revered, Percy Barnevik was now an exemplar of arrogance, of greed, of bad leadership.



During World War I, the American psychologist Edward Thorndike studied how superiors rated their subordinates.  Thorndike noticed that good soldiers were good on nearly every attribute, whereas underperforming soldiers were bad on nearly every attribute.  Rosenzweig comments:

It was as if officers figured that a soldier who was handsome and had good posture should also be able to shoot straight, polish his shoes well, and play the harmonica, too.

Thorndike called this the Halo Effect.  Rosenzweig:

There are a few kinds of Halo Effect.  One refers to what Thorndike observed, a tendency to make inferences about specific traits on the basis of a general impression.  It’s difficult for most people to independently measure separate features; there’s a common tendency to blend them together.  The Halo Effect is a way for the mind to create and maintain a coherent and consistent picture, to reduce cognitive dissonance.

(Image by Aliaksandra Molash)

Rosenzweig gives the example of George W. Bush.  After the September 11 attacks in 2001, Bush’s approval ratings rose sharply, not surprisingly as the public rallied behind him.  But Bush’s ratings on other factors, such as his management of the economy, also rose significantly.  There was no logical reason to think Bush’s handling of the economy was suddenly much better after the attacks.  This is an instance of the Halo Effect.

By October 2005, the situation had reversed.  Support for the Iraq War waned, and people were upset about the government response to Hurricane Katrina.   Bush’s overall ratings were at 37 percent.  His rating was also lower in every individual category.

Rosenzweig then explains another kind of Halo Effect:

…the Halo Effect is not just a way to reduce cognitive dissonance.  It’s also a heuristic, a sort of rule of thumb that people use to make guesses about things that are hard to assess directly.  We tend to grasp information that is relevant, tangible, and appears to be objective, and then make attributions about other features that are more vague or ambiguous.

Rosenzweig later adds:

All of which helps explain what we saw at Cisco and ABB.  As long as Cisco was growing and profitable and setting records for its share price, managers and journalists and professors inferred that it had a wonderful ability to listen to its customers, a cohesive corporate culture, and a brilliant strategy.  And when the bubble burst, observers were quick to make the opposite attribution.  It all made sense.  It told a coherent story.  Same for ABB, where rising sales and profits led to favorable evaluations of its organization structure, its risk-taking culture, and most clearly the man at the top—and then to unfavorable evaluations when performance fell.

Rosenzweig recounts an experiment by professor Barry Staw.  Various groups of people were asked to forecast future sales and earnings based on a set of financial data.  Then some groups were told they’d done a good job, while other groups were told the opposite.  But this was done at random, completely independent of actual performance.

Later, each group was asked about how it had functioned as a group.  Groups that had been told that they did well on their forecasts reported that their group had been cohesive, with good communication, openness to change, and good motivation.  Groups that had been told that they didn’t do well on their forecasts reported that they lacked cohesion, had poor communication, and were unmotivated.

Staw’s experiment is a clear demonstration of the Halo Effect.

  • If people believe that a group is effective—irrespective of whether the group can be measured as such—then they attribute one set of characteristics to it.
  • If people believe that a group is ineffective—irrespective of whether the group can be measured as such—then they attribute the opposite set of characteristics to it.

This doesn’t mean that cohesiveness, motivation, etc., is unimportant for group communication.  Rather, it means that people typically cannot assess these types of qualities with much (or any) objectivity, especially if they already have a belief about how a given group has performed in some task.

When it’s hard to measure something objectively, people tend to look for something that is objective and use that as a heuristic, inferring that harder-to-measure attributes must be similar to whatever is objective (like financial peformance).

As yet another example, Rosenzweig mentions that IBM’s employees were viewed as smart, creative, and hardworking in 1984 when IBM was doing well.  In 1992, after IBM had faltered, the same people were described as complacent and bureauratic.

As we’ve seen, the Halo Effect is particularly frequent when people try to judge how good a leader is.  Just as we don’t have much scientific knowledge for how a company can succeed, we also don’t have much scientific knowledge about what makes a good leader.  Experts, when they look at a company that is doing well, tend to think that the leader has many good qualities such as courage, clear vision, and integrity.  When the same experts examine a company that is doing poorly, they tend to conclude that the leader lacks courage, vision, and integrity.  This happens even when experts are looking at the same company and that company is doing the same things.

(Image by Kirsty Pargeter)

When Microsoft was doing well, Bill Gates was described as ambitious, brilliant, and visionary.  When Microsoft appeared to falter in 2001, after Judge Thomas Penfield Jackson ordered Microsoft to be broken up, Bill Gates was described as arrogant and stubborn.

Rosenzweig gives two more examples:  Fortune’s World’s Most Admired Companies, and the Great Places to Work Institute’s Best Companies to Work For index.  Both lists appear to be significantly impacted by the Halo Effect.  Companies that have been doing well financially tend to be viewed and described much more favorably on a range of metrics.

Rosenzweig closes the chapter by noting that the Halo Effect is the most basic delusion, but that there are several more delusions he will examine in the coming chapters.




The Halo Effect shapes how we commonly talk about so many topics in business, from decision processes to people to leadership and more.  It shows up in our everyday conversations and in newspaper and magazine articles.  It affects case studies and large-sample surveys.  It’s not so much the result of conscious distortion as it is a natural human tendency to make judgments about things that are abstract and ambiguous on the basis of other things that are salient and seemingly objective.  The Halo Effect is just too strong, the desire to tell a coherent story too great, the tendency to jump on bandwagons too appealing.

The most fundamental business question is:

What leads to high business performance?

The Halo Effect is far from inevitable, despite being very common.  There are researchers who use careful statistical tests to isolate the effects of independent variables on dependent variables.

The dependent variables relate to company performance.  And we have good data on that, from revenues to profits to return on capital.

As for the independent variables, some of these, such as R&D spending, are not tainted.  Much trickier is what happens inside a company, such as quality of management, customer orientation, company culture, etc.

Rosenzweig explores the question of whether customer focus leads to better company performance.  It probably does.  However, in order to measure the effect of customer focus on performance objectively, we should not look at magazine and newspaper articles—since these are impacted by the Halo Effect.  Nor should we ask company employees about their customer focus.  How a company is performing—well or poorly—will impact the opinions of managers and employees regarding customer focus.

Similar logic applies to the question of how corporate culture impacts business performance.  Surveys of managers and employees will be tainted by the Halo Effect.  Yes, corporate culture impacts business performance.  But to figure out the statistical correlation, we have to be sure to avoid data likely to be skewed by the Halo Effect.

Delusion Two: The Delusion of Correlation and Causality

Rosenzweig gives the example of employee turnover and company performance.  If there is a statistical correlation between the two, then what does that mean?  Does lower employee turnover lead to higher company performance?  That sounds reasonable.  On the other hand, does higher company performance lead to lower employee turnover?  That could very well be the case.

Potential confusion about correlation versus causality is widespread when it comes to the study of business.

One way to get some insight into potential causality is to conduct a longitudinal study, looking at independent variables in one period and hypothetically dependent variables in some later period.  Rosenzweig:

One recent study, by Benjamin Schneider and colleagues at the University of Maryland, used a longitudinal design to examine the question of employee satisfaction and company performance to try to find out which one causes which.  They gathered data over several years so they could watch both changes in satisfaction and changes in company performance.  Their conclusion?  Financial performance, measured by return on assets and earnings per share, has a more powerful effect on employee satisfaction than the reverse.  It seems that being on a winning team is a stronger cause of employee satisfaction; satisfied employees don’t have as much of an effect on company performance.  How were Schneider and his colleagues able to break the logjam and answer the question of which leads to which?  By gathering data over time.

Delusion Three: The Delusion of Single Explanations

Rosenzweig describes two studies that were carefully conducted, one on the effect of market orientation on company performance, and the other on the effect of CSR—corporate social responsibility—on company performance.  The studies were careful in that they didn’t just ask for opinions.  They asked about different activities in which the company did or did not engage.

The conclusion of the first study was that market orientation is responsible for 25 percent of company performance.  The second study concluded that CSR is responsible for 40 percent of company performance.  Rosenzweig asks: Does that mean that market orientation and CSR together explain 65 percent of company performance?  Or do the variables overlap to an extent?  The problem with studying a single cause of company performance is that you don’t know if part of the effect may be due to some other variable you’re not measuring.  If a company is well-managed, then wouldn’t that be seen in market orientation and also in CSR?

(Photo by Jörg Stöber)

We could throw human resource management—HRM—into the mix, too.  Same goes for leadership.  One study found that good leadership is responsible for 15 percent of company performance.  But is that in addition to market orientation, CSR, and HRM?  Or do these things overlap to an extent?  It’s likely that there is significant overlap among these four variables.

One problem is that many researchers would like to tell a clear story about cause and effect.  Admitting that many key variables likely overlap means that the story is much less clear.  People—especially if busy or pressured—prefer simple stories where cause and effect seem obvious.

Furthermore, many important questions are at the intersection of different fields.  Rosenzweig gives the example of decision making, which involves psychology, sociology, and economics.  The trouble is that an expert in marketing will tend to exaggerate the importance of marketing.  An expert in CSR will tend to exaggerate the importance of CSR.  And so forth for other specialties.



Rosenzweig lists the eight practices of America’s best companies according to In Search of Excellence: Lessons from America’s Best-Run Companies, published by Tom Peters and Bob Waterman in 1982:

  • A bias for action—a preference for doing something—anything—rather than sending a question through cycles and cycles of analyses and committee reports.
  • Staying close to the customer—learning his preferences and catering to them.
  • Autonomy and entrepreneurship—breaking the corporation into small companies and encouraging them to think independently and competitively.
  • Productivity through people—creating in all employees the awareness that their best efforts are essential and that they will share in the rewards of the company’s success.
  • Hands-on, value-driven—insisting that executives keep in touch with the firm’s essential business.
  • Stick to the knitting—remaining with the business the company knows best.
  • Simple form, lean staff—few administrative layers, few people at the upper levels.
  • Simultaneous loose-tight properties—fostering a climate where there is dedication to the central values of the company combined with a tolerance for all employees who accept those values.

Rosenzweig points out that this list looks familiar:  Care about your customers.  Have strong values.  Create a culture where people can thrive.  Empower your employees.  Stay focused.

If these look correlated, says Rosenzweig, that’s because they are.  The best companies do all of them.  Of course, again there’s the Halo Effect.  If you isolate the top-performing companies (43 of them in this case), and then ask managers and employees about customer focus, values, culture, leadership, focus, etc., then you won’t know what caused what.  Did clear strategy, good organization, strong corporate culture, and customer focus lead to the high performance?  Or do people view high-performing companies as doing well in these areas?

(Image by Eriksvoboda)

When the book was published in 1982, there was a widespread concern among American businesses that Japanese companies were better overall.  Peters and Waterman made the point that the leading American businesses were doing well in a variety of key areas.  This message was viewed not only as inspirational, but even as patriotic.  It was the right story for the times.

Many thought that In Search of Excellence contained scientific knowledge:  if x, then y (with probability z).  People thought that if they implemented the principles highlighted by Peters and Waterman, then they would be successful in business.

However, just two years later, some of the excellent companies did not seem as excellent as before.  Some were blamed for changing—not sticking to their knitting.  Others were blamed for NOT changing—not being adaptable enough, not taking action.  More generally, some were blamed for overemphasizing certain principles, while underemphasizing other principles.

Rosenzweig examined the profitability of 35 of the 43 excellent companies—the 35 companies for which data were available because these companies were public.  He found that, in the five years after 1982, 30 out of 35 had a decline in profitability.  If these were truly excellent companies, then such a decline for 30 of 35 doesn’t make sense.

(Image by Dejan Lazarevic)

Rosenzweig observes that it’s possible that the previous success of these companies was due to more than the eight principles identified by Peters and Waterman.  And so changes in other variables may explain the subsequent declines in profitability.  It’s also possible—because Peters and Waterman identified 43 highly successful companies and then interviewed managers at those companies—that the Halo Effect came into play.  The eight principles may reflect attributions that people tend to make about currently successful companies.

Delusion Four: The Delusion of Connecting the Winning Dots

You can’t choose a sample based only on the dependent variable you’re trying to test.  The dependent variable in this case is successful companies.  If all you look at is successful companies, then you won’t be able to compare successful companies directly to unsuccessful companies in order to learn about their respective causes—the independent variables.  Rosenzweig refers to this error as the Delusion of Connecting the Winning Dots.  You can connect the dots any way you wish, but following this approach, you can’t learn about the independent variables that lead to success.

Like many areas of social science, it’s not easy.  You can’t run an experiment where you take 100 companies, and manage half of them one way, and half of them another way, and then compare results.

(Image by Macrovector)

Jim Collins and Jerry Porras isolated 18 companies based on excellent performance over a long period of time.  Also, for each of these companies, Collins and Porras identified a similar company that had been less successful.  This at least could avoid the error that Peters and Waterman made.  As Collins and Porras said, if all you looked at were successful companies, you might find that they all reside in buildings.

Collins, Porras, and their team read more than 100 books and looked at more than 3,000 documents.  All told, they had a huge amount of data.  They certainly worked very hard.  But that in itself does not increase the scientific validity of their study.

Collins and Porras claimed to have found “timeless principles,” which they listed:

  • Having a strong core ideology that guides the company’s decisions and behavior
  • Building a strong corporate culture
  • Setting audacious goals that can inspire and stretch people—so-called big hairy audacious goals, or BHAGs
  • Developing people and promoting them from within
  • Creating a spirit of experimentation and risk taking
  • Driving for excellence

Unfortunately, much of the data came from books, the business press, and company documents, all likely to contain Halos.  They also conducted interviews with managers, who were asked to look back on their success and explain the reasons.  These interviews were probably tinged by Halos in many cases.  Some of the principles identified may have led to success.  However, successful companies were also likely to be described in these terms.  The Halo Effect hadn’t been dealt with by Collins and Porras.

Rosenzweig looked at profitability over the subsequent five years.  Eleven companies saw profits decline.  One was unchanged.  Only five of the best companies had profits increase.  It seems the “master blueprint for long-term prosperity” is largely a delusion, writes Rosenzweig.

(Graph by Experimental)

It’s not just some of the companies, but most of the companies that saw profits decline.  Characterizations of the “best” companies were probably impacted significantly by the Halo Effect.  The very fact that these companies had been doing well for some time led many to see them as having positive attributes across the board.

Delusion Five: The Delusion of Rigorous Research

As noted, psychologist Philip Tetlock tracked the predictions of 284 leading experts over two decades.  Tetlock looked at over 27,000 predictions in real time of the form:  more of x, no change in x, or less of x.  He found that these predictions were no better than random chance.

Many experts have deep knowledge—historical or otherwise—that can give us valuable insights into human affairs.  Some of this expertise is probably accurate.  But until we have testable predictions, it’s difficult to say which hypotheses are true and to what degree.

We should never forget the difference between scientific knowledge and other types of knowledge, including stories.  It’s very easy for us humans to be overconfident and deluded, especially if certain stories are the result of “many years of hard work.”

Delusion Six: The Delusion of Lasting Success

Richard Foster and Sarah Kaplan looked at companies in the S&P 500 from 1957 to 1997.  By 1997, only 74 out of the original largest 500 companies were still in the S&P 500.  Of those 74 survivors, how many outperformed the S&P 500 over those 40 years?  Only 12.

Foster and Kaplan conclude:

KcKinsey’s long-term studies of corporate birth, survival, and death in America clearly show that the corporate equivalent of El Dorado, the golden company that continually performs better than the markets, has never existed.  It is a myth.  Managing for survival, even among the best and most revered corporations, does not guarantee strong long-term performance for shareholders.  In fact, just the opposite is true.  In the long run, the markets always win.

It’s not that busines success is completely random.  Of course not.  But there is usually a large degree of luck involved.  More fundamentally, capitalism is about competition through innovation, or creative destruction, as the great Austrian economist Joseph Schumpeter called it.  There is some inherent unpredictability—or luck—in this endless process.

Delusion Seven: The Delusion of Absolute Performance

Kmart improved noticeably from 1994 to 2002, but Wal-Mart and Target were ahead at the beginning of that period, and they improved even faster than Kmart.  Thus, although it would seem Kmart was doing the right things in terms of absolute performance, Kmart was falling even further behind in terms of relative performance.

In 2005, GM was making much better cars than in the 1980s.  But its market share kept slipping, from 35 percent in 1990 to 25 percent in 2005.  GM’s competitors were improving faster.

Rosenzweig sums it up:

The greater the number of rivals, and the easier for competitors to enter the market, and the more rapidly technology changes, the more difficult it is to sustain success.  That’s an uncomfortable truth, because it admits that some elements of business performance are outside of our control.  It’s far more appealing to downplay the relative nature of performance or ignore it completely.  Telling a company it can achieve high performance, regardless of what competitors do, makes for a more attractive story.

Delusion Eight: The Delusion of the Wrong End of the Stick

In Good to Great, Collins argues that a company can decide to become great and follow the blueprint in the book.  Part of the recipe is to be like a Hedgehog—to have a narrow focus and pursue it with great discipline.  The problem, again, is that the role of chance—or factors outside one’s control—is not considered.  (The terms “Hedgehog” and “Fox” come from an essay by Isaiah Berlin.  The Hedgehog knows one big thing, whereas the Fox knows many things.)

(Image by Marek Uliasz)

Statistically, it’s possible that, on the whole, more Hedgehogs than Foxes failed.  You could still argue that the potential upside for becoming a great company is so large that it’s worth taking the risk of being like a Hedgehog.  But Collins doesn’t mention risk, or chance, at all.

Of course, we’d all prefer a story where greatness is purely a matter of choice.  But it’s rarely that simple and luck nearly always plays a pivotal role.

Delusion Nine: The Delusion of Organizational Physics

For many questions in business, we can’t run experiments.  That said, with enough care, important statistical correlations can be discovered.  Other things can be measured even more precisely.

But to think that the study of business is like the science of physics is a delusion, at least for now.

It’s reasonable to suppose that, with enough scientific knowledge in neuroscience, genetics, psychology, economics, artificial intelligence, and related areas, eventually human behavior may become largely predictable.  But there’s a long way to go.



By nature, we prefer stories where business success is entirely a result of choosing to do the right things, while not reaching success must be due to a failure to do the right things.  But stories like this neglect the role of chance.  Rosenzweig writes:

…all the emphasis on steps and formulas may obscure a more simple truth.  It may further the fiction that a specific set of steps will lead, predictably, to success.  And if you never achieve greatness, well, the problem isn’t with our formula—which was, after all, the product of rigorous research, of extensive data exhaustively analyzed—but with you and your failure to follow the formula.  But in fact, the truth may be considerably simpler than these formula suggest.  They may divert our attention from a more powerful insight—that while we can do many things to improve our chances of success, at its core business performance contains a large measure of uncertainty.  Business performance may actually be simpler than it is often made out to be, but may also be less certain and less amenable to engineering with predictable outcomes.

There is a simpler way to think about business performance—suggested by Michael Porter—without neglecting the role of chance.  Strategy is doing certain things different from rivals.  Execution is people working together to create products by implementing the strategy.  This is a reasonable way to think about business performance as long as you also note the role of chance.

It’s usually hard to know how potential customers will behave.  There are, of course, many examples where, contrary to expectations, a product was embraced or rejected.  Moreover, even if you correctly understand customers, competitors may come up with a better product.

There’s also the issue of technological change, which can be a significant source of unpredictability in some industries.

(Illustration by T. L. Furrer)

Clayton Christensen has demonstrated—in The Innovator’s Dilemma—that frequently companies fail because they keep doing the right things, giving customers what they want.  Meanwhile, competitors develop a new technology that, at first, is not profitable—which is part of why the company “doing the right things” ignores it.  But then, unpredictably, some of these new technologies end up being popular and also profitable.

One good question is:  What should a company do when its core comes under pressure?  Should it redouble its focus on the core, like a Hedgehog?  Or should it be adaptable, like a Fox?  There are no good answers at the moment, says Rosenzweig.  There are too many variables.  Chance—or uncertainty—plays a key role.

Rosenzweig continues:

In the meantime, we’re left with the brutal fact that strategic choice is hugely consequential for a company’s performance yet also inherently risky.  We may look at successful companies and applaud them for what seem, in retrospect, to have been brilliant decisions, but we forget that at the time those decisions were made, they were controversial and risky.  McDonald’s bet on franchising looks smart today, but in the 1950s it was a leap in the dark.  Dell’s strategy of selling direct now seems brilliant but was attempted only after multiple failures with conventional channels.  Or, recalling companies we discussed in earlier chapters, remember Cisco’s decision to assemble a full range of product offerings through acquisitions or ABB’s bet on leading rationalization of the European power industry through consolidation and cost cutting.  The managers who took those choices appraised a wide variety of factors and decided to be different from their rivals.  We remember all of these decisions because they turned out well, but success was not inevitable.  As James March of Stanford and Zur Shapira of New York University explained, “Post hoc reconstruction permits history to be told in such a way that ‘chance,’ either in the sense of genuinely probabilistic phenomena or in the sense of unexplained variation, is minimized as an explanation.”  But chance DOES play a role, and the difference between a brilliant visionary and a foolish gambler is usually inferred after the fact, an attribution based on outcomes.  The fact is, strategic choices always involve risk.  The task of strategic leadership is to gather appropriate information and evaluate it thoughtfully, then make choice that, while risky, provide the best chances for success in a competitive industry setting.

(Image by Donfiore)

As for execution, certain practices do correlate with modestly higher performance.  If leaders can identify the few areas where better execution is needed, then some progress can be made.

But inherent unpredictability is hidden by the Halo Effect.  If a company succeeds, it’s easy to say it executed well.  If a company fails, it’s natural to conclude that execution was poor.  Often to a large extent, these conclusions are driven by the Halo Effect, even if there is some truth to them.

In brief, smart strategic choices and good execution—plus good luck—may lead to success, at least temporarily.  But success brings challengers, some of whom will take greater risks that may work.  There’s no formula to guarantee success.  And if success is achieved, there’s no way to guarantee continued success over time.



Given that there’s no simple formula that brings business success, what should we do?  Rosenzweig answers:

A first step is to set aside the delusions that color so much of our thinking about business performance.  To recognize that stories of inspiration may give us comfort but have little more predictive power than a pair of coconut headsets on a tropical island.  Instead, managers would do better to understand that business success is relative, not absolute, and that competitive advantage demands calculated risks.  To accept that few companies achieve lasting success, and that those that do are perhaps best understood as having strung together several short-term successes rather than having consciously pursued enduring greatness.  To admit that, as Tom Lester of the Financial Times so neatly put it, “the margin between success and failure is often very narrow, and never quite as distinct or as enduring as it appears at a distance.”  By extension, to recognize that good decisions don’t always lead to favorable outcomes, that unfavorable outcomes are not always the result of mistakes, and therefore to resist the natural tendency to make attributions based solely on outcomes.  And finally, to acknowledge that luck often plays a role in company success.  Successful companies aren’t “just lucky”—high performance is not purely random—but good fortune does play a role, and sometimes a pivotal one.

Rosenzweig mentions Robert Rubin as a good example of someone who learned to make decisions in terms of scenarios and their probabilities.

(Image by Elnur)

Rubin worked for eight years in the Clinton administration, first as director of the White House National Economic Council and later as secretary of the Treasury.  Prior to working in the Clinton administration, Rubin toiled for twenty-six years at Goldman Sachs.

Rubin first learned about the fundamental uncertainties of the world when he studied philosophy as an undergraduate.  He learned to view every proposition with skepticism.  Later at Goldman Sachs, Rubin saw first-hand that one had to consider possible outcomes and their associated probabilities.

Rubin spent years in risk arbitrage.  Many times Goldman made money, but roughly one out of every seven times, Goldman lost money.  Sometimes the loss would greatly exceed Goldman’s worst-case scenario.  But occasionally large and painful losses didn’t mean that Goldman’s decision-making process was flawed.  In fact, if Goldman wasn’t taking some losses, then they almost certainly weren’t taking enough risk.

(Photo by Alain Lacroix)

Rosenzweig asks:  If a large and painful loss doesn’t mean a mistake, then what does?

We have to take a close look at the decision process itself, setting aside the eventual outcome.  Had the right information been gathered, or had some important data been overlooked?  Were the assumptions reasonable, or had they been flawed?  Were calculations accurate, or had there been errors?  Had the full set of eventualities been identified and their impact estimated?  Had Goldman Sachs’s overall risk portfolio been properly considered?

Once again, a profitable outcome doesn’t necessarily mean the decision was good.  An unprofitable outcome doesn’t necessarily mean the decision was bad.  If you’re making decisions under uncertainty—probabilistic decisions—the only way to improve is to evaluate the process of decision-making independently of specific outcomes.

Of course, often important decisions for an individual business are quite infrequent.  Rosenzweig highlights important lessons for managers:

  • If independent variables aren’t measured independently, we may find ourselves standing hip-deep in Halos.
  • If the data are full of Halos, it doesn’t matter how much we’ve gathered or how sophisticated our analysis appears to be.
  • Success rarely lasts as long as we’d like—for the most part, long-term success is a delusion based on selection after the fact.
  • Company performance is relative, not absolute.  A company can get better and fall further behind at the same time.
  • It may be true that many successful companies bet on long shots, but betting on long shots does not often lead to success.
  • Anyone who claims to have found laws of business physics either understands little about business, or little about physics, or both.
  • Searching for the secrets of business success reveals little about the world of business but speaks volumes about the searchers—their aspirations and their desires for certainty.

Getting rid of delusions is a crucial step.  Furthermore, writes Rosenzweig, a wise manager knows:

  • Any good strategy involves risk.  If you think your strategy is foolproof, the fool may well be you.
  • Execution, too, is uncertain—what works in one company with one workforce may have different results elsewhere.
  • Chance often plays a greater role than we think, or than successful managers usually like to admit.
  • The link between inputs and outcomes is tenuous.  Bad outcomes don’t always mean that managers made mistakes; and good outcomes don’t always mean they acted brilliantly.
  • But when the die is cast, the best managers act as if chance is irrelevant—persistence and tenacity are everything.

Of course, none of this guarantees success.  But the sensible goal is to improve your chances of success.



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

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

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

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


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

My e-mail: jb@boolefund.com




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

Value Investing: The Most Important Thing

(Image:  Zen Buddha Silence by Marilyn Barbone.)

June 17, 2018

Value investing can be a relatively low risk way for some investors to beat the market over time.  Yet it often takes a decade to get the hang of it.  Even then, you have to keep improving indefinitely.  But the great thing is that you can keep improving indefinitely as long as your health stays good.  In addition to learning from experience, an excellent way to progress is by studying the best value investors.

Howard Marks is not only a great value investor.  But he also has written an outstanding book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia University Press, 2011).  Like most classics, Marks’s book is worth re-reading periodically.

This blog post is intended for two groups:

  • People who already have some experience with value investing.  It’s worth regularly reviewing the teachings of the masters.
  • People who are interested in learning about value investing.

Here’s an outline.  Each section can be read independently:

  • A Value Investing Philosophy
  • Second-Level Thinking
  • Understanding Market Efficiency
  • Value
  • The Relationship Between Price and Value
  • Understanding Risk
  • Recognizing Risk
  • Controlling Risk
  • Being Attentive to Cycles
  • Awareness of the Pendulum
  • Combating Negative Influences
  • Contrarianism
  • Finding Bargains
  • Patient Opportunism
  • Knowing What You Don’t Know
  • Having a Sense of Where We Stand
  • Appreciating the Role of Luck
  • Investing Defensively


The title of the book is based on the fact that Marks wrote a series of memos to clients identifying “the most important thing.”  Looking back, Marks realized that there were many “most important things.”

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



A value investing philosophy takes time to develop, as Marks notes:

A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources.  One cannot develop an effective philosophy without having been exposed to life’s lessons.  In my life I’ve been quite fortunate in terms of both rich experiences and powerful lessons.

Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk.  The most valuable lessons are learned in tough times.

(Photo by Yuryz)



Marks first points out how variable the investing landscape is:

No rule always works.  The environment isn’t controllable, and circumstances rarely repeat exactly.  Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.

The goal for an investor is to do better than the market over time.  Otherwise, the best option for most investors is simply to buy and hold low-cost broad market index funds.  Doing better than the market requires an identifiable edge:

Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have.  You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess.  You have to react differently and behave differently.  In short, being right may be a necessary condition for investment success, but it won’t be sufficient.  You must be more right than others… which by definition means your thinking has to be different.

(Photo by Andreykuzmin)

Marks gives some examples of second-level thinking:

First-level thinking says, ‘It’s a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not.  So the stock’s overrated and overpriced; let’s sell.’

First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’   Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic.  Buy!’

First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’

Marks explains that first-level thinking is generally simplistic.  By contrast, second-level thinking requires thinking of the full range of possible future outcomes, along with estimating probabilities for each possible outcome.  Second-level thinking means understanding what the consensus thinks, why you have a different view, and the likelihood that one’s contrarian view is correct.  Marks observes that second-level thinking is far more difficult than first-level thinking, thus few investors truly engage in second-level thinking.  First-level thinkers cannot expect to outperform the market.

To outperform the average investor, you have to be able to outthink the consensus.  Are you capable of doing so?  What makes you think so?



Marks holds a view of market efficiency similar to that of Warren Buffett:  The market is usually efficient, but it is far from always efficient.

(Illustration by Lancelotlachartre)

Marks says that the market reflects the consensus view, but the consensus is not always right:

In January 2000, Yahoo sold at $237.  In April 2001 it was $11.  Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions.  But that doesn’t mean many investors were able to detect and act on the market’s error.

Marks summarizes his view:

The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences—to consistently hold views that are different from the consensus and closer to being correct.  That’s what makes the mainstream markets awfully hard to beat—even if they aren’t always right.

Marks makes an important point about riskier investments:

Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise.  Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments.  But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.

Marks notes that inefficient prices imply that for each investor who buys at a cheap price, another investor must sell at that cheap price.  Inefficiency essentially implies that each investment that beats the market implies another investment that trails the market by an equal amount.

Generally it is exceedingly difficult to beat the market.  To highlight this fact, Marks asks a series of questions:

  • Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that is too cheap?
  • If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?
  • Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
  • Do you really know more about the asset than the seller does?
  • If it’s such a great proposition, why hasn’t someone else snapped it up?

Market inefficiency alone, argues Marks, is not a sufficient condition for outperformance:

All that means is that prices aren’t always fair and mistakes are occurring: some assets are priced too low and some too high.  You still have to be more insightful than others in order to regularly buy more of the former than the latter.  Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.

(Photo by Marijus Auruskevicius)

Marks ends this section by saying that a key turning point in his career was when he concluded that he should focus on relatively inefficient markets.

Important Note:  One area of the stock market that is remarkably inefficient is microcap stocks, especially when compared with midcap or largecap stocks.  See: http://boolefund.com/cheap-solid-microcaps-far-outperform-sp-500/

A few comments about deep value investing:

In order to buy a stock that is very cheap in relation to its intrinsic value, some other investor must be willing to sell the stock at such an irrationally low price.  Sometimes such sales happen due to forced selling.  The rest of the time, the seller must be making a mistake in order for the value investor to make a market-beating investment.

And yet many deep value approaches are fully quantitative, relying on statistical rules for stock selection.  The quantitative deep value investor does not typically make a detailed judgment on each individual stock—a judgment which would imply that the buyer is correct and the seller is incorrect in the individual case.  Rather, the quantitative deep value investor forms a portfolio of the statistically cheapest stocks.  All of the studies have shown that a basket of quantitatively cheap stocks does better than the market over time, and is less risky (especially during down markets).

Blog post on quantitative deep value investing: http://boolefund.com/quantitative-deep-value-investing/

A concentrated deep value approach, by contrast, involves the effort to select the most promising and the cheapest individual stocks available.  Warren Buffett and Charlie Munger—both inspired in part by Philip Fisher—followed this approach when they were managing smaller amounts of capital.  They would usually have between 3 and 8 positions making up nearly the entire portfolio.



Marks begins by saying that “buy low; sell high” is one of the oldest rules in investing.  But since selling will occur in the future, how can you figure out a price today that will be lower than some future price?  What’s needed is an ability to accurately assess the intrinsic value of the asset.  The intrinsic value of a stock can be derived from the price that an informed buyer would pay for the entire company, based on net asset value or normalized earnings.  Writes Marks:

The quest in value investing is for cheapness.  Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases.  The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.

(Photo by Farang)

Marks notes that a successful value investment requires a non-consensus view on net asset value or normalized earnings.  Successful growth investing, by contrast, requires a non-consensus view on future earnings (based on growth).  Sometimes the rewards for growth investing are higher, but a value investing approach is much more repeatable and achievable.

Buying assets below fair value, however, does not mean those assets will outperform right away.  Value investing requires having a firmly held view because quite often after buying, cheap assets will continue to underperform the market.  Marks elaborates:

If you liked it at 60, you should like it more at 50… and much more at 40 and 30.  But it’s not that easy.  No one’s comfortable with losses, and eventually any human will wonder, ‘Maybe it’s not me who’s right.  Maybe it’s the market.’…

Thus, successful value investing requires not only the consistent ability to identify assets available at cheap prices; it also requires the ability to ignore various signals (many of which are subconscious) flashing the message that one is wrong.  As Marks writes:

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out.  Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong.  Oh yes, there’s a third: you have to be right.



Many investors make the mistake of thinking that a good company is automatically a good investment, while a bad company is automatically a bad investment.  But what really matters for the value investor is the relationship between price and value:

For a value investor, price has to be the starting point.  It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price.  And there are few assets so bad that they can’t be a good investment when bought cheaply enough.

In the 1960’s, there was a group of stocks called the Nifty Fifty—companies that were viewed as being so good that all you had to do was buy at any price and then hold for the long term.  But it turned out not to be true for many stocks in the basket.  Moreover, the early 1970’s led to huge declines:

Within a few years, those price/earnings ratios of 80 or 90 had fallen to 8 or 9, meaning investors in America’s best companies had lost 90 percent of their money.  People may have bought into great companies, but they paid the wrong price.

Marks explains the policy at his firm Oaktree:

‘Well bought is half sold.’  By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or to whom, or through what mechanism.  If you’ve bought it cheap, eventually those questions will answer themselves.  If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.

Marks, similar to Buffett and Munger, holds that psychology plays a central role in value investing:

Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship—and the outlook for it—lies largely in insight into other investor’s minds.  Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.  

The safest and most potentially profitable thing is to buy something when no one likes it.  Given time, its popularity, and thus its price, can only go one way: up.

A successful value investor must build systems or rules for self-protection because all investors—all humans—suffer from cognitive biases, which often operate subconsciously.

(Illustration by Alain Lacroix)

Marks again on the importance of cheapness:

Of all the possible routes to investment profit, buying cheap is clearly the most reliable.  Even that, however, isn’t sure to work.  You can be wrong about the current value.  Or events can come along that reduce value.  Or deterioration in attitudes or markets can make something sell even further below its value.  Or the convergence of price and intrinsic value can take more time than you have…

Trying to buy below value isn’t infallible, but it’s the best chance we have.



As Buffett frequently observes, the future is always uncertain.  Prices far below probable intrinsic value usually only exist when the future is highly uncertain.  When there is not much uncertainty, asset prices will be much higher than otherwise.  So high uncertainty about the future is the friend of the value investor.

(Photo by Alain Lacroix)

On the other hand, in general, assets that promise higher returns entail higher risk.  If a potentially higher-returning asset was obviously as low risk as a U.S. Treasury, then investors would rush to buy the higher-returning asset, thereby pushing up its price to the point where it would promise returns on par with a U.S. Treasury.

A successful value investor has to determine whether the potential return on an ostensibly cheap asset is worth the risk.  High risk is not necessarily bad as long as it is properly controlled and as long as the potential return is high enough.  But if the risk is too high, then it’s not the type of repeatable bet that can produce long-term success for a value investor.  Repeatedly taking too much risk virtually guarantees long-term failure.

Consider the Kelly criterion.  If the probability of success and the returns from a potential investment can be quantified, then the Kelly criterion tells you exactly how much to bet in order to maximize the long-term compound returns from a long series of such bets.  Betting any other amount than what the Kelly criterion says will inevitably lead to less than the maximum potential returns.  Most importantly, betting more than what the Kelly criterion says guarantees negative long-term returns.  Repeatedly overbetting guarantees long-term failure.

This is part of why Howard Marks, Warren Buffett, Charlie Munger, Seth Klarman and other great value investors often point out that minimizing big mistakes is more important for long-term success in investing than hitting home runs.

Again, while riskier investments promise higher returns, those higher returns are not guaranteed, otherwise riskier investments wouldn’t be riskier!  The probability distribution of potential returns is wider for riskier investments, typically including some large potential losses.  A certain percentage of future outcomes will be negative for riskier investments.

(Photo by Wittayayut Seethong)

Marks agrees with Buffett and Munger that the best definition of risk is the potential to experience loss.

Of course, even the best investors are generally right only two-thirds of the time, while they are wrong one-third of the time.  Thus, following a successful long-term value investing framework where you consistently and carefully pays cheap prices for assets still entails being wrong once every three tries, whether due to a mistake, bad luck, or unforeseen events.

More Notes on Deep Value

Investors are systematically too pessimistic about companies that have been doing poorly, and systematically too optimistic about companies that have been doing well.  This is why a deep value approach, if applied systematically, is very likely to produce market-beating returns over a long enough period of time.

Marks explains:

Dull, ignored, possibly tarnished and beaten-down securities—often bargains exactly because they haven’t been performing well—are often ones value investors favor for high returns…. Much of the time, the greatest risk in these low-luster bargains lies in the possibility of underperforming in heated bull markets.  That’s something the risk-conscious value investor is willing to live with.

Measuring Risk-Adjusted Returns

Marks mentions the Sharpe ratio—or excess return compared to the standard deviation of the return.  While far from perfect, the Sharpe ratio is a solid measure of risk-adjusted return for many public market securities.

It’s important to point out again that risk can no more be objectively measured after an investment than it can be objectively measured before the investment.  Marks:

The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed.  Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa.  With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)?  And ditto for a loser: how do we ascertain whether it was a reasonable but ill-fated venture, or just a wild stab that deserved to be punished?

Did the investor do a good job of assessing the risk entailed?  That’s another good question that’s hard to answer.  Need a model?  Think of the weatherman.  He says there’s a 70 percent chance of rain tomorrow.  It rains; was he right or wrong?  Or it doesn’t rain; was he right or wrong?  It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.

Marks believes (as do Buffett, Munger, and other top value investors) that there is some merit to the expected value framework whereby you attempt to identify possible future scenarios and the probabilities of their occurrence:

If we have a sense for the future, we’ll be able to say which outcome is most likely, what other outcomes also have a good chance of occurring, how broad the range of possible outcomes is and thus what the ‘expected result’ is.  The expected result is calculated by weighing each outcome by its probability of occurring; it’s a figure that says a lot—but not everything—about the likely future.

Again, though, having a reasonable estimate of the future probability distribution is not enough.  You must also make sure that your portfolio can withstand a run of bad luck; and you must recognize when you have experienced a run of good luck.  Marks quotes his friend Bruce Newberg (with whom he has played cards and dice): “There’s a big difference between probability and outcome.  Probable things fail to happen—and improbable things happen—all the time.”  This is one of the most important lessons to know about investing, asserts Marks.

(via Wikimedia Commons)

Marks defines investment performance in the context of risk:

… investment performance is what happens when a set of developments—geopolitical, macro-economic, company-level, technical and psychological—collide with an extant portfolio.  Many futures are possible, to paraphrase Dimson, but only one future occurs.  The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck.  The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many ‘alternative histories’ that were possible.

A portfolio can be set up to withstand 99 percent of all scenarios but succumb because it’s the remaining 1 percent that materializes.  Based on the outcome, it may seem to have been risky, whereas the investor might have been quite cautious.

Another portfolio may be structured so that it will do very well in half the scenarios and very poorly in the other half.  But if the desired environment materializes and it prospers, onlookers can conclude that it was a low-risk portfolio.

The success of a third portfolio can be entirely contingent on one oddball development, but if it occurs, wild aggression can be mistaken for conservatism and foresight.

It’s tough to quantify risk without a large number of repeated trials under similar circumstances.  Marks:

Risk can be judged only by sophisticated, experienced second-level thinkers.

The past seems very definite: for every evolving set of possible scenarios, only one scenario happened at each point along the way.  But that does not at all mean that the scenarios that actually occurred were the only scenarios that could have occurred.

Furthermore, most people assume that the future will be like the past, especially the more recent past.  As Ray Dalio suggests, the biggest mistake most investors make is to assume that the recent past will continue into the future.

Marks also reminds us that the “worst-case” assumed by most investors is typically not negative enough.  Marks relates a funny story his father told about a gambler who bet everything on a race with only one horse in it.  How could he lose?  “Halfway around the track, the horse jumped over the fence and ran away.  Invariably things can get worse than people expect.”  Taking more risk usually leads to higher returns, but not always.  “And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.”



(Photo by Shawn Hempel)

The main source of risk, argues Marks, is high prices.  When stock prices move higher, for instance, most investors feel more optimistic and less concerned about downside risk.  But value investors have the opposite point of view: risk is typically very low when stock prices are very low, while risk tends to increase significantly when stock prices have increased significantly.

Most investors are not value investors:

So a prime element in risk creation is a belief that risk is low, perhaps even gone altogether.  That belief drives up prices and leads to the embrace of risky actions despite the lowness of prospective returns.

Marks emphasizes that recognizing risk—which comes primarily from high prices—has nothing to do with predicting the future, which cannot be done with any sort of consistency when it comes to the overall stock market or the economy.

Marks also highlights, again, how the psychology of eager buyers—who are unworried about risk—is precisely what creates greater levels of risk as they drive prices higher:

Thus, the market is not a static arena in which investors operate.  It is responsive, shaped by investors’ own behavior.  Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk.  I call this the ‘perversity of risk.’

In a nutshell:

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all.  Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.

And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk they usually bid it up to the point where it’s enormously risky.  No risk is feared, and thus no reward for risk bearing—no ‘risk premium’—is demanded or provided.  That can make the thing that’s most esteemed the riskiest.

This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.  But high quality assets can be risky, and low quality assets can be safe.  It’s just a matter of the price paid for them…



Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return.

Great investors generate high returns with moderate risk, or moderate returns with low risk.  If they generate high returns with “high risk,” but they do so consistently for many years, then perhaps the high risk “either wasn’t really high or was exceptionally well-managed.”  Mark says that great investors such as Buffett or Peter Lynch tend to have very few losing years over a relatively long period of time.

It’s important, notes Marks, to see that risk leads to loss only when lower probability negative scenarios occur:

… loss is what happens when risk meets adversity.  Risk is the potential for loss if things go wrong.  As long as things go well, loss does not arise.  Risk gives rise to loss only when negative events occur in the environment.

We must remember that when the environment is salutary, that is only one of the environments that could have materialized that day (or that year).  (This is Nassim Nicholas Taleb’s idea of alternative histories…)  The fact that the environment wasn’t negative does not mean that it couldn’t have been.  Thus, the fact that the environment wasn’t negative doesn’t mean risk control wasn’t desirable, even though—as things turned out—it wasn’t needed at that time.

The absence of losses does not mean that there was no risk.

(Photo by Michele Lombardo)

Only a skilled investor can look at a portfolio during good times and tell how much risk has been taken.

Bottom line: risk control is invisible in good times but still essential, since good times can so easily turn into bad times.

Marks says that an investment manager adds value by generating higher than market returns for a given level of risk.  Achieving the same return as the market, but with less risk, is adding value.  Achieving better than market returns without undue risk is also adding value.

Many value investors, such as Marks and Buffett, somewhat underperform during up markets, but far outperform during down markets.  The net result over a long period of time is market-beating performance with very little incremental risk.  But it does take some time in order to see the value added.

Controlling the risk in your portfolio is a very important and worthwhile pursuit.  The fruits, however, come only in the form of losses that don’t happen.  Such what-if calculations are difficult in placid times.

On the other hand, the intelligent acceptance of recognized risk for profit underlies some of the wisest, most profitable investments—even though (or perhaps due to the fact that) most investors dismiss them as dangerous speculations.

Marks’ firm Oaktree invests in high yield bonds.  High yield bonds can be good investments over time if the prices are low enough:

I’ve said for years that risky assets can make for good investments if they’re cheap enough.  The essential element is knowing when that’s the case.  That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.

Risk bearing per se is neither wise nor unwise, says Marks.  Investing in the more aggressive niches with risk properly controlled is ideal.  But controlling risk always entails being prepared for bad scenarios.

Extreme volatility and loss surface only infrequently.  And as time passes without that happening, it appears more and more likely that it’ll never happen—that assumptions regarding risk were too conservative.  Thus, it becomes tempting to relax rules and increase leverage.  And often this is done just before the risk finally rears its head…

Marks quotes Nassim Taleb:

Reality is far more vicious than Russian roulette.  First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six.  After a few dozen tries, one forgets about the existence of the bullet, under a numbing false sense of security… Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality… One is thus capable of unwittingly playing Russian roulette—and calling it by some alternative ‘low risk’ name.

A good example, which Marks does mention, is large financial institutions in 2004-2007.  Virtually no one thought that home prices could decline on a nationwide scale, since they had never done so before.

Of course, it’s also possible to be too conservative.

You can’t run a business on the basis of worst-case assumptions.  You wouldn’t be able to do anything.  And anyway, a ‘worst-case assumption’ is really a misnomer; there’s no such thing, short of a total loss.  Now, we know the quants shouldn’t have assumed there couldn’t be a nationwide decline in home prices.  But once you grant that such a decline can happen… what should you prepare for?  Two percent?  Ten?  Fifty?

(Photo by Donfiore)

Marks continues:

If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year [2008], it’s possible no leverage would ever be used.  Is that a reasonable reaction?

Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so.  Once in a while, a ‘black swan’ will materialize.  But if in the future we always said, ‘We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,’ we’d be frozen in inaction.

Marks sums it up:

… It’s by bearing risk when we’re well paid to do so—and especially by taking risks toward which others are averse in the extreme—that we strive to add value for our clients.



  • Rule number one: most things will prove to be cyclical.
  • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

Marks explains:

… processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical.  The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

Objective factors do play a large part in cycles, of course—factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions.  But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.

(Image by Anhluong.tdnb, via Wikimedia Commons)

Because people inevitably overreact or underreact, both business activity and stock prices overshoot on the upside and on the downside:

Economies will wax and wane as consumers spend more or less, responding emotionally to economic factors or exogenous events, geopolitical or naturally occurring.  Companies will anticipate a rosy future during the up cycle and thus overexpand facilities and inventories; these will become burdensome when the economy turns down.  Providers of capital will be too generous when the economy’s doing well, abetting overexpansion with cheap money, and then they’ll pull the reins too tight when things cease to look as good.  Investors will overvalue companies when they’re doing well and undervalue them when things get difficult.



Marks holds that there are two risks in investing:

  • the risk of losing money
  • the risk of missing opportunity

Most investors consistently do the wrong thing at the wrong time:  when prices are high, most investors rush to buy;  when prices are low, most investors rush to sell.  Thus, the value investor can profit over time by following Warren Buffett’s advice:

Be fearful when others are greedy.  Be greedy when others are fearful.


Stocks are cheapest when everything looks grim.  The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions.



(Photo by Nikki Zalewski)

Like Buffett and Munger, Marks believes that temperament, or the ability to master your emotions, is more important than intellect for success in investing:

Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology.  To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently.  The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.  Investor psychology includes many separate elements, which we will look at in this chapter, but the key thing to remember is that they consistently lead to incorrect decisions.  Much of this falls under the heading of ‘human nature.’

Marks writes about the following psychological tendencies:

  • Greed
  • Fear
  • Self-deception
  • Conformity to the crowd
  • Envy
  • Ego or overconfidence
  • Capitulation

How might these psychological tendencies have been useful in our evolutionary history? 

When food was often scarce, being greedy by hoarding food made sense.  When a movement in the grass frequently meant the presence of a dangerous predator, immediate fear—triggered by the amygdala even before the conscious mind is aware of it—was essential for survival.  When hunting for food was dangerous, often with low odds of success, self-deception—accompanied by various naturally occurring chemicals—helped hunters to persevere over long periods of time, regardless of danger and injury.  (Chemical reactions would cause an injured hunter not to feel much pain.)  If everyone in your tribe was running away as fast as possible, following the crowd was usually the most rational response.  If a starving hunter saw another person with a huge pile of food, envy would trigger a strong desire to possess it.  This would often lead to a hunting expedition with a heightened level of determination.  When hunting a dangerous prey, with low odds of success, ego or overconfidence would cause the hunter to be convinced that he would succeed.  From the point of view of the community, having self-deceiving and overconfident hunters was a net benefit because the hunters would persevere despite difficulties, injuries, and even deaths.

How do these psychological tendencies cause people to make errors in modern activities such as investing?

Greed causes people to follow the crowd by paying high prices for stocks in the hope that there will be even higher prices in the future.  Fear causes people to sell or to avoid ugly stocks—stocks trading at low multiples because the businesses in question are facing major difficulties.

As humans, we have an amazingly strong tendency towards self-deception:

  • The first principle is that you must not fool yourself, and you are the easiest person to fool. – Richard Feynman
  • Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true. – Demosthenes, as quoted by Charlie Munger

There have been many times in history when self-deception was probably crucial for the survival of a given individual or community.  I’ve mentioned hunters pursuing dangerous prey.  A much more recent example might be Winston Churchill, who was firmly convinced—even when virtually all the evidence was against it—that England would defeat Germany in World War II.  Churchill’s absolute belief helped sustain England long enough for both good luck and aid to arrive:  the Germans ended up overextended in Russia, and huge numbers of American troops (along with mass amounts of equipment) arrived in England.

Thus, like other psychological tendencies, self-deception often plays a constructive role.  However, when it comes to investing, self-deception is generally harmful, especially as the time horizon is extended so that luck virtually disappears.

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

(The experiment involved a control group in which there were no shills.  Almost every subject—over 99 percent—gave the correct answer under these circumstances.)

Greed, conformity, and envy together operate powerfully on the brains of many investors:

Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense.

A good example from history is the tulip mania in Holland, during which otherwise rational people ended up paying exorbitant sums for colorful tulip bulbs.  See: https://en.wikipedia.org/wiki/Tulip_mania

At the peak of tulip mania, in March 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman.

The South Sea Bubble is another example, during which even the extremely intelligent Isaac Newton, after selling out early for a solid profit, could not resist buying in again as prices seemed headed for the stratosphere.  Newton and many others lost huge sums when prices inevitably returned to earth.

Envy may have been useful for hunter-gatherers.  But today envy has a very powerful and often negative effect on most human brains.  And as Charlie Munger always points out, envy is particularly stupid because it’s a sin that, unlike other sins, is no fun at all.  There are many people who could easily learn to be very happy—grateful for blessings, grateful for the wonders of life itself, etc.—who become miserable because they fixate on other people who have more of something, or who are doing better in some way.  Envy is fundamentally irrational and stupid, but it is powerful enough to consume many people.  Buffett: “It’s not greed that drives the world, but envy.”  Envy and jealousy have caused the downfall of human beings for millenia.  This certainly holds true in investing.

Ego and overconfidence are powerful psychological tendencies that humans have.  Overconfidence will kill any investor eventually.  The antidote is humility and objectivity.  Many of the best investors—from Warren Buffett to Ray Dalio—are fundamentally humble and objective.  And women tend to be better investors than men on the whole because women are not as overconfident.  Marks writes:

[Thoughtful] investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad years.  They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check.  This, in my opinion, is the greatest formula for long-term wealth creation—but it doesn’t provide much ego gratification in the short run.  It’s just not that glamorous to follow a path that emphasizes humility, prudence, and risk control.  Of course, investing shouldn’t be about glamour, but often it is.

Capitulation is a final phenomenon that Marks emphasizes.  In general, people become overly negative about a stock that is deeply out of favor because the business in question is going through hard times.  Moreover, when overly negative investors are filled with fear and when they see everyone selling in a panic, they themselves often sell near the very bottom.  Often these investors know analytically that the stock is cheap, but their emotions (fear of loss, conformity to the crowd, etc.) are too strong, so they disbelieve their own sound logic.  The rational, contrarian, long-term value investor does just the opposite:  he or she buys near the point of maximum pessimism (to use John Templeton’s phrase).

Similarly, most investors become overly optimistic when a stock is near its all-time highs.  They see many other investors who have done well with the sky-high stock, and so they tend to buy at a price that is near the all-time highs.  Again, many of these investors—like Isaac Newton—know analytically that buying a stock when it is near its all-time highs is often not a good idea.  But greed, envy, self-deception, crowd conformity, etc. (fear of missing out, dream of a sure thing), overwhelm their own sound logic.  By contrast, the rational, long-term value investor does the opposite:  he or she sells near the point of maximum optimism.

Marks gives a marvelous example of psychological excess from the tech bubble of 1998-2000:

From the perspective of psychology, what was happening with IPOs is particularly fascinating.  It went something like this: The guy next to you in the office tells you about an IPO he’s buying.  You ask what the company does.  He says he doesn’t know, but his broker told him it’s going to double on the day of issue.  So you say that’s ridiculous.  A week later he tells you it didn’t double… it tripled.  And he still doesn’t know what it does.  After a few more of these, it gets hard to resist.  You know it doesn’t make sense, but you want protection against continuing to feel like an idiot.  So, in a prime example of capitulation, you put in for a few hundred shares of the next IPO… and the bonfire grows still higher on the buying from new converts like you.



(Illustration by Sasinparaksa)

Sir John Templeton:

To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.

Superior value investors buy when others are selling, and sell when others are buying.  Value investing is simple in concept, but it is very difficult in practice.

Of course, it’s not enough just to be contrarian.  Your facts and your reasoning also have to be right, as Buffett points out:

You’re neither right nor wrong because the crowd disagrees with you.  You’re right because your data and reasoning are right—and that’s the only thing that makes you right.  And if your facts and reasoning are right, you don’t have to worry about anybody else.

Only by being right about the facts and the reasoning can a long-term value investor hold (or add to) a position when everyone else continues to sell.  Getting the facts and reasoning right still involves being wrong roughly one-third of the time, whether due to bad luck, unforeseen events, or a mistake.  But getting the facts and reasoning right leads to ‘being right’ roughly two-third of the time.

A robust process correctly followed should produce positive results—on both an absolute and relative basis—over most rolling five-year periods, and over nearly all rolling ten-year periods.

It’s never easy to consistently follow a careful, contrarian value investing approach.  Marks quotes David Swensen:

Investment success requires sticking with positions made uncomfortable by their variance with popular opinion… Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.

… Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.

Marks puts it in his own words:

The ultimately most profitable investment actions are by definition contrarian:  you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).  These actions are lonely and… uncomfortable.

(Illustration by Sangoiri)

Marks writes about the paradoxical nature of investing:

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

The best bargains are typically only available when pessimism and uncertainty are high.  Many investors say, ‘We’re not going to try to catch a falling knife; it’s too dangerous… We’re going to wait until the dust settles and the uncertainty is resolved.’  But waiting until uncertainty gets resolved usually means missing the best bargains, as Marks says:

The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left.  When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.  Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

It’s our job as contrarians to catch falling knives, hopefully with care and skill.  That’s why the concept of intrinsic value is so important.  If we hold a view of value that enables us to buy when everyone else is selling—and if our view turns out to be right—that’s the route to the greatest rewards earned with the least risk.



It cannot be too often repeated:

A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy.  The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.

What is the process by which some assets become cheap relative to intrinsic value?  Marks explains:

  • Unlike assets that become the subject of manias, potential bargains usually display some objective defect. An asset class may have weaknesses, a company may be a laggard in its industry, a balance sheet may be over-levered, or a security may afford its holders inadequate structural protection.
  • Since the efficient-market process of setting fair prices requires the involvement of people who are analytical and objective, bargains usually are based on irrationality or incomplete understanding.  Thus, bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non-value-based tradition, bias or stricture.
  • Unlike market darlings, the orphan asset is ignored or scorned. To the extent it’s mentioned at all by the media and at cocktail parties, it’s in unflattering terms.
  • Usually its price has been falling, making the first-level thinker ask, ‘Who would want to own that?’ (It bears repeating that most investors extrapolate past performance, expecting the continuation of trends rather than the far-more-dependable regression to the mean.  First-level thinkers tend to view price weakness as worrisome, not as a sign that the asset has gotten cheaper.)
  • As a result, a bargain asset tends to be one that’s highly unpopular. Capital stays away from it or flees, and no one can think of a reason to own it.

(Illustration by Chris Dorney)

Where is the best place to look for underpriced assets?  Marks observes that a good place to start is among things that are:

  • little known and not fully understood;
  • fundamentally questionable on the surface;
  • controversial, unseemly or scary;
  • deemed inappropriate for ‘respectable’ portfolios;
  • unappreciated, unpopular and unloved;
  • trailing a record of poor returns; and
  • recently the subject of disinvestment, not accumulation.

Marks puts it briefly:

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.  That means the best opportunities are usually found among things most others won’t do.  After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

Marks started a fund for high yield bonds—junk bondsin 1978.  One rating agency described high yield bonds as “generally lacking the characteristics of a desirable investment.”  Marks remarks:

if nobody owns something, demand for it (and thus the price) can only go up and…. by going from taboo to even just tolerated, it can perform quite well.

In 1987, Marks formed a fund to invest in distressed debt:

Who would invest in companies that already had demonstrated their lack of financial viability and the weakness of their management?  How could anyone invest responsibly in companies in free fall?  Of course, given the way investors behave, whatever asset is considered worst at a given point in time has a good likelihood of being the cheapest.  Investment bargains needn’t have anything to do with high quality.  In fact, things tend to be cheaper if low quality has scared people away.



(Illustration by Marek)

Marks makes the same point that Buffett and Munger often make: Most of the time, by far the best thing to do is absolutely nothing.  Finding one good idea a year is enough to get outstanding returns over time.  Marks offers:

So here’s a tip: You’ll do better if you wait for investments to come to you rather than go chasing after them.  You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own.  An opportunist buys things because they’re offered at bargain prices.  There’s nothing special about buying when prices aren’t low.

Marks took five courses in Japanese studies as an undergraduate business major in order to fulfill his requirement for a minor.  He learned the Japanese value of mujo:

mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control.  Thus we must recognize, accept, cope and respond.  Isn’t that the essence of investing?

… What’s past is past and can’t be undone.  It has led to the circumstances we now face.  All we can do is recognize our circumstances for what they are and make the best decisions we can, given the givens.

Marks quotes Buffett, who notes that there are no called strikes in investing:

Investing is the greatest business in the world because you never have to swing.  You stand at the plate; the pitcher throws you General Motors at 47!  U.S. steel at 39!  And nobody calls a strike on you.  There’s no penalty except opportunity.  All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.

It’s dumb to invest when the opportunities are not there.  But when the overall market is high, there are still a few ways to do well as a long-term value investor.  If you are able to ignore short-term volatility and focus on the next five to ten years, then you can probably find some undervalued stocks, especially if you look at microcaps.  At some point—the precise timing of which is unpredictable—there will be a bear market.  But that would create many bargains for the long-term value investor.



John Kenneth Galbraith:

We have two classes of forecasters: Those who don’t know—and those who don’t know they don’t know.

Marks, like Buffett, Munger, and most other top value investors, thinks that financial forecasting simply cannot be done with any sort of consistency.  But Marks has two caveats:

The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage.  With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies.  Thus, I suggest people try to ‘know the knowable.’

An exception comes in the form of my suggestion, on which I elaborate in the next chapter, that investors should make an effort to figure out where they stand at a moment in time in terms of cycles and pendulums.  That won’t render the future twists and turns knowable, but it can help one prepare for likely developments.

Marks has tracked (in a limited way) many macro predictions, including of U.S. interest rates, the U.S. stock market, and the yen/dollar exchange rate.  He found quite clearly that most forecasts were not correct.

(Illustration by Maxim Popov)

I can elaborate on two examples that I spent much time on (when I should have stayed focused on finding individual companies available at cheap prices):

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

See my detailed discussion of these two “can’t lose” investments here: http://boolefund.com/the-art-value-investing/

Every year, there are many people making financial forecasts, and so purely as a matter of chance, a few forecasters will be correct in a given year.  But the ones correct this year are almost never the ones correct the next time around, because what they’re trying to predict can’t be predicted with any consistency.  Marks writes thus:

I am not going to try to prove my contention that the future is unknowable.  You can’t prove a negative, and that certainly includes this one.  However, I have yet to meet anyone who consistently knows what lies ahead macro-wise…

One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later.  And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did.  But that doesn’t mean your forecasts are regularly of any value…

It’s possible to be right about the macro-future once in a while, but not on a regular basis.  It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are.  And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.

Marks gives one more example: How many predicted the crisis of 2007-2008?  Of those who did predict it—there was bound to be some from pure chance alone—how many of those then predicted the recovery starting in 2009 and continuing until today (mid-2018)?  The answer is “very few.”  The reason, observes Marks, is that those who got 2007-2008 right “did so at least in part because of a tendency toward negative views.”  They probably were negative well before 2007-2008, and more importantly, they probably stayed negative afterwards, during which the U.S. stock market increased (from the lows) roughly 300% as the U.S. economy expanded from 2009 to today (mid-2018).

Marks has a description for investors who believe in the value of forecasts.  They belong to the “I know” school, and it’s easy to identify them:

  • They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.
  • They’re confident it can be achieved.
  • They know they can do it.
  • They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
  • They’re comfortable investing based on their opinions regarding the future.
  • They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
  • They rarely look back to rigorously assess their record as forecasters.

Marks contrasts the confident “I know” folks with the guarded “I don’t know” folks.  The latter believe you can’t predict the macro-future, and thus the proper goal for investing is to do the best possible job analyzing individual securities.  If you belong to the “I don’t know” school, eventually everyone will stop asking you where you think the market’s going.  Marks:

You’ll never get to enjoy that one-in-a-thousand moment when your forecast comes true and the Wall Street Journal runs your picture.  On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowledge of the future.

Marks continues by noting that no one likes investing on the assumption that the future is unknowable.  But if the future IS largely unknowable, then it’s far better as an investor to acknowledge that fact than to pretend otherwise.

(Photo by Elnur)

Furthermore, says Marks, the biggest problems for investors tend to happen when investors forget the difference between probability and outcome (i.e., the limits of foreknowledge):

  • when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
  • when they assume the most likely outcome is the one that will happen,
  • when they assume the expected result accurately represents the actual result, or
  • perhaps most important, when they ignore the possibility of improbable outcomes.

In a word:

Overestimating what you’re capable of knowing or doing can be extremely dangerous—in brain surgery, transocean racing or investing.  Acknowledging the boundaries of what you can know—and working within those limits rather than venturing beyond—can give you a great advantage.

Or as Warren Buffett has written:

Intelligent investing is not complex, though that is far from saying that it is easy.  What an investor needs is the ability to correctly evaluate selected businesses.  Note that word ‘selected’:  You don’t have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important;  knowing its boundaries, however, is vital.



Marks believes that market cycles—inevitable ups and downs—cannot be predicted as to extent and (especially) as to timing, but have a profound influence on us as investors.  The only thing we can predict is that market cycles are inevitable.

Marks holds that as investors, we can have a rough idea of market cycles.  We can’t predict what will happen exactly or when.  But we can at least develop valuable insight into various future events.

So look around, and ask yourself:  Are investors optimistic or pessimistic?  Do the media talking heads say the markets should be piled into or avoided?  Are novel investment schemes readily accepted or dismissed out of hand?  Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls?  Has the credit cycle rendered capital readily available or impossible to obtain?  Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous?  All of these things are important, and yet none of them entails forecasting.  We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.

Marks likens the process of assessing the current cycle with “taking the temperature” of the market.  Again, one can never precisely time market turning points, but one can at least become aware of when markets are becoming overheated, or when they’ve become unusually cheap.

(Image by Walta, via Wikimedia Commons)

It may be more difficult today to take the market’s temperature because of the policy of low interest rates in many of the world’s major economies.  This obviously distorts all asset prices.  As Buffett remarked recently, if U.S. rates were going to stay very low for many decades into the future, U.S. stocks would eventually be much higher than they are today.  Zero rates indefinitely would easily mean price/earnings ratios of 50 or more.

If you are able to buy enough cheap stocks, while maintaining a focus on the next five or ten years, and if you are psychologically prepared for the occasional bear market—the precise timing of which is always unpredictable—then you will be in good position.

It can also help if you find cheap stocks that have low or even negative correlation with the broad stock market:

  • Gold mining stocks have often been negatively correlated with the broad market.  The great economist and value investor J. M. Keynes recommended having a gold mining stock—as long as you know the company well—in your portfolio .
  • Oil stocks have low correlation with the broad stock market.  Many oil-related stocks are very cheap today as long as you can hold for at least five years.
  • Cheap turnarounds also have low correlation with the broad stock market.  If the company is turned around, the stock is likely to do well even in a bear market.



Luck—chance or randomness—influences investment outcomes.  Marks considers Nassim Taleb’s Fooled by Randomness to be essential reading for investors.  Writes Marks:

Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not.

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

Marks quotes Taleb:

If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win.  They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day—but so did thousands of others who live in the musty footnotes of history.

A central concept from Taleb is that of “alternative histories.”  What actually has happened in history is merely a small subset of all the things that could have happened, at least as far as we know.  As long as there is a component of indeterminacy in human behavior (not to mention the rest of reality), you must usually assume that many “alternative histories” were possible.

As an investor, given a future that is currently unknowable in many respects, you need to develop a reasonable set of scenarios along with estimated probabilities for each scenario.  And, when judging the quality of past decisions, you should think carefully about various possible histories.  What actually happened is a small subset of what could have happened.

Thus, the fact that a stratagem or action worked—under the circumstances that unfolded—doesn’t necessarily prove that the decision behind it was wise.

Marks says he agrees with all of Taleb’s important points:

  • Investors are right (and wrong) all the time for the ‘wrong reason.’ Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit).
  • The correctness of a decision can’t be judged from the outcome.  Nevertheless, that’s how people assess it.  A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown.  Thus, correct decisions are often unsuccessful, and vice versa.
  • Randomness alone can produce just about any outcome in the short run.  In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof).  But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).
  • For these reasons, investors often receive credit they don’t deserve.  One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone.  Few of these “geniuses” are right more than once or twice in a row.
  • Thus, it’s essential to have a large number of observations—lots of years of data—before judging a given manager’s ability.

Over the long run, the rational investor learns, refines, and sticks with a robust investment process that reliably produces good results.  In the short run, when a good process sometimes leads to bad outcomes (often due to bad luck but sometimes due to a mistake), you must simply be stoic and patient.

Marks continues:

The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable.  My ‘I don’t know’ school thinks of future events in terms of a probability distribution.  That’s a big difference.  In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.

Marks concludes:

  • We should spend our time trying to find value among the knowable—industries, companies and securities—rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.
  • Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves.
  • We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.
  • To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high.
  • Given the highly indeterminate nature of outcomes, we must view strategies and their results—both good and bad—with suspicion until proved over a large number of trials.



Unlike professional tennis, where a successful outcome depends on which player hits the most winners, successful investing generally depends on minimizing mistakes more than it does on finding winners.

… investing is full of bad bounces and unanticipated developments, and the dimensions of the court and the height of the net change all the time.  The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment.  Even if you do everything right, other investors can ignore your favorite stock;  management can squander the company’s opportunities;  government can change the rules;  or nature can serve up a catastrophe.

Marks argues that successful investing is a balance between offense and defense, and that this balance often differs for each individual investor.  What’s important is to stick with an investment process that works over the long term:

… Few people (if any) have the ability to switch tactics to match market conditions on a timely basis.  So investors should commit to an approach—hopefully one that will serve them through a variety of scenarios.  They can be aggressive, hoping they’ll make a lot on the winners and not give it back on the losers.  They can emphasize defense, hoping to keep up in good times and excel by losing less than others in bad times.  Or they can balance offense and defense, largely giving up on tactical timing but aiming to win through superior security selection in both up and down markets.

Marks continues:

And by the way, there’s no right choice between offense and defense.  Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.

Marks argues that defense can be viewed as aiming for higher returns, but through the avoidance of mistakes and through consistency, rather than through home runs and occasional flashes of brilliancy.

Avoiding losses first involves buying assets at cheap prices (well below intrinsic value).  Another element to avoiding losses is to ensure that your portfolio can survive a bear market.  If the five-year or ten-year returns appear to be high enough, an investor still may choose to play more offense than defense, even when the broad market appears to be high.  But you must be fully prepared—psychologically and in your portfolio—for stocks that are already very cheap to get cut in half or worse during a bear market.

Again, some investors can accept higher volatility in exchange for higher long-term returns.  Know thyself.  You must really think through all the possible scenarios, because things can get much worse than you can imagine during bear markets.  And bear markets are inevitable, though unpredictable.

There is usually a trade-off between potential return and potential downside.  Choosing to aim for higher long-term returns means accepting higher downside volatility over shorter periods of time.

It’s important to keep in mind that many investors fail not due to lack of home runs, but due to having too many strikeouts.  Overbetting—either betting too often (investing in too many different stocks) or betting too much (having position sizes that are too large)—is thus a common cause of failure for long-term investors.  We know from the Kelly criterion that overbetting guarantees negative long-term returns.  Therefore, it’s wise for most investors to aim for consistency—a high batting average based on many singles and doubles—rather than to aim for the maximum number of home runs.

Put differently, it is easier for most investors to minimize losses than it is to hit a lot of home runs.  Thus, most investors are more likely to achieve long-term success by minimizing losses and mistakes, than by hitting a lot of home runs.

As Marks concludes:

Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate.  You may hit fewer home runs than another investor… but you’re also likely to have fewer strikeouts and fewer inning-ending double plays.

Defensive investing sounds very erudite, but I can simplify it: Invest scared!  Worry about the possibility of loss.  Worry that there’s something you don’t know.  Worry that you can make high-quality decisions but still be hit by bad luck or surprise events.  Investing scared will prevent hubris;  will keep your guard up and your mental adrenaline flowing;  will make you insist on adequate margin of safety;  and will increase the chances that your portfolio is prepared for things going wrong.  And if nothing does go wrong, surely the winners will take care of themselves.



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

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

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

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


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

My e-mail: jb@boolefund.com




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

The Warren Buffett Way

(Image:  Zen Buddha Silence by Marilyn Barbone.)

June 3, 2018

Would you like to improve as an investor?  One of the best things you can do is to study great investors like Warren Buffett.

Robert Hagstrom has written an excellent book—The Warren Buffett Way (Wiley, 2014)—explaining Buffett’s approach to investing.  Hagstrom’s goal is to help investors improve.

Here is the outline for this blog post:

  • A Five-Sigma Event: The World’s Greatest Investor
  • The Education of Warren Buffett
  • Buying a Business: The Twelve Immutable Tenets
  • Common Stock Purchases: Nine Case Studies
  • Portfolio Management: The Mathematics of Investing
  • The Psychology of Investing
  • The Value of Patience
  • The World’s Greatest Investor


(Photo by USA International Trade Administration)



Buffett has always maintained that he won the ovarian lottery.

My wealth has come from a combination of living in America, some lucky genes, and compound interest.  My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well.

Buffett keeps things in perspective by saying that he happens to work “in an economy that rewards someone who saves lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect mispricing of securities with sums reaching into the billions.”

Buffett was entrepreneurial from a young age.  He would buy a six-pack of coke for 25 cents, then sell each one for 6 cents.  He had two paper routes during the time he lived in Washington, D.C., when his father was a congressman from Nebraska.  He and a buddy bought used pinball machines, and made a profit from them.

(Photo by Shahroozporia, via Wikimedia Commons)

But Buffett didn’t figure out the right way to invest for some time.  He tried charting.  He read books on technical analysis.  He got hot tips from brokers.  Finally, he came across a copy of The Intelligent Investor, by Benjamin Graham.  Buffett then realized that the strategy of value investing explained by Graham was a reliable way to succeed at investing over time.

Buffett attended graduate school at Columbia University in order to study under Graham.  Once in Graham’s class, everyone saw that Buffett was the brightest and most knowledgeable student.  The class was like a conversation between Graham and Buffett.  Buffett got an A+ in the course, the first A+ Graham had given in 22 years of teaching.

Upon graduating from Columbia, Buffett was not able to work for Graham at Graham-Newman right away.  At the time, Graham was only hiring Jewish analysts because they were being discriminated against elsewhere.  Buffett periodically sent Graham stock ideas until Graham finally hired him.

Two years later in 1956, after Graham retired, Buffett returned to Omaha.  Buffett launched a limited investment partnership, which included some family and friends as investors.  At the outset, the partnership had $105,000 under management.

Buffett’s goal was to beat the Dow Jones Industrial Average by 10 percentage points a year.  Approximately thirteen years later, Buffett had beaten the Dow Jones Average by over 22 percentage points a year.

In the early 1960s there was a corporate scandal.  The Allied Crude Vegetable Oil Company, led by Tino De Angelis, found that it could get loans based on its inventory of salad oil.  De Angelis built a refinery in New Jersey with 139 five-story storage tanks.  Because oil floats on top of water, De Angelis filled the tanks with water with just a few feet of oil on the top.  The inspectors didn’t notice for some time.

American Express lost $58 million in the salad oil scandal, and its stock dropped over 50 percent.  Buffett went to restaurants in Omaha, and discovered that there was no decrease in usage of the American Express Green Card.  Buffett also visited banks and learned that the scandal was having no impact on the use of American Express Travelers Cheques.

(Amex Logo, by American Express via Wikimedia Commons)

The strong brand of American Express was still intact.  The stock had plummeted based on a huge, but temporary problem.  So Buffett invested 40 percent of the partnership in American Express.  The shares nearly tripled over the next two years.

By 1965, Buffett had acquired—via the partnership—a controlling interest in Berkshire Hathaway, a struggling New England textile company.  When Buffett closed his investment partnership in 1969, he himself kept his stock in Berkshire Hathaway and limited partners received some stock in Berkshire Hathaway.  Buffett advised limited partners on how to invest in municipal bonds.  (Buffett thought that stocks were not a very good value in 1969.)  Or limited partners could invest with Bill Ruane, Buffett’s friend from Columbia University and Graham-Newman.  Meanwhile, Berkshire Hathaway, despite excellent management from Ken Chace, had disappointing results for many years.  Buffett only kept Berkshire Hathaway open out of concern for the workers.

The textile mills were the largest employer in the area;  the workforce was an older age group that possessed relatively nontransferable skills;  management had shown a high degree of enthusiasm;  the unions were being reasonable;  and, very importantly, Buffett believed that some profits could be realized from the textile business.

But Berkshire Hathaway continued to struggle.  Buffett siphoned off cash from the business in order to invest in better businesses.  (Had the cash been reinvested in Berkshire, the returns would have been below the cost of capital, thus destroying value.)  Later, Buffett reluctantly closed Berkshire Hathaway because unending losses would otherwise have been the result.

(Hathaway Mills, Photo by Marcbela via Wikimedia Commons)

In 1967, with the excess cash from the textile operations, Berkshire Hathaway purchased two insurance companies headquartered in Omaha:  National Indemnity Company and National Fire & Marine Insurance Company.  As Hagstrom writes, this was the beginning of Berkshire Hathaway’s legendary success story.

Instead of having the float from the insurance operations invested mostly in bonds, Buffett invested much of the float in stocks.  Over time, due to Buffett’s great skill in investing, investment assets grew significantly in value.  Importantly, the underlying insurance operations themselves were profitable because they were disciplined in pricing their policies.  The profitability of the insurance operations meant that the float had a very low cost.

Going forward, Buffett was open to investing in more insurance companies.  By 1991, Berkshire owned nearly half of GEICO.  GEICO was a very profitable auto insurer.  GEICO had structurally lower costs than its competitors because GEICO sold direct to customers, without needing agents or branch offices.

Buffett bought other insurance companies over time, including large reinsurers.  Hagstrom notes that Buffett’s best acquisition was a person—Ajit Jain.  Jain has brilliantly managed the Berkshire Hathaway Reinsurance Group over the years.  Buffett said of Ajit:

His operation combines capacity, speed, decisiveness, and most importantly, brains in a manager that is unique in the insurance business.

Over several decades, Buffett invested in a focused portfolio of common stocks.  He also acquired a number of private businesses.  He views both types of investment the same way:  he looks to pay a good price for a simple business, run by able and honest management, with good economics.

Hagstrom notes Buffett’s track record:

Over the past 48 years, starting in 1965, the year Buffett took control of Berkshire Hathaway, the book value of the company has grown from $19 to $114,214 per share, a compounded gain of 19.7 percent;  during that period, the Standard & Poor’s (S&P) 500 index gained 9.4 percent, dividends included.

The margin of outperformance combined with the length of the track record is simply unparalleled in the investment world.  But Hagstrom argues that other investors can improve by studying Buffett’s career.  Hagstrom quotes Buffett:

What we do is not beyond anyone else’s competence.  I feel the same way about managing that I do about investing:  it is just not necessary to do extraordinary things to get extraordinary results.



Hagstrom writes that Buffett was influenced primarily by three investors:  Benjamin Graham, Philip Fisher, and Charlie Munger.

At age 20, Graham graduated from Columbia University and was offered several positions at the university (in literature, mathematics, and philosophy).  Graham was clearly a genius.  Perhaps based partly on his experience of poverty—his father had died while Graham was young, leaving the family in a difficult financial situation—Graham decided to work on Wall Street rather than work in academia.

Graham’s first job was as a messenger—for $12 a week—for the brokerage firm of Newburger, Henderson & Loeb.  Five years later, in 1919, Graham was earning $600,000 a year (almost $8 million in 2012 dollars) as a partner in the firm.

Graham launched Graham-Newman in 1926.  In 1929-1932, Graham-Newman lost most of its value.  Graham personally was financially ruined.

From 1929 to 1934, Graham, while teaching at Columbia University and in cooperation with another professor, David Dodd, produced Security Analysis, which continues to be the bible for value investors to this day.  Graham was slowly rebuilding his fortune, and the philosophy of value investing—as expressed in Security Analysis—was the key.

(Ben Graham, by Equim43 via Wikimedia Commons)

Graham realized that many investors try to get good results over short periods of time.  He saw that short-term movements in stock prices are largely random and unpredictable, but that over time, a stock price follows the earnings of a company.  Graham thus distinguished between speculation and investing.  Speculation meant trying to predict stock prices over the short term, whereas investing means buying below probable intrinsic value—based on net asset value or earnings power.

Intrinsic value is based on net asset value or earnings power.  As long as the investor pays a price below intrinsic value, the investor has a margin of safety.  The margin of safety offers protection against errors by the investor and against bad luck (or unforeseen negative events).  Simultaneously, the margin of safety represents the profit the investor can earn in those cases where he or she is right and the stock price approaches intrinsic value.

Graham preferred to focus on net asset value.  If you take the current assets of the company and subtract all liabilities, and if the stock price can be bought below that level, there is a strong margin of safety present.  This is Graham’s net-net approach.  It is meant to be applied to a basket of stocks.

The net-net approach is inherently safer than buying stocks at a discount to their earnings power.  It is generally more difficult to estimate the earnings power of a company than to estimate the net-net value.  (The net-net value is simply an extremely conservative measure of liquidation value.)

Thus Graham placed much more emphasis on quantitative cheapness than he did on qualitative factors like competitive position and management capability.  If you keep buying stocks at a huge discount to net asset value, you are nearly certain to get good results over time.  On the other hand, if you keep buying stocks at a discount to earnings power, you cannot be as certain because in many cases future earnings may turn out to be different than expected.

In brief, Graham offered two methods for investors to succeed:  buying below net current asset value and buying at a low price-to-earnings ratios (P/E).  In either case, the stock in question is deeply out of favor.

Every business, at any given time, is either in one of two states:  it is experiencing problems or it will be experiencing problems.  When a business runs into problems, the stock price typically will decline and the company will fall out of favor.  The key is that most business problems are temporary and not permanent, at least when viewed over the subsequent 3 to 5 years.

When a company runs into problems, investors usually overreact and sell the stock to much lower levels than is justified by net asset value or earnings power.  By systematically buying a basket of these oversold stocks, you can do well over time.

Philip Fisher

Fisher believed in a concentrated portfolio of five to eight stocks.  Fisher would conduct ‘scuttlebutt’ research, which involved speaking with customers, suppliers, competitors, and industry experts.  Fisher wanted to understand the quality of management and the strength of the company’s competitive position.

(Philip A. Fisher)

If you can buy stock in a company that has a strong competitive position based on continued innovation, and that is run by able and honest managers, then you’ll do well over time.  Fisher also insisted that the sales force of the company in question be strong.  This should be ensured by strong management.  As well, Fisher made sure the company had good profits.

Good managers focus on building shareholder value.  And they are honest about their mistakes and about the real difficulties being encountered by the business.

Charlie Munger

Charlie Munger was from Omaha, like Buffett.  As a kid, Munger had worked for the grocery store run by Warren Buffett’s grandfather.

Munger’s grandfather was a federal judge and his father was a lawyer.  Munger became a successful lawyer in Los Angeles after graduating from Harvard Law School.

One of Buffett’s early investors, Dr. Edwin Davis, had decided to invest in the Buffett Partnership because Buffett reminded him of Charlie Munger.  A few years later, in 1959, Dr. David arranged a meeting between Buffett and Munger.  This was the beginning of an extraordinary partnership.

(Charlie Munger at the 2010 Berkshire Hathaway shareholders meeting.  Photo by Nick Webb)

Munger realized that it is better to pay a fair price for a wonderful company than a wonderful price for a fair company.  Buffett had recently invested in several statistically cheap companies:

My punishment was an education in the economies of short-line farm implementation manufacturers (Dempster Mill Manufacturing), third-place department stores (Hochschild-Kohn), and New England textile manufacturers (Berkshire Hathaway).

These were three situations of paying a wonderful price for a fair company.  Only the investment in Dempster worked, thanks to a turnaround specialist, Harry Bottle, whom Munger had introduced to Buffett.  The Dempster investment easily could have failed.  Hochschild-Kohn didn’t work.  Berkshire Hathaway—the textile manufacturer—eventually went out of business.

Note:  Buffett took cash out of the textile business and made a long series of highly successful investments.  This was the beginning of Buffett and Munger creating today’s Berkshire Hathaway.  The old textile business was closed.

In 1972, Berkshire Hathaway acquired See’s Candies at a large premium to book value.  This stock was not at all statistically cheap.  But it was a wonderful company at a fair price, which Munger argued made excellent sense.

Over the ensuing decades, See’s Candies produced an extraordinarily high return on invested capital (ROIC) and return on equity (ROE).  Thus even though Buffett and Munger paid nearly three times book value, the investment turned out to be a grand slam.  Charlie said it was ‘the first time we paid for quality.’

The success of the See’s Candies investment is what made Buffett open to making a large investment in Coca-Cola in the late 1980s.  Buffett invested about one billion dollars in Coca-Cola—about a third of Berkshire’s portfolio—even though the P/E and the P/CF were high.  The key was that Coca-Cola could develop and maintain a very high ROE (and ROIC).

A Blending of Influences

From Graham, Buffett learned the importance of a margin of safety.  Buffett learned that it is important to estimate the intrinsic value of the business, and then pay a price well below that value.  Buffett also learned from Graham that stock price fluctuations are largely random and should be ignored except when they create bargains.  Thirdly, Buffett learned from Graham the importance of being an independent thinker.  As Graham said:

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

From Fisher, Buffett learned to concentrate his portfolio in his best ideas:  it is safer to own a few ideas with which you are thoroughly familiar than to own many ideas without knowing much about them.  Buffett also learned from Fisher the value of ‘scuttlebutt’ research, which meant interviewing customers, suppliers, competitors, and industry experts.  Finally, Buffett learned that a high-quality company can increase its intrinsic value over a long period of time.

Charlie Munger figured out on his own that it made sense to pay a fair price for a wonderful company.  Even paying a large premium to book value, you could still have a significant margin of safety relative to a long future of compounding intrinsic value.

Thus it was primarily Munger’s influence that got Buffett to agree to purchase See’s Candies at a large premium to book value.  Munger also became an expert in psychology, which impacted Buffett.

Hagstrom sums up the three influences:

Graham gave Buffett the intellectual basis for investing—the margin of safety—and helped him learn to master his emotions in order to take advantage of market fluctuations.  Fisher gave Buffett an updated, workable methodology that enabled him to identify good long-term investments and manage a focused portfolio over time.  Charlie helped Buffett appreciate the economic returns that come from buying and owning great businesses.  [And] Charlie helped educate Buffett on the psychological missteps that often occur when individuals make financial decisions.



Buffett uses the same basic approach whether he is acquiring the business outright or buying a piece of the business via shares of stock.  Owning the entire company allows Buffett to control the capital allocation of the business.  On the other hand, because the stock market is so large, there are many more opportunities to find bargains among public equities than among private businesses.  Hagstrom quotes Buffett:

When investing, we view ourselves as business analysts, not as market analysts, not as macroeconomic analysts, and not even as security analysts.

Thus Buffett acts primarily as a businessperson, whether he is acquiring a company or buying stock.

Hagstrom has distilled Buffett’s investment approach into twelve key tenets:

Business Tenets

  • Is the business simple and understandable?
  • Does the business have a consistent operating history?
  • Does the business have favorable long-term prospects?

Management Tenets

  • Is management rational?
  • Is management candid with its shareholders?
  • Does management resist the institutional imperative?

Financial Tenets

  • Focus on return on equity (ROE), not earnings per share (EPS).
  • Calculate ‘owner earnings.’
  • Look for companies with high profit margins.
  • For every dollar retained, make sure the company has created at least one dollar of market value.

Market Tenets

  • What is the value of the business?
  • Can the business be purchased at a significant discount to its value?


Business Tenets

  • Is the business simple and understandable?
  • Does the business have a consistent operating history?
  • Does the business have favorable long-term prospects?

Buffett holds that most business success stories involve companies doing the same things they have been doing for decades.  This often does involve ongoing innovation, but in the context of a business that already has a sustainable competitive advantage.

Investment success is not how much you know, but how well you understand the limits of what you know (and what you can know).  Buffett:

Invest in your circle of competence.  It’s not how big the circle is that counts;  it’s how well you define the parameters.

Buffett is looking for a company with a sustainable competitive advantage demonstrated in a consistent operating history and expected to last well into the future.  This doesn’t guarantee success in every case, but it does maximize the probability of success over time.

Buffett looks for great businesses or franchises:

He defines a franchise as a company providing a product or service that is (1) needed or desired, (2) has no close substitute, and (3) is not regulated.  These traits allow the company to hold its prices, and occasionally raise them, without the fear of losing market share or unit volume.  This pricing flexibility is one of the defining characteristics of a great business;  it allows the company to earn above-average returns on capital.

(Image by Marek Uliasz)


The key to investing is determining the competitive advantage of any given company and, above all, the durability of the advantage.  The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

Buffett again:

[The] definition of a great company is one that will be great for 25 to 30 years.


Management Tenets

  • Is management rational?
  • Is management candid with its shareholders?
  • Does management resist the institutional imperative?

Buffett looks for honest and able managers who behave like owners.  Such managers understand that their mission is to build business value over time.

Allocating capital in a rational way is central to maximizing the value of the business over time.  Particularly for mature companies, which Buffett often prefers based on their predictability, the allocation of excess cash can have a large impact on the value of the business.

The key is to get a return on invested capital (ROIC)—or return on equity (ROE)—that exceeds the cost of capital.  (ROE is close to ROIC for companies with low or no debt, which Buffett has always preferred.)  If there is no project that promises a sufficiently high return on capital, then the managers should consider buying back stock or paying dividends.  Buying back stock only creates value when the stock price is below intrinsic value.

When considering projects that may have a high ROIC (or high ROE), it’s vital that managers are thinking independently.

(Photo by  Marijus Auruskevicius)

Similarly, managers should never simply copy what other managers in the same industry are doing.  This is a recipe for disaster.  But it happens often enough.  Buffett and Munger call it the institutional imperativethe lemming-like tendency of managers to imitate the behavior of others, no matter how silly or irrational.  Buffett and Munger think the institutional imperative is responsible for several problems:

(1) [The organization] resists 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 quickly be 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.

Jack Ringwalt was the head of National Indemnity when Berkshire acquired it in 1967.  There were times when Ringwalt would simply stop selling insurance altogether if the rates on policies didn’t make sense.  Buffett learned this lesson well, both for Berkshire’s many insurance operations and in general.

Management candor is essential.  Good managers admit their mistakes and confront their problems rather than hiding behind GAAP (generally accepted accounting principles).


Financial Tenets

  • Focus on return on equity (ROE), not earnings per share (EPS).
  • Calculate ‘owner earnings.’
  • Look for companies with high profit margins.
  • For every dollar retained, make sure the company has created at least one dollar of market value.

Buffett does not take yearly results too seriously.  He focuses on five-year averages.  There is too much randomness in periods shorter than five years.

ROE (or ROIC) is more important than EPS.  As noted earlier, a company only creates value over time to the extent that its ROIC exceeds its cost of capital.  Often the cost of capital can be understood as the opportunity cost of capital, or the next best investment opportunity with a similar level of risk.

In calculating ROE—or ROIC—Buffett excludes extraordinary items.  He seeks to isolate the underlying performance of the business.

The intrinsic value of any business is all future free cash flow (FCF) discounted back to the present.  Buffett uses the term owner earnings in place of FCF.  It equals net income plus depreciation, depletion, and amortization, and minus capital expenditures.  (There may also be adjustments for changes in working capital.)

Buffett’s favorite managers minimize costs just like they breathe.  They do it automatically at all times.


Market Tenets

  • What is the value of the business?
  • Can the business be purchased at a significant discount to its value?

The value of any business is all future FCF discounted back to the present.  This definition was first explained by John Burr Williams in The Theory of Investment Value.

Buffett compares valuing a business to valuing a bond.  You know the coupon and maturity date for the bond, so you know the future cash flows.  Then you discount those future cash flows back to the present using an appropriate discount rate.

Buffett nearly always insists on a ‘coupon-like’ certainty for the future cash flows of a business in which he invests.  Therefore, Buffett uses the rate of the long-term U.S. government bond as his discount rate.  (If rates are very low, as today, Buffett often uses 6% as the discount rate.)

Hagstrom quotes Buffett:

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

Buffett wrote in the 1981 Berkshire Hathaway Letter to Shareholders:

[We have made mistakes as to:]  (1) the management we have elected to join;  (2) the future economics of the business;  or (3) the price we have paid. We have made plenty of such mistakes—both in the purchase of non-controlling and controlling interests in businesses.  Category (2) miscalculations are the most common.

Ben Graham taught that you only buy when there is a margin of safety between the price you pay and the intrinsic value of the business.  A margin of safety simultaneously lowers the risk of the investment AND increases the potential return.  The notion that lowering your risk can increase your return is directly contrary to what is taught in modern finance, where higher returns always require higher risks.

Buffett has adopted Graham’s view that investing means becoming a part owner of a business.  Investing is not trading pieces of paper.  Graham:

Investing is most intelligent when it is most businesslike.

Buffett says these are “the nine most important words ever written about investing.”  For Buffett, becoming a part owner of a public business by buying stock is no different than becoming a part owner—or full owner—of a private business.  Buffett notes:

I am a better investor because I am a businessman, and a better businessman because I am an investor.



The Washington Post Company

Millionaire financier Eugene Meyer bought the Washington Post for $825,000 at an auction held to pay off creditors.  Much later, Philip Graham, a brilliant Harvard-educated lawyer, took over management of the paper.  Graham had married Meyer’s daughter Katharine.  Graham transformed the Washington Post from a single newspaper into a media and communications company.

(Photo by Michael Fleischhacker, via Wikimedia Commons)

After Graham’s tragic suicide, control of the paper passed to Katharine Graham.  She learned quickly that she had to make decisions.  She made two great decisions:  hiring Ben Bradlee as managing editor and then inviting Warren Buffett to become a director.  Bradlee persuaded Katharine Graham to publish the Pentagon Papers and to pursue the Watergate investigation.  This earned the paper a reputation for award-winning journalism.  Meanwhile, Buffett taught Katharine Graham how to run a successful business.  (Buffett later tutored Katharine’s son, Don Graham.)

Simple and Understandable

For Buffett, the newspaper business was simple and understandable.  Buffett has said that if he were not an investor, he probably would be a journalist.

Consistent Operating History;  Favorable Long-Term Prospects

The Washington Post had a consistent operating history and favorable long-term prospects.  Newspapers had outstanding economics at the time.  (This was in the early 1970s, well before the advent of the internet.)  Even mediocre newspapers were generally quite profitable.  People and businesses wanting to get a message out to the community would typically use the newspaper to do so.  Moreover, newspapers had low capital needs, which meant a high ROIC and high profit margins.

Buy at Attractive Prices

In 1973, the total market value of the Washington Post Company was $80 million.  Buffett held that most security analysts, media brokers, and media executives at the time would have estimated WPC’s value at $400 or $500 million.  Assuming a $400 million intrinsic value, Buffett was buying at 20 percent of intrinsic value.

Return on Equity and Profit Margins

When Buffett purchased a stake in the WPC, its return on equity (ROE) was 15.7 percent.  Within five years, ROE had doubled.  WPC maintained a high ROE over the next ten years.  At the same time, WPC had paid down most of its debt.

By 1988, pretax margin reached a high of 31.8 percent, compared to 16.9 percent for its newspaper peer group and 8.6% for S&P Industrials.

Management Rationality

Using the gobs of excess cash, between 1975 and 1991, the Washington Post Company repurchased an incredible 43 percent of its shares at relatively low prices.

GEICO Corporation

Leo Goodwin, an insurance accountant, founded the Government Employees Insurance Company (GEICO) in 1936.  His idea was to insure only preferred-risk drivers and to sell this insurance directly by mail, bypassing the need for agents or branch offices.  Direct selling eliminated overhead expenses equal to 10 to 25 percent of every premium dollar.  Goodwin also realized that government employees had fewer accidents than the general public.

(GEICO logo by Dream out loud, via Wikimedia Commons)

Goodwin partnered with a Fort Worth, Texas, banker Cleaves Rhea.  Goodwin invested $25,000 for a 25% stake in the business, while Rhea invested $75,000 for a 75% stake in the business.  In 1948, the Rhea family decided to sell its interest.  Ben Graham decided to buy half Rhea’s stock for $720,000.  David Kreeger, a Washington, D.C., lawyer and Lorimer Davidson, a Baltimore bond salesperson, bought the other half.

Lorimer Davidson joined GEICO’s management team and became chairman in 1958.  By 1970, GEICO not only had written policies that would lead to underwriting losses;  but it also had inadequate reserves.  Norman Gidden was tapped to run the company when Davidson retired.

GEICO attempted to grow out of its problems.  By 1974, GEICO was facing a potential underwriting loss of $140 million (it turned out to be $126 million).  The stock fell from $61 to $5, and was heading lower.  GEICO had lost underwriting and cost control discipline.

In 1976, John J. Byrne, a 43-year-old marketing executive from Travelers Corporation, took over as president of GEICO.  Meanwhile, the stock drifted down to $2.

Warren Buffett invested $4.1 million at an average price of $3.18.

Simple and Understandable

Back in 1950, Ben Graham—Buffett’s teacher at Columbia University—was a director of GEICO.  One Saturday, Buffett went to visit the company in Washington, D.C., to try to learn.  A janitor let him in the building, and Buffett ended up getting a 5-hour tutorial from Lorimer Davidson, who was the only executive in the office that day.

Later, when Buffett returned to Omaha and his father’s brokerage firm, he recommended GEICO to the firm’s clients.  Buffett himself invested $10,000, two-thirds of his net worth.  He sold a year later at a 50 percent profit.  Buffett would not invest again in GEICO until 1976.

Buffett owned Kansas City Life and Massachusetts Indemnity & Life Insurance.  In 1967, Buffett purchased a controlling interest in National Indemnity.  Over the next decade, Buffett learned the insurance business from Jack Ringwalt, the CEO of National Indemnity.

Buffett’s expertise in insurance is what gave him the confidence to invest heavily in GEICO.  Between 1976 and 1980, Berkshire invested $47 million in GEICO, 7.2 million shares at an average price of $6.67.  The stake was worth $105 million by 1980, representing Buffett’s largest holding.

Consistent Operating History;  Favorable Long-Term Prospects

Buffett’s large investment in GEICO seemed to violate the consistent operating history tenet, since GEICO was a turnaround.  But Buffett had determined that the essential competitive advantage of the business—providing low-cost agentless insurance—was still intact.  Thus, Buffett judged that the problems in 1976, though huge, would ultimately be temporary.

Management Candor and Rationality

Byrne drastically reduced costs.  The number of policyholders went from 2.7 million to 1.5 million.  GEICO went from being the 18th largest insurer to 31st a year later.  But GEICO went from losing $126 million in 1976 to earning an impressive $58.6 million (on $463 million in revenues) in 1977.

Byrne continued to reduce costs.  The company stumbled in 1985.  But Byrne was very candid about it, and the company quickly recovered.  By this point, Byrne had developed a reputation not only for great leadership, but also for candor with shareholders.

From 1983 to 1992, GEICO used excess cash to repurchase 30 million shares, reducing total shares outstanding by 30 percent.  GEICO also increased the dividend.

Return on Equity and Profit Margins

In 1980, the ROE at GEICO was 30.8 percent, almost twice as high as the peer group average.  Buying back stock and paying dividends helped maintain a high ROE by reducing capital.

GEICO’s combined ratio of corporate expenses and underwriting losses was significantly better than the industry average.

Capital Cities/ABC

(Wikimedia Commons)

In 1954, Lowell Thomas, the famous journalist;  his business manager, Frank Smith;  and a group of associates bought Hudson Valley Broadcasting Company, which included an Albany television and AM radio station.  At the time, Tom Murphy was a product manager at Lever Brothers.

Frank Smith was a golfing partner of Murphy’s father.  Smith hired Murphy to manage the company’s television station.  In 1957, the company purchased a Raleigh-Durham television station.  The company was renamed Capital Cities Broadcasting, since Albany and Raleigh were capital cities.

In 1960, Murphy hired Dan Burke to manage the Albany station.  During the next several decades, Murphy and Burke ran Capital Cities.  They made more than 30 acquisitions in broadcasting and publishing.

In the late 1960s, Murphy met Buffett.  Murphy invited Buffett to join the board of Cap Cities.  Buffett declined, but he and Murphy became good friends.

In early 1985, Murphy obtained an initial agreement for a merger between Cap Cities and ABC.  Although Murphy had always done his own deals up until then, this time he brought his friend Warren Buffett.  They worked out the largest media merger in history (up to that point).  Berkshire Hathaway agreed to purchase three million newly issued shares of Cap Cities at $172.50 per share.  Murphy asked Buffett again to join the board, and this time Buffett agreed.

Simple and Understandable

Having served on the Washington Post Company board for more than a decade, Buffett had a very good understanding of television broadcasting, and newspaper and magazine publishing.

Consistent Operating History;  Favorable Long-Term Prospects

Both Cap Cities and ABC had more than 30 years of profitable histories.  ABC averaged 17 percent ROE from 1975 through 1984.  Cap Cities, in the decade before its purchase of ABC, averaged 19 percent ROE.  (Both companies also had low debt.)

Hagstrom explains the economics:

Once a broadcasting tower is built, capital reinvestment and working capital needs are minor and inventory investment is nonexistent.  Movies and programs can be bought on credit and settled later when advertising dollars roll in.  Thus, as a general rule, broadcasting companies produce above-average returns on capital and generate substantial cash in excess of their operating needs.

In 1985, the basic economics were above average.

Determine the Value

Berkshire’s $517 million investment in Cap Cities was the single largest investment Buffett ever made up until then.  This was not a cheap price.  Buffett joked, ‘I doubt if Ben’s up there applauding me on this one.’

Much of Buffett’s investment depended on Murphy.  Operating margins at Cap Cities were 28 percent, but were only 11 percent at ABC.  Murphy could improve the margins at ABC.

In essence, Murphy was Buffett’s margin of safety.  Murphy and Burke used a decentralized management style, hiring the best people and then leaving them alone to do their job.  Managers were expected to operate their businesses as if they owned them.  Moreover, Murphy excelled at minimizing costs, while Burke excelled at ongoing operations.

The Institutional Imperative and Rationality

Despite enormous free cash flow, Murphy remained very disciplined about not overpaying for acquisitions.  He would sometimes wait for years until the right property at the right price became available.

Because the stock of Cap Cities/ABC was cheap for several years, Murphy repurchased a large number of shares.  Murphy also reduced the company’s debt that had resulted from the ABC acquisition.

Buffett viewed Cap Cities/ABC as the best-managed public company in the United States.  He assigned all voting rights for the ensuing 11 years to Murphy and Burke as long as at least one of them managed the company.

The Coca-Cola Company

(Wikimedia Commons)

Hagstrom writes:

By the spring of 1989, Berkshire Hathaway shareholders learned that Buffett had spent $1.02 billion buying Coca-Cola shares.  He had bet a third of the Berkshire portfolio, and now owned 7 percent of the company.  It was the single-largest Berkshire investment to date, and already Wall Street was scratching its head.  Buffett had paid five times book value and over 15 times earnings, then a premium to the stock market, for a hundred-year-old company that sold soda pop.  What did the Wizard of Omaha see that everyone else missed?

As a kid, Buffett would buy six Cokes for 25 cents, then resell them at 5 cents each.  And in 1986, Buffett announced that Cherry Coke would be the official soft drink at Berkshire Hathaway’s annual meetings.  But it wasn’t until 1988 that Buffett began buying shares.

Simple and Understandable

The company sells a concentrate to bottlers, who combine it with other ingredients and then sell the finished product to retail outlets.  The company also sells soft drink syrups to restaurants and fast-food retailers.

Consistent Operating History;  Favorable Long-Term Prospects

Buffett explained in an interview with Melissa Turner of the Atlanta Constitution his reasoning:  If he could make one investment and then go away for ten years without access to any information about the investment, what would he buy?  As far as remaining a worldwide leader and experiencing big ongoing unit growth, there was nothing (in 1989) like Coke.

Furthermore, the chairman and CEO of Coke, Roberto Goizueta, and the president Donald Keough, were doing an outstanding job erasing mistakes that had been made in the 1970s.  Robert Woodruff, the company’s 91-year-old patriarch, hired Roberto Goizueta in 1980.  Goizueta cut costs and demanded that any business owned by Coca-Cola maximize return on assets.

High Profit Margins and ROE

Under Goizueta and Keough, pretax margins rose from 12.9 percent to a record 19 percent by 1988.  Goizueta sold any business that did not generate good ROE.  By 1988, the company’s ROE reached 31 percent, up from 20 percent during the 1970s.

Management Candor and Rationality

Under Goizueta’s leadership, Coke’s mission became crystal clear:  maximize shareholder value over time.  This would be achieved by optimizing profit margins and ROE.

Meanwhile, Goizueta announced that the company would repurchase shares, which were trading at a discount to the company’s now-higher intrinsic value.

The Institutional Imperative

Hagstrom describes Goizueta’s leadership:

When Goizueta took over Coca-Cola, one of his first moves was to jettison the unrelated businesses that Paul Austin had developed, and return the company to its core business:  selling syrup.  It was a clear demonstration of Coca-Cola’s ability to resist the institutional imperative.

Reducing the company to a single-product business was undeniably a bold move…

… Because the economic returns of selling syrup far outweighed the economic returns of the other businesses, the company was now reinvesting its profits in its highest-return business.

Determine the Value

Buffett paid 5 times book value, 15 times earnings, and 12 times cash flow.  This was at a time when long-term bonds were yielding 9 percent.  Hagstrom:

…The company was earning 31 percent on equity while employing relatively little in capital investment.  Buffett has explained that price tells you nothing about value.  The value of Coca-Cola, he said, like that of any other company, is determined by the total owner earnings expected to occur over the life of the business, discounted by the appropriate interest rate.

Owner earnings is the term Buffett uses for free cash flow (FCF).  We can use a two-stage discount model to calculate the present value in 1988.  Assuming 15 percent growth in owner earnings for the next 10 years, and then 5 percent growth thereafter, and assuming a 9 percent discount rate, intrinsic value for Coca-Cola would be $48.377 billion.  That’s compared to the 1988 market value of $14.8 billion.

At year-end 1999, the market value of Coke was $143 billion, and Berkshire’s original $1.02 billion investment was worth $11.6 billion.

General Dynamics

In 1990, General Dynamics was the country’s second-largest defense contractor behind McDonnell Douglas Corporation.  General Dynamics produced missile systems in addition to air defense systems, space-launched vehicles, and fighter planes for the U.S. armed forces.

(Wikimedia Commons)

In January 1991, General Dynamics appointed William Anders as CEO.  Within six months, the company had raised $1.25 billion by selling noncore businesses.  With the cash, the company first paid down its debt.  Then as excess cash flow continued, General Dynamics purchased 13.2 million shares at prices between $65.37 and $72.25, reducing its shares outstanding by 30 percent.

Although Buffett initially had purchased General Dynamics as an arbitrage—in anticipation of stocks buybacks—Buffett later noticed that Anders was very focused on maximizing shareholder value.  So Buffett held the stake:

From July 1992 through the end of 1993, for its investment of $72 per share, Berkshire received $2.60 in common dividends, $50 in special dividends, and a share price that rose to $103.  It amounted to a 116 percent return over 18 months.

Wells Fargo & Company

In October 1990, Buffett announced that Berkshire had purchased five million shares in Wells Fargo, investing $289 million at an average price of $57.88 per share.  This turned into a battle between bulls like Buffett and bears like the Feshbach brothers.

(Wikimedia Commons)

Buffett knew a lot about the business of banking.  In 1969, Berkshire Hathaway purchased 98 percent of the holdings of Illinois National Bank and Trust Company.  Gene Abegg, the chairman of Illinois National Bank, taught Buffett about the banking business.  Buffett learned that banks were profitable if they issued loans intelligently and curtailed costs.

Favorable Long-Term Prospects

When assets are 20 times equity, which is normal in banking, even a small mistake can cause the bank to go bankrupt.  But if management does a good job, a bank can earn 20 percent on equity, which is above the average of most businesses.  Also, Buffett believed he had the best management team in Carl Reichardt and Paul Hazen.  Buffett:  “In many ways, the combination of Carl and Paul reminds me of another—Tom Murphy and Dan Burke at Capital Cities/ABC.”

Munger explained:  ‘It’s all a bet on management.  We think they will fix the problems faster and better than other people.”


Reichardt was legendary for relentlessly lowering costs.  He never let up, always searching for ways to improve profitability.

American Express Company

(Wikimedia Commons)

Buffett:  “I find that a long-term familiarity with a company and its products is often helpful in evaluating it.”  Hagstrom explains:

With the exception of selling bottles of Coca-Cola for a nickel, delivering copies of the Washington Post, and recommending that his father’s clients buy shares of GEICO, Buffett has had a longer history with American Express than any other company Berkshire owns.  You may recall that in the mid-1960s, the Buffett Limited Partnership invested 40 percent of its assets in American Express shortly after the company’s losses in the salad oil scandal.  Thirty years later, Berkshire accumulated 10 percent of American Express shares for $1.4 billion.

Consistent Operating History

American Express was essentially the same business when Berkshire invested as it had been when the Buffett partnership invested.  Travel Related Services (TRS) made up 72 percent of American Express’s sales.  American Express Financial Advisors represented 22 percent of sales.  American Express Bank was about 5%.

Under James Robinson, the company used excess cash to acquire related business.  Although IDS (renamed American Express Financial Advisors) had proved to be a profitable purchase, Robinson’s $4 billion investment in Shearson-Lehman was a financial drain and prompted Robinson to contact Buffett.  Buffett was willing to buy $300 million in preferred shares.  But Buffett was not ready to invest in the common shares until he saw more management rationality.


In 1992, Harvey Golub took over as CEO.  Golub clearly recognized the brand value of the American Express Card.  Over the next two years, Golub sold off American Express’s underperforming assets, and restored profitability and high ROE.  By 1994, American Express management was focused on making the American Express Card the “world’s most respected service brand.”

Golub also set financial targets:  to increase EPS by 12 to 15 percent annually and to achieve an 18 to 20 percent ROE.  Management was also planning to repurchase 20 million shares of its common stock.

In the summer of 1994, Buffett converted Berkshire’s preferred issue into American Express common stock.  And he began to acquire even more shares of common stock.  Berkshire owned 27 million shares at an average price of $25 by the end of the year.  When American Express finished repurchasing 20 million shares, it announced that it would repurchase an additional 40 million shares, or 8 percent of the stock outstanding.  By March 1995, Buffett had added another 20 million shares, which increased Berkshire’s ownership to a bit less than 10 percent of American Express.

Determine the Value

Assuming 12 percent growth in owner earnings for 10 years, then 5 percent growth thereafter, and assuming a discount rate of 10 percent—which is conservative—the intrinsic value of American Express at the end of 1994 was about $50 billion, or $100 per share.  Thus Buffett’s purchase of 27 million shares at $25 had a significant margin of safety, and therefore significant potential upside.

International Business Machines

Buffett had always avoided investing in technology companies because constant disruption and innovation make for very short company life spans.  But by the end of 2011, Berkshire Hathaway had purchased 63.9 million shares of IBM, or 5.4 percent of the company.  At $10.8 billion, it was the largest purchase of individual stock Buffett has ever made.

(Photo by Paul Rand, via Wikimedia Commons)

Favorable Long-Term Prospects

After 50 years of reading the financial statements of IBM, Buffett suddenly realized the competitive advantages IBM has in finding and keeping clients.  IBM dominates information technology (IT) services, which includes consulting, systems integration, IT outsourcing, and business process outsourcing.  IBM is number-one globally in the consulting and systems integration space, and number-one globally in IT outsourcing.

Revenues from IT services are relatively stable.  Consulting, systems integration, and IT outsourcing are even thought to possess ‘moat-like’ qualities, writes Hagstrom.  In consulting and systems integration, intangible assets like reputation, track record, and client relationships are sources of a moat.  In IT outsourcing, switching costs and scale advantages create a moat.

J. Heinz Company

On February 14, 2013, Berkshire Hathaway and 3G Capital purchased H. J. Heinz Company for $23 billion.  The purchase price was $72.50 a share, a 20 percent premium to the stock price the day before.

(Wikimedia Commons)

Favorable Long-Term Prospects;  Rationality

Heinz is number one in ketchup globally and second in sauces.  The company is poised to do well in rapidly growing emerging markets.

Buffett has partnered with 3G Capital in the purchase of Heinz.  3G has a track record of relentlessly lowering costs.

Holding Period:  Forever

Buffett is “quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.”



If you do not have the time or inclination to study companies in depth, then a low-cost index fund is best.  But if you can understand some businesses, then a concentrated portfolio makes sense.

There is a mathematical formula, the Kelly criterion, that you can use to get an idea of how large a position to take on your best ideas.  The formula was invented by the physicist John L. Kelly.

(John L. Kelly, Wikimedia Commons)

Buffett talked about index funds vs. focused portfolios in the 1993 Berkshire Hathaway Letter to Shareholders:

By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.  Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you.  It is apt simply to hurt your results and increase your risk.  I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices—the businesses he understands best and that present the least risk, along with the greatest profit potential.

Here is Buffett in a 1998 lecture at the University of Florida:

If you can identify six wonderful businesses, that is all the diversification you need.  And you will make a lot of money.  And I can guarantee that going into the seventh one instead of putting more money into your first one is [going to] be a terrible mistake.  Very few people have gotten rich on their seventh best idea.  So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I [would] probably have half of [it in] what I like best.

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

Even in a highly focused portfolio of 5 to 10 stocks, often your best idea should be by far the largest position in your portfolio.

Recall that Buffett invested two-thirds of his net worth in GEICO before he launched the Buffett partnership.  He had over a 50 percent profit after a year.  Later, Buffett invested 40 percent of the Buffett partnership in American Express.  The shares nearly tripled over the next two years.  A couple of decades later, Buffett invested $1.02 billion—about a third of Berkshire Hathaway’s portfolio—in Coca-Cola.  This turned out to be a 10-bagger for Berkshire, netting $10 billion in profit over the ensuing decade.

It can be tempting for an investor to listen to forecasters predict the stock market, the economy, or elections.  But owning a few good businesses over time is a far more reliable and safer way to compound your capital—at higher rates—than speculating on the stock market or the economy.

Here are a few good quotes from Buffett on forecasting:

  • I don’t invest a dime based on macro forecasts.
  • Market forecasters will fill your ear but never fill your wallet.
  • We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
  • 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.

Hagstrom puts it as follows:

In shorter periods, we realize that changes in interest rates, inflation, or near-term expectations for a company’s earnings can affect share prices.  But as the time horizon lengthens, the trendline economics of the underlying business will increasingly dominate its share price.

… Focus investors tolerate the [short-term] bumpiness because they know that, in the long run, the underlying economics of the companies will more than compensate for any short-term price fluctuations.

Investing is Probabilistic

(Photo by Michele Lombardo)

Nearly all investments are probabilistic decisions, or decisions under uncertainty.  Hagstrom quotes Buffett:

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

Hagstrom also quotes 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 and think about it, a pari-mutuel system is a market.  Everybody goes there and bets and the odds are changed 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 good position et cetera 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.  The prices have changed in such a way that it’s very hard to beat the system.

When you find a high-probability bet with substantial upside—which will only happen rarely—then you should take a big position.  How big?  You have to know yourself in terms of how much portfolio volatility you can tolerate.  As long as you can hold for the longer term—for at least 5 or 10 years—without reacting to shorter term volatility, then it makes sense to take large positions on the best ideas you find.

If you apply the Kelly criterion to a focused portfolio of value stocks, then you typically need to normalize positions sizes.  Mohnish Pabrai has explained this:  http://boolefund.com/the-dhandho-investor/

John Maynard Keynes was very successful as a focused value investor:  http://boolefund.com/greatest-economist-defied-convention-got-rich/

Hagstrom has a quote from Keynes:

It is a mistake to think one limits one’s risk by spreading too much between enterprises 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.

Keynes was against market timing, and in favor of a very concentrated portfolio.

Hagstrom also mentions Ruane, Cuniff & Company, started by Bill Ruane and Rick Cuniff.  They would have 90 percent of the fund in 6 to 10 positions.

Lou Simpson used a very concentrated approach when he managed GEICO’s equity portfolio.  Between 1980 and 2004, GEICO’s portfolio returned 20.3 percent per year compared to 13.5 percent for the market.

Active share is the percentage of a portfolio that differs from the benchmark index holdings.  The only way to do better than the index is to invest differently.  Yet most professional investors have portfolios not much different than the index.  They are more worried about not underperforming the index than they are focused on doing better than the index.  Hagstrom reports that just 25 percent of mutual funds today are considered truly active.

Moreover, many professional investors are focused on short-term results.  The problem is that the performance of a portfolio of stocks is largely random for time horizons less than 5 years.  That is why Buffett focuses on 5-year periods to measure Berkshire Hathaway’s performance.  After 5 years—and even more after 10 years—a stock will track the performance of the underlying business.

(Illustration by Marek)

Many professional investors fixate on quarterly or annual results because many of their clients (or potential clients) decide to invest in the fund based on these short-term results.

Many of the best long-term investors have had periods of significant underperformance over shorter periods of time.  When Keynes managed the Chest Fund, it underperformed the market one-third of the time.  This includes underperforming the market by 18 percentage points in the first three years Keynes managed the fund.  But Keynes’ record over a couple of decades was outstanding.

The Sequoia Fund, managed by Bill Ruane, underperformed the market 37 percent of the time.  In fact, Sequoia underperformed for the first 4 years of its existence.  By the end of 1974, the fund was 36 percentage points behind the market.  Yet three years later—seven years since inception—Sequoia was up 220 percent, versus 60 percent for the S&P 500 Index.

Over 14 years, Charlie Munger underperformed 36 percent of the time.  But Munger’s overall record was far better than the market.  (Lou Simpson underperformed the market 24 percent of the time, but also had a remarkable long-term record of beating the market.)

If you’re a long-term investor in businesses—whether public or private—what matters over time is the economic performance of those businesses, not the prices at which the businesses can be bought or sold.  Hagstrom:

If you owned a business and there were no daily quotes to measure its performance, how would you determine your progress?  Likely you would measure the growth in earnings, the increase in return on capital, or the improvement in operating margins.  You simply would let the economics of the business dictate whether you were increasing or decreasing the value of your investment.

Hagstrom quotes Buffett:

While market values track business values quite well over long periods, in any given year the relationship can gyrate capriciously.

Buffett again:

The speed at which a business’s success is recognized… is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate.  In fact, delayed recognition can be an advantage:  It may give you a chance to buy more of a good thing at a bargain price.

When you consider a new investment idea, you should always compare it to the best ideas already in your portfolio.  Since good ideas are rare, this should set a high threshold and screen out 99 percent of what you consider.  Hagstrom observes:

You already have at your disposal, with what you now own, an economic benchmark—a measuring stick.  You can define your own personal benchmark in several different ways:  look-through earnings, return on equity, or margin of safety, for example.  When you buy or sell stock of a company in your portfolio, you have either raised or lowered your economic benchmark.  The job of a portfolio manager who is a long-term owner of securities, and who believes future stock prices eventually will match with underlying economics, is to find ways to raise your benchmark.

If you step back and think for a moment, the Standard & Poor’s 500 index is a measuring stick.  It is made up of 500 companies and each has its own economic return.  To outperform the S&P 500 index over time—to raise that benchmark—we have to assemble and manage a portfolio of companies with economics that are superior to the average weighted economics of the index.


If my universe of business possibilities 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?  Our motto is:  If at first you succeed, quit trying.

Buffett again:

Inactivity strikes us as an 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 has reversed his views on the market.  Why, then, should we behave differently with our minority positions in wonderful businesses?

Buying and holding wonderful businesses has two important benefits in addition to growing capital at an above-average rate.  Transaction costs are kept to an absolute minimum, and after-tax returns are maximized.

Buffett gives an example of $1 doubling every year for 20 years.  First assume that you sell and pay tax at the end of each year.  So after the first year, you would have a total of $1.66.  By the end of 20 years, you would have a net gain of $25,200, after paying taxes of $13,000.  By contrast, if you held the $1 dollar as it repeatedly doubled, and didn’t sell until the end of the 20-year period, you would have $692,000 after paying taxes of about $356,000.

To achieve high after-tax returns, turnover should be between 0 and 20 percent.  20 percent turnover implies a 5-year holding period.  As long as you are very patient and can stay focused on the long term without reacting emotionally to shorter term volatility, you should be able to construct and stick with a focused portfolio of businesses that you understand.  Always being rational and not reacting out of emotion is more important than IQ.  Buffett:

You don’t need to be a rocket scientist.  Investing is not a game where the 160 IQ guy beats the guy with the 130 IQ.  The size of an investor’s brain is less important than his ability to detach the brain from the emotions.



Although it’s not widely recognized, Ben Graham was keenly aware of the importance of psychology for investors.  Graham held that your worst enemy as an investor is usually yourself.

Warren Buffett, Graham’s most famous student, says there are three important principles in Graham’s approach to investing:

  • Stock is a fractional ownership in a business. What matters for the investor is how the business performs over time.
  • Margin of safety:  Given a reasonable estimate of intrinsic value—based on net asset value or earnings power—you should only buy when the price is well below that estimate.  The lower the price is compared to intrinsic value, the safer the investment and simultaneously the higher the potential reward.
  • Short-term price fluctuations have no meaning for the true investor because on the whole they do not reflect changes in business value. Fluctuations do occasionally create opportunities, however, for the investor to buy if the price becomes cheap enough.

When the stock price drops, a rational investor’s reaction should be the same as a businessperson who gets a lowball offer on his or her privately owned business:  Ignore it.  Graham:

The true investor scarcely ever is forced to sell his shares and at all other times is free to disregard the current price quotation.

Behavioral Finance

(Daniel Kahneman, via Wikimedia Commons)

Behavioral finance is based on discoveries (in the past few decades) in psychology by Daniel Kahneman, Amos Tversky, and many others.  Kahneman was awarded the Nobel Prize in economics in 2002 for discoveries that he and Tversky made from decades of experiments of people making decisions under uncertainty.

Before Kahneman and Tversky, economists always assumed—based on utility theory as described by John von Neumann and Oskar Morgenstern—that people make rational decisions under uncertainty.  (Investment decisions are decisions under uncertainty.)

We now know that nearly all investors make systematic errors.  Behavioral finance allows us to understand these errors.

Overconfidence, Confirmation Bias, Availability Bias

People by nature are overconfident.  Typically if you ask people in a random group how good a driver they are, at least 80-90 percent will say ‘above average.’  But of course no more than 50% can be above average.

In many areas of life, overconfidence is not bad and often even is helpful.  When we were hunter-gatherers, it was a net benefit for the tribe if hunters were individually overconfident.  Similarly today, although many entrepreneurs fail, it is a net benefit for the economy that nearly all entrepreneurs believe they will succeed.

When you are investing, however, overconfidence will penalize your results over time.  Hagstrom points out:

Investors, as a rule, are highly confident they are smarter than everyone else.  They have a tendency to overestimate their skills and their knowledge.  They typically rely on information that confirms what they believe, and disregard contrary information.  In addition, the mind works to assess whatever information is readily available rather than to seek out information that is little known….

Overconfidence explains why so many money managers make wrong calls.  They take too much confidence from the information they gather, and think they are more right than they actually are.

Confirmation bias means only seeing information that confirms what you already believe, rather than seeking and being aware of potentially disconfirming information.  Availability bias means only noticing information that is readily available.

Overreaction Bias

Overreaction Bias means investors overreact to bad news and react slowly to good news.  If there is bad news and the stock price drops, an investor is likely to overreact and to sell, even though the long-term, underlying economics of the business are often unchanged.

Richard Thaler researched overreaction.  He constructed a portfolio of ‘Loser’ stocks—stocks that had been the worst performers over the preceding 5 years.   He compared the ‘Loser’ portfolio to a portfolio of ‘Winner’ stocks—stocks that had performed best over the preceding 5 years.  Thaler found that over the subsequent 5 years, the ‘Loser’ portfolio far outperformed both the market and the ‘Winner’ portfolio.

Loss Aversion

People are risk averse when considering potential gains, but risk seeking when facing the possibility of a certain loss.  This is the essence of prospect theory—invented by Kahneman and Tversky—which is captured in the following graph:

(Value function in Prospect Theory, drawing by Marc Rieger, via Wikimedia Commons)

Loss aversion means that, in general, people feel a loss 2 to 2.5 times more than an equivalent gain.  (That’s why the value function in the graph is steeper for losses.)  Therefore, when people are presented with a 50/50 bet, on average they will only bet if the potential gain is at least twice as large as the potential loss.

Loss aversion causes people to hold on to their losing investments for too long.  By not selling an investment that hasn’t worked, the investor can postpone the feeling of a loss.  Yet the sooner the investor can recognize a mistake and close the position, the sooner the investor can reinvest that capital in a potentially more profitable way.

Mistakes in investing are inevitable.  Even for the best value investors, on average they tend to be right about two-thirds of the time and wrong one-third of the time.  The best investors can recognize quickly when either they have made a mistake or when unforeseeable events have invalidated the investment thesis.

Long-Term Investment Time Horizon

Warren Buffett focuses on the performance of the business over a 5-year or 10-year period.  He invests in a stock when it is a bargain relative to the probable long-term earnings power of the business.

Many investors are way too focused on the short term.  The problem is that if you check a stock price each day, there is 50 percent chance it will be lower.  And due to loss aversion, you will feel the pain of a lower price at least twice as much as the pleasure of an equivalent gain.  Therefore, after carefully constructing your portfolio, it’s essential to stay focused on the performance of the businesses over rolling 5-year periods.  It’s also essential to check stock prices as infrequently as you can.

Very often the individual investors who have gotten the best results over the course of 20-30 years are those investors who effectively forgot about their investments.  These investors often didn’t check stock prices for years at a time.  As Ben Graham said, for many investors it would be better if they couldn’t get any stock quote at all.

Warren Buffett has often said you should only invest in a business where you wouldn’t worry at all if the stock market closed for 5 or 10 years.  All that matters for the long-term value investor is how the underlying business performs over time.  If it’s a good business that increases earnings and maintains a high return on capital over time, then your fractional ownership of the business will track the increase in intrinsic value.



Too many investors have the mistaken belief that the stock market can be predicted.  But it can’t.  Ben Graham:

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

Hagstrom did some research about long-term investing, and here is what he found:

We calculated the one-year return, trailing three-year return, and trailing five-year return (price only) between 1970 and 2012.  During this 43-year period, the average number of stocks in the S&P 500 index that doubled in any one year averaged 1.8 percent, or about nine stocks out of 500.  Over three-year rolling periods, 15.3 percent of stocks doubled, about 77 stocks out of 500.  In rolling five-year blocks, 29.9 percent doubled, about 150 out of 500.

So, back to the original question:  Over the long term, do large returns from buying and holding stocks actually exist?  The answer is indisputably yes.  And unless you think a double over five years is trivial, this equates to a 14.9 percent average annual compounded return.

Then Hagstrom notes that the greatest number of opportunities to get high excess returns is after three years.  So, as an investor, you should patiently find cheap and good stocks that you can hold for at least 3 to 5 years.  There continue to be many opportunities over this time frame because many investors only look at the very short term.  The average holding period is only a few months, which is hardly different from a coin flip.


Keith Stanovich holds that rationality is not the same thing as intelligence.  He says IQ tests or SAT/ACT exams do a poor job of measuring rational thought:

It is a mild predictor at best, and some rational thinking skills are totally dissociated from intelligence.

There appear to be two main reasons why even many high IQ people are not able to think rationally:  a processing problem and a content problem.

To understand the processing problem, we must first note that we have essentially two different brains:  System 1 and System 2.

System 1 operates automatically and quickly.  It makes instinctual decisions based on heuristics.

System 2 allocates attention (which has a limited budget) to the effortful mental activities that demand it, including complex computations involving logic, math, or statistics.

Usually System 1 and System 2 work well together, but not always.  Daniel Kahneman explains in his great book, Thinking, Fast and Slow:

The division of labor between System 1 and System 2 is highly efficient:  it minimizes effort and optimizes performance.  The arrangement works well most of the time because System 1 is generally very good at what it does: its models of familiar situations are accurate, its short-term predictions are usually accurate as well, and its initial reactions to challenges are swift and generally appropriate.  System 1 has biases, however, systematic errors that it is prone to make in specified circumstances…  it sometimes answers easier questions than the one it was asked, and it has little understanding of logic and statistics.  One further limitation of System 1 is that it cannot be turned off.

If the situation requires a complex computation in order to arrive at a good decision, then System 1 makes predictable errors.  In order to avoid these mistakes, a person must train his or her System 2 to activate and to think carefully.

So the processing problem requires training System 2.  But there is a second problem the investor also must solve:  the content problem.  The ability to think rationally using System 2 can only lead to good decisions if System 2 has access to enough mindware.  Mindware—as defined by Harvard cognitive scientist David Perkins—is all the rules, strategies, procedures, and knowledge people have at their disposal to help solve a problem.

In investing, the most important thing is reading a great deal, especially the financial statements of various companies.  Over time, an investor can slowly develop useful mindware.



To determine how good Warren Buffett is, there are two basic variables:  relative outperformance and duration.  Hagstrom argues that both are needed.  Over shorter periods of time, luck plays a large role.  But as you extend out in time—several decades and then some—luck plays less and less of a role.

Buffett has crushed the market over a period of almost 60 years.  Buffett is  unmatched over this time frame.

Buffett also remains very bullish on the United States.  He says the luckiest new babies in history are those being born today:

…Warren Buffett is unabashedly bullish on the United States of America.  He has never been shy to express his belief that the United States offers tremendous opportunity to anyone who is willing to work hard.  He is upbeat, cheerful, and optimistic about life in general.  Conventional wisdom holds that it is the young who are the eternal optimists and as you get older pessimism begins to tilt the scale.  But Buffett appears to be the exception.  And I think part of the reason is that for almost six decades he has managed money through a long list of dramatic and traumatic events, only to see the market, the economy, and the country recover and thrive.

It is a worthwhile exercise to Google the noteworthy events of the 1950s, 1960s, 1970s, 1980s, 1990s, and the first decade of the twenty-first century.  Although too numerous to list here, the front-page headlines would include nuclear war brinksmanship;  presidential assassination and resignation;  civil unrest and riots;  regional wars;  oil crisis, hyperinflation, and double-digit interest rates;  and terrorist attacks—not to mention the occasional recession and periodic stock market crash.

Hagstrom proceeds to argue that Buffett has three advantages:  behavioral, analytical, and organizational.

Behavioral Advantage

Those who know Buffett agree that it is rationality that sets him apart.  Buffett is extremely rational.  As Roger Lowenstein writes in Buffett: The Making of an American Capitalist, “Buffett’s genius [is] largely a genius of character—of patience, discipline, and rationality.”  The maximization of shareholder value depends largely on the rational allocation of capital.  This is a key trait Buffett looks for in good managers, and it’s a trait he himself has to a remarkable degree.

Analytical Advantage

For Buffett, both the investor and the businessperson should look at a company in terms of how much cash it can produce over time.  By recognizing, furthermore, that short-term stock prices are largely random, you can learn to value a business—based on discounted FCF or net asset value—and wait patiently until its stock price is well below intrinsic value.

Don’t waste time trying to predict the stock market, the economy, or elections.  No one has been able to predict these things.  Instead, stay focused on understanding individual businesses.  Over a long period of time—at least 5-10 years—what really matters, as long as you paid reasonable prices, is the performance of the businesses you own.

Organizational Advantage

Buffett has set up Berkshire Hathaway so that he can focus on long-term capital allocation, while the managers of the businesses Berkshire owns can focus on maximizing long-term business value.

If you’re an individual investor, you don’t have to worry about short-term performance or consensus opinions.  You can find a simple business that you understand, and then wait patiently for it to go on sale.  Find a few such businesses.  Then buy and hold, paying attention only to how the businesses perform over the years.

I would add that, for the individual investor, most often you can find the best investment opportunities among microcap companies—companies with market caps up to $300 million.  Because very few professional investors ever look at micro caps, the greatest pricing inefficiencies usually occur here.



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

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

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

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


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

My e-mail: jb@boolefund.com




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

Walter Schloss: Cigar-Butt Specialist

May 6, 2018

Walter Schloss generated one of the best investment track records of all time—close to 21% (gross) annually over 47 years—by investing exclusively in cigar butts (deep value stocks).  Cigar butt investing usually means buying stock at a discount to book value, i.e., a P/B < 1 (price-to-book ratio below 1).

The highest returning cigar butt strategy comes from Ben Graham, the father of value investing.  It’s called the net-net strategy whereby you take current assets minus all liabilities, and then invest at 2/3 of that level or less.

  • The main trouble with net nets today is that many of them are tiny microcap stocks—below $50 million in market cap—that are too small even for most microcap funds.
  • Also, many net nets exist in markets outside the United States.  Some of these markets have had problems periodically related to the rule of law.

Schloss used net nets in the early part of his career (1955 to 1960).  When net nets became too scarce (1960), Schloss started buying stocks at half of book value.  When those became too scarce, he went to buying stocks at two-thirds of book value.  Eventually he had to adjust again and buy stocks at book value.  Though his cigar-butt method evolved, Schloss was always using a low P/B to find cheap stocks.

(Photo by Sky Sirasitwattana)

One extraordinary aspect to Schloss’s track record is that he invested in roughly 1,000 stocks over the course of his career.  (At any given time, his portfolio had about 100 stocks.)  Warren Buffett commented:

Following a strategy that involved no real risk—defined as permanent loss of capital—Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500.  It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type.  A few big winners did not account for his success.  It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.

Schloss was aware that a concentrated portfolio—e.g., 10 to 20 stocks—could generate better long-term returns.  However, this requires unusual insight on a repeated basis, which Schloss humbly admitted he didn’t have.

Most investors are best off investing in low-cost index funds or in quantitative value funds.  For investors who truly enjoy looking for undervalued stocks, Schloss offered this advice:

It is important to know what you like and what you are good at and not worry that someone else can do it better.  If you are honest, hardworking, reasonably intelligent and have good common sense, you can do well in the investment field as long as you are not too greedy and don’t get too emotional when things go against you.

I found a few articles I hadn’t seen before on The Walter Schloss Archive, a great resource page created by Elevation Capital: https://www.walterschloss.com/

Here’s the outline for this blog post:

  • Stock is Part Ownership;  Keep It Simple
  • Have Patience;  Don’t Sell on Bad News
  • Have Courage
  • Buy Assets Not Earnings
  • Buy Based on Cheapness Now, Not Cheapness Later
  • Boeing:  Asset Play
  • Less Downside Means More Upside
  • Multiple Ways to Win
  • History;  Honesty;  Insider Ownership
  • You Must Be Willing to Make Mistakes
  • Don’t Try to Time the Market
  • When to Sell
  • The First 10 Years Are Probably the Worst
  • Stay Informed About Current Events
  • Control Your Emotions;  Be Careful of Leverage
  • Ride Coattails;  Diversify



A share of stock represents part ownership of a business and is not just a piece of paper.

Try to establish the value of the company.  Use book value as a starting point.  There are many businesses, both public and private, for which book value is a reasonable estimate of intrinsic value.  Intrinsic value is what a company is worth—i.e., what a private buyer would pay for it.  Book value—assets minus liabilities—is also called “net worth.”

Follow Buffett’s advice: keep it simple and don’t use higher mathematics.

(Illustration by Ileezhun)

Some kinds of stocks are easier to analyze than others.  As Buffett has said, usually you don’t get paid for degree of difficulty in investing.  Therefore, stay focused on businesses that you can fully understand.

  • There are thousands of microcap companies that are completed neglected by most professional investors.  Many of these small businesses are simple and easy to understand.



Hold for 3 to 5 years.  Schloss:

Have patience.  Stocks don’t go up immediately.

Schloss again:

Things usually take longer to work out but they work out better than you expect.

(Illustration by Marek)

Don’t sell on bad news unless intrinsic value has dropped materially.  When the stock drops significantly, buy more as long as the investment thesis is intact.

Schloss’s average holding period was 4 years.  It was less than 4 years in good markets when stocks went up more than usual.  It was greater than 4 years in bad markets when stocks stayed flat or went down more than usual.



Have the courage of your convictions once you have made a decision.

(Courage concept by Travelling-light)

Investors shun companies with depressed earnings and cash flows.  It’s painful to own stocks that are widely hated.  It can also be frightening.  As John Mihaljevic explains in The Manual of Ideas (Wiley, 2013):

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

A related worry is that if a company is burning through its cash, it will gradually destroy net asset value.  Ben Graham:

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

It’s true that an individual cigar butt (deep value stock) is more likely to underperform than an average stock.  But because the potential upside for a typical cigar butt is greater than the potential downside, a basket of cigar butts (portfolio of at least 30) does better than the market over time and also has less downside during bad states of the world—such as bear markets and recessions.

Schloss discussed an example: Cleveland Cliffs, an iron ore producer.  Buffett owned the stock at $18 but then sold at about that level.  The steel industry went into decline.  The largest shareholder sold out because he thought the industry wouldn’t recover.

Schloss bought a lot of stock at $6.  Nobody wanted it.  There was talk of bankruptcy.  Schloss noted that if he had lived in Cleveland, he probably wouldn’t have been able to buy the stock because all the bad news would have been too close.

Soon thereafter, the company sold some assets and bought back some stock.  After the stock increased a great deal from the lows, then it started getting attention from analysts.

In sum, often when an industry is doing terribly, that’s the best time to find cheap stocks.  Investors avoid stocks when they’re having problems, which is why they get so cheap.  Investors overreact to negative news.



(Illustration by Teguh Jati Prasetyo)


Try to buy assets at a discount [rather] than to buy earnings.  Earnings can change dramatically in a short time.  Usually assets change slowly.  One has to know much more about a company if one buys earnings.

Not only can earnings change dramatically; earnings can easily be manipulated—often legally.  Schloss:

Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore.



Buy things based on cheapness now.  Don’t buy based on cheapness relative to future earnings, which are hard to predict.

Graham developed two ways of estimating intrinsic value that don’t depend on predicting the future:

  • Net asset value
  • Current and past earnings

Professor Bruce Greenwald, in Value Investing (Wiley, 2004), has expanded on these two approaches.

  • As Greenwald explains, book value is a good estimate of intrinsic value if book value is close to the replacement cost of the assets.  The true economic value of the assets is the cost of reproducing them at current prices.
  • Another way to determine intrinsic value is to figure out earnings power—also called normalized earnings—or how much the company should earn on average over the business cycle.  Earnings power typically corresponds to a market level return on the reproduction value of the assets.  In this case, your intrinsic value estimate based on normalized earnings should equal your intrinsic value estimate based on the reproduction value of the assets.

In some cases, earnings power may exceed a market level return on the reproduction value of the assets.  This means that the ROIC (return on invested capital) exceeds the cost of capital.  It can be exceedingly difficult, however, to determine by how much and for how long earnings power will exceed a market level return.  Often it’s a question of how long some competitive advantage can be maintained.  How long can a high ROIC be sustained?

As Buffett remarked:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.  The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

A moat is a sustainable competitive advantage.  Schloss readily admits he can’t determine which competitive advantages are sustainable.  That requires unusual insight.  Buffett can do it, but very few investors can.

As far as franchises or good businesses—companies worth more than adjusted book value—Schloss says he likes these companies, but rarely considers buying them unless the stock is close to book value.  As a result, Schloss usually buys mediocre and bad businesses at book value or below.  Schloss buys “difficult businesses” at clearly cheap prices.

Buying a high-growing company on the expectation that growth will continue can be quite dangerous.  First, growth only creates value if the ROIC exceeds the cost of capital.  Second, expectations for the typical growth stock are so high that even a small slowdown can cause the stock to drop noticeably.  Schloss:

If observers are expecting the earnings to grow from $1.00 to $1.50 to $2.00 and then $2.50, an earnings disappointment can knock a $40 stock down to $20.  You can lose half your money just because the earnings fell out of bed.

If you buy a debt-free stock with a $15 book selling at $10, it can go down to $8.  It’s not great, but it’s not terrible either.  On the other hand, if things turn around, that stock can sell at $25 if it develops its earnings.

Basically, we like protection on the downside.  A $10 stock with a $15 book can offer pretty good protection.  By using book value as a parameter, we can protect ourselves on the downside and not get hurt too badly.

Also, I think the person who buys earnings has got to follow it all the darn time.  They’re constantly driven by earnings, they’re driven by timing.  I’m amazed.



(Boeing 377 Stratocruiser, San Diego Air & Space Museum Archives, via Wikimedia Commons)

Cigar butts—deep value stocks—are characterized by two things:

  • Poor past performance;
  • Low expectations for future performance, i.e., low multiples (low P/B, low P/E, etc.)

Schloss has pointed out that Graham would often compare two companies.  Here’s an example:

One was a very popular company with a book value of $10 selling at $45.  The second was exactly the reverse—it had a book value of $40 and was selling for $25.

In fact, it was exactly the same company, Boeing, in two very different periods of time.  In 1939, Boeing was selling at $45 with a book of $10 and earning very little.  But the outlook was great.  In 1947, after World War II, investors saw no future for Boeing, thinking no one was going to buy all these airplanes.

If you’d bought Boeing in 1939 at $45, you would have done rather badly.  But if you’d bought Boeing in 1947 when the outlook was bad, you would have done very well.

Because a cigar butt is defined by poor recent performance and low expectations, there can be a great deal of upside if performance improves.  For instance, if a stock is at a P/E (price-to-earnings ratio) of 5 and if earnings are 33% of normal, then if earnings return to normal and if the P/E moves to 15, you’ll make 900% on your investment.  If the initial purchase is below true book value—based on the replacement cost of the assets—then you have downside protection in case earnings don’t recover.



If you buy stocks that are protected on the downside, the upside takes care of itself.

The main way to get protection on the downside is by paying a low price relative to book value.  If in addition to quantitative cheapness you focus on companies with low debt, that adds additional downside protection.

If the stock is well below probable intrinsic value, then you should buy more on the way down.  The lower the price relative to intrinsic value, the less downside and the more upside.  As risk decreases, potential return increases.  This is the opposite of what modern finance theory teaches.  According to theory, your expected return only increases if your risk also increases.

In The Superinvestors of Graham-and-Doddsville, Warren Buffett discusses the relationship between risk and reward.  Sometimes risk and reward are positively correlated.  Buffett gives the example of Russian roulette.  Suppose a gun contains one cartridge and someone offers to pay you $1 million if you pull the trigger once and survive.  Say you decline the bet as too risky, but then the person offers to pay you $5 million if you pull the trigger twice and survive.  Clearly that would be a positive correlation between risk and reward.  Buffett continues:

The exact opposite is true with value investing.  If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.  The greater the potential for reward in the value portfolio, the less risk there is.

One quick example:  The Washington Post Company in 1973 was selling for $80 million in the market.  At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more.  The company owned the Post, Newsweek, plus several television stations in major markets.  Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater.  And to people that think beta measures risk, the cheaper price would have made it look riskier.  This is truly Alice in Wonderland.  I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.

Link: https://bit.ly/2jBezdv

Most brokers don’t recommend buying more on the way down because most people (including brokers’ clients) don’t like to buy when the price keeps falling.  In other words, most investors focus on price instead of intrinsic value.



A stock trading at a low price relative to book value—a low P/B stock—is usually distressed and is experiencing problems.  But there are several ways for a cigar-butt investor to win, as Schloss explains:

The thing about buying depressed stocks is that you really have three strings to your bow:  1) Earnings will improve and the stocks will go up;  2) somebody will come in and buy control of the company;  or 3) the company will start buying its own stock and ask for tenders.

Schloss again:

But lots of times when you buy a cheap stock for one reason, that reason doesn’t pan out but another reason does—because it’s cheap.



Look at the history of the company.  Value line is helpful for looking at history 10-15 years back.  Also, read the annual reports.  Learn about the ownership, what the company has done, when business they’re in, and what’s happened with dividends, sales, earnings, etc.

It’s usually better not to talk with management because it’s easy to be blinded by their charisma or sales skill:

When we buy into a company that has problems, we find it difficult talking to management as they tend to be optimistic.

That said, try to ensure that management is honest.  Honesty is more important than brilliance, says Schloss:

…we try to get in with people we feel are honest.  That doesn’t mean they’re necessarily smart—they may be dumb.

But in a choice between a smart guy with a bad reputation or a dumb guy, I think I’d go with the dumb guy who’s honest.

Finally, insider ownership is important.  Management should own a fair amount of stock, which helps to align their incentives with the interests of the stockholders.

Speaking of insider ownership, Walter and Edwin Schloss had a good chunk of their own money invested in the fund they managed.  You should prefer investment managers who, like the Schlosses, eat their own cooking.



(Illustration by Lkeskinen0)

You have to be willing to make mistakes if you want to succeed as an investor.  Even the best value investors tend to be right about 60% of the time and wrong 40% of the time.  That’s the nature of the game.

You can’t do well unless you accept that you’ll make plenty of mistakes.  The key, again, is to try to limit your downside by buying well below probable intrinsic value.  The lower the price you pay (relative to estimated intrinsic value), the less you can lose when you’re wrong and the more you can make when you’re right.



No one can predict the stock market.  Ben Graham observed:

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

(Illustration by Maxim Popov)

Or as value investor Seth Klarman has put it:

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

Perhaps the best quote comes from Henry Singleton, a business genius (100 points from being a chess grandmaster) who was easily one of the best capital allocators in American business history:

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

Singleton built Teledyne using extraordinary capital allocation skills over the course of more than three decades, from 1960 to the early 1990’s.  Fourteen of these years—1968 to 1982—were a secular bear market during which stocks were relatively flat and also experienced a few large downward moves (especially 1973-1974).  But this long flat period punctuated by bear markets didn’t slow down or change Singleton’s approach.  Because he consistently bought very good value, on the whole his acquisitions grew significantly in worth over time regardless of whether the broader market was down, flat, or up.

Of course, it’s true that if you buy an undervalued stock and then there’s a bear market, it may take longer for your investment to work.  However, bear markets create many bargains.  As long as you maintain a focus on the next 3 to 5 years, bear markets are wonderful times to buy cheap stocks (including more of what you already own).

In 1955, Buffett was advised by his two heroes, his father and Ben Graham, not to start a career in investing because the market was too high.  Similarly, Graham told Schloss in 1955 that it wasn’t a good time to start.

Both Buffett and Schloss ignored the advice.  In hindsight, both Buffett and Schloss made great decisions.  Of course, Singleton would have made the same decision as Buffett and Schloss.  Even if the market is high, there are invariably individual stocks hidden somewhere that are cheap.

Schloss always remained fully invested because he knew that virtually no one can time the market except by luck.



Don’t be in too much of a hurry to sell… Before selling try to reevaluate the company again and see where the stock sells in relation to its book value.

Selling is hard.  Schloss readily admits that many stocks he sold later increased a great deal.  But he doesn’t dwell on that.

The basic criterion for selling is whether the stock price is close to estimated intrinsic value.  For a cigar butt investor like Schloss, if he paid a price that was half book, then if the stock price approaches book value, it’s probably time to start selling.  (Unless it’s a rare stock that is clearly worth more than book value, assuming the investor was able to buy it low in the first place.)

If stock A is cheaper than stock B, some value investors will sell A and buy B.  Schloss doesn’t do that.  It often takes four years for one of Schloss’s investments to work.  If he already has been waiting for 1-3 years with stock A, he is not inclined to switch out of it because he might have to wait another 1-3 years before stock B starts to move.  Also, it’s very difficult to compare the relative cheapness of stocks in different industries.

Instead, Schloss makes an independent buy or sell decision for every stock.  If B is cheap, Schloss simply buys B without selling anything else.  If A is no longer cheap, Schloss sells A without buying anything else.



John Templeton’s worst ten years as an investor were his first ten years.  The same was true for Schloss, who commented that it takes about ten years to get the hang of value investing.



(Photo by Juan Moyano)

Walter Schloss and his son Edwin sometimes would spend a whole day discussing current events, social trends, etc.  Edwin Schloss said:

If you’re not in touch with what’s going on or you don’t see what’s going on around you, you can miss out on a lot of investment opportunities. So we try to be aware of everything around us—like John Templeton says in his book about being open to new ideas and new experiences.



Try not to let your emotions affect your judgment.  Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.

Quantitative investing is a good way to control emotion.  This is what Graham suggested and practiced.  Graham just looked at the numbers to make sure they were below some threshold—like 2/3 of current assets minus all liabilities (the net-net method).  Graham typically was not interested in what the business did.

On the topic of discipline and controlling your emotions, Schloss told a great story about when Warren Buffett was playing golf with some buddies:

One of them proposed, “Warren, if you shoot a hole-in-one on this 18-hole course, we’ll give you $10,000 bucks.  If you don’t shoot a hole-in-one, you owe us $10.”

Warren thought about it and said, “I’m not taking the bet.”

The others said, “Why don’t you?  The most you can lose is $10. You can make $10,000.”

Warren replied, If you’re not disciplined in the little things, you won’t be disciplined in the big things.”

Be careful of leverage.  It can go against you.  Schloss acknowledges that sometimes he has gotten too greedy by buying highly leveraged stocks because they seemed really cheap.  Companies with high leverage can occasionally become especially cheap compared to book value.  But often the risk of bankruptcy is too high.

Still, as conservative value investor Seth Klarman has remarked, there’s room in the portfolio occasionally for a super cheap, highly indebted company.  If the probability of success is high enough, it may not be a difficult decision.  If you pick the right one, you can make 10 times your money.



Sometimes you can get good ideas from other investors you know or respect.  Even Buffett did this.  Buffett called it “coattail riding.”

Schloss, like Graham and Buffett, recommends a diversified approach if you’re doing cigar butt (deep value) investing.  Have at least 15-20 stocks in your portfolio.  A few investors can do better by being more concentrated.  But most investors will do better over time by using a quantitative, diversified approach.

Schloss tended to have about 100 stocks in his portfolio:

…And my argument was, and I made it to Warren, we can’t project the earnings of these companies, they’re secondary companies, but somewhere along the line some of them will work out.  Now I can’t tell you which ones, so I buy a hundred of them.  Of course, it doesn’t mean you own the same amount of each stock.  If we like a stock we put more money in it.  Positions we are less sure about we put less in… We then buy the stock on the way down and try to sell it on the way up.

Even though Schloss was quite diversified, he still took larger positions in the stocks he liked best and smaller positions in the stocks about which he was less sure.

Schloss emphasized that it’s important to know what you know and what you don’t know.  Warren Buffett and Charlie Munger call this a circle of competence.  Even if a value investor is far from being the smartest, there are hundreds of microcap companies that are easy to understand with enough work.

(Image by Wilma64)

The main trouble in investing is overconfidence: having more confidence than is warranted by the evidence.  Overconfidence is arguably the most widespread cognitive bias suffered by humans, as Nobel Laureate Daniel Kahneman details in Thinking, Fast and Slow.  By humbly defining your circle of competence, you can limit the impact of overconfidence.  Part of this humility comes from making mistakes.

The best choice for most investors is either an index fund or a quantitative value fund.  It’s the best bet for getting solid long-term returns, while minimizing or removing entirely the negative influence of overconfidence.



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

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

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

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


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

My e-mail: jb@boolefund.com


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

University of Berkshire Hathaway

(Image:  Zen Buddha Silence by Marilyn Barbone.)

April 22, 2018

Daniel Pecaut and Corey Wrenn recently published a wonderful book, University of Berkshire Hathaway.  The book is a summary of 30 years’ worth of teachings delivered by Warren Buffett and Charlie Munger at the annual meetings of Berkshire Hathaway (1986 through 2015).

Pecaut and Wrenn had the same idea that many value investors have had:  To figure out how to succeed as a value investor, it makes sense to study the best.  Warren Buffett and Charlie Munger are at the top of the list.

(Photo by USA International Trade Administration, via Wikimedia Commons)

Through 2017, after 52 years under Buffett and Munger’s management, the value of Berkshire Hathaway has grown 2,404,748% versus 15,508% for the S&P 500 Index.  Compounded annually, that’s 20.9% per year for Berkshire stock versus 9.9% per year for the S&P 500.

(Photo by Nick Webb)

Pecaut and Wrenn point out a key fact about how Buffett and Munger have achieved this stunning success:

More than two-thirds of Berkshire’s performance over the S&P was earned during down years.  This is the fruit of Buffett and Munger’s “Don’t lose” philosophy.  It’s the losing ideas avoided, as much as the money made in bull markets that has built Berkshire’s superior wealth over the long run.

Buffett himself has made the same point, including at the 2007 meeting.  His best ideas have not outperformed the best ideas of other great value investors.  However, his worst ideas have not been as bad, and have lost less over time, as compared with the worst ideas of other top value investors.

Pecaut then states:

Though Corey and I have been aware of the results for a number of years, we still marvel at Buffett and Munger’s marvelous achievement.  They have presided over one of the greatest records of wealth-building in history.  For five decades, money under Buffett’s control has grown at a phenomenal rate.

In the 1970s, the annual meeting of Berkshire Hathaway was attended by a half-dozen people or so.  In recent years, there have been roughly 40,000 attendees.  The event has been dubbed “Woodstock for Capitalists.”

(2011 Berkshire Hathaway Annual Meeting, Photo by timbu, licensed under CC BY 2.0)

Pecaut and Wrenn write that studying the teachings of Professors Buffett and Munger can be as good as an MBA if you’re a value investor.  They declare:

It is, without a shadow of a doubt, the best investment either of us has ever made.

That’s not to say there are any easy answers if you want to become a good value investor.  It takes many years to master the art.  And even after you’ve found an investment strategy that fits you personally, you must keep learning and improving forever.

There are two important points to make immediately.  First, it’s a statistical fact that most of us will do better over time by adopting a fully automated investment strategy — whether indexed or quantitative.

Second, whether you use an automated strategy or not, if you’re investing relatively small sums, you are likely to do best by focusing on micro caps (companies with market caps under $300 million).  Most great value investors, including Buffett and Munger, started their careers investing in micro caps.  In general, you can get the best returns by investing in micro caps because they are largely neglected by investors.  Also, most microcap businesses are tiny and thus easier to understand.

Although Pecaut and Wrenn’s book is organized by year, I’ve re-arranged the teachings of Buffett and Munger based on topic.  Here’s the outline:

Value Investing

  • Value Investing
  • What vs. When
  • Temperament and Discipline
  • Modern Portfolio Theory
  • Growth, Book Value
  • Business Risk
  • Good Managers
  • Sustainable Competitive Advantage
  • Know the Big Cost
  • Basic “Macro Thesis”
  • Macro Forecasting
  • Capital-Intensive Businesses
  • Cyclical Industries

Thinking for Yourself

  • Logic, Not Emotion
  • Intellectual Independence
  • In/Out/Too Hard
  • Information:  Good, Not Quick

Lifetime Learning

  • Lifetime Learning and Constructive Criticism
  • Invest in Yourself
  • Making It In Business
  • Multidisciplinary Models, Opportunity Cost
  • Biographies:  Improve Your Friends

What is Berkshire Hathaway?

  • Berkshire Hathaway
  • Berkshire:  Good Home for Good Businesses
  • No Master Plan
  • Culture
  • Munger’s Optimism
  • Legacy


  • Buying National Indemnity
  • Insurance and Hurricanes
  • Building the Insurance Business
  • The Unexpected

Comments on Specific Investments

  • BYD
  • 3G Capital Partners

Other Topics

  • The Game of Bridge
  • The Ovarian Lottery
  • Predicting Changes in Technology
  • Inflation:  Gold vs. Wonderful Business
  • Luck and an Open Mind
  • The Luckiest Crop in History


Value Investing


Here’s a summary of the basic concepts of value investing.  The intrinsic value of any business is the total cash that will be generated by the business in the future, discounted back to the present.  Another way to think of intrinsic value is “what a company would bring if sold to a knowledgeable buyer.”

Typically, if a value investor thinks a business is worth X, they will try to buy it at 1/2 X.  This creates a margin of safety in case the investor has made a mistake or experiences bad luck.  If the investor is roughly correct, they can double their money or better.

(Ben Graham, the father of value investing and Warren Buffett’s teacher and mentor, Equim43 via Wikimedia Commons)

Many good value investors are right 60% of the time and wrong 40% of the time.  Mistakes and surprises (both good and bad) are inevitable for every investor.  That’s why a margin of safety is essential.

Another wrinkle is business quality.  When Buffett and Munger started their careers, they followed the teachings of Ben Graham.  In Graham’s approach, business quality doesn’t matter as long as you buy a basket of cheap stocks.  However, Buffett and Munger slowly learned from experience the following lesson:

It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

If you buy a mediocre or bad business at half price, the problem is that the intrinsic value of the business can decline.  On the other hand, if you buy a great business, it’s often hard to overpay because the value compounds over time.

A great business is one that has a high return on invested capital (ROIC) — and high return on equity (ROE) — that can be sustained, ideally for decades.  If you pay a fair or even high price, but hold the business for decades, then your annual return eventually will approximate the ROE of the business.

  • Say a business has an ROE of 40% and can sustain it over time.  Then your annual return as investor, if you hold the stock over decades, eventually will approximate 40%.  That’s the power of investing in a high-quality business.
  • But such a great business is exceedingly rare and hard to find.  Tread very carefully.  The vast majority of investors are unable to invest successfully using this method.

Also bear in mind that Buffett and Munger have never paid any attention to forecasts, whether of the economy, interest rates, the stock market, or elections.  When they’ve been able to find a good or great business at a reasonable price, they’ve always bought, regardless of forecasts and regardless of the current economic or political situation.

  • Most investors who’ve paid attention to forecasts have done worse than they would have done had they simply ignored forecasts.
  • Buffett and Munger focus exclusively on the future cash flow of the individual business as compared to its current price.  Typically they assume the future cash flow will occur over decades.  Thus, shorter term forecasts of the stock market or the economy are irrelevant, in addition to being fundamentally unreliable (see Macro Forecasting below).

Central to this approach is circle of competence, or a clear awareness of which businesses you can understand.  It doesn’t matter if most businesses are beyond your ability to analyze as long as you stick with those businesses than you can analyze.

  • Even if you were only able to understand 100-200 simple businesses, eventually a few of them will become cheap for temporary reasons.  That’s all you need.  Getting to that point may take a few years, though, so it’s essential that you enjoy the process.  Otherwise, just stick with index funds or quantitative value funds.

For a value investor, there are no called strikes.  As Buffett has explained, you can stand at the plate all day and watch hundreds of “pitches” — businesses at specific prices — without taking a swing.  You wait for the “fat pitch” — a business you can really understand that’s available at a good price.

What’s the ideal business?  One that has a high and sustainable ROIC (and ROE).  Or, as Buffett put it at the 1987 Berkshire meeting:

Something that costs a penny, sells for a dollar and is habit forming.

Moreover, a company with a sustainably high ROIC is the best hedge against inflation over time, according to Buffett and Munger.  But it’s very difficult to find businesses like this.  There just aren’t that many.  And since Buffett and Munger have to invest tens of billions of dollars a year — unlike earlier in their careers — they’re forced to focus mostly on larger businesses.

At the 1996 meeting, Buffett observed that they invested in high-quality businesses that were easy to understand and not likely to change much.  Specifically, they had investments in soft drinks, candy, shaving, and chewing gum.  Buffett:

There’s not a whole lot of technology going into the art of the chew.



Buffett and Munger have observed that having the right temperament and extraordinary discipline is far more important than IQ for long-term success in investing.  (Of course, if you’ve got the right temperament plus a great deal of discipline, high IQ certainly helps.)

High IQ alone won’t bring success in investing.  Buffett said at the 2004 meeting that Sir Isaac Newton, one of the smartest people in history, wasted much time trying to turn lead into gold and also lost a bundle in the South Sea Bubble.



Buffett and Munger have been critical of modern portfolio theory for a long time.  Munger often notes that to a man with a hammer, every problem looks pretty much like a nail.  Buffett has observed that academics have been able to gather huge amounts of data on past stock prices.  When there’s so much data, it’s often easy to find patterns.  Also, those who have been trained in higher mathematics sometimes feel the need to apply that skill even to areas that are better understood in very simple terms.  Buffett:

The business schools reward difficult, complex behavior more than simple behavior, but simple behavior is more effective.

A key part of modern portfolio theory is EMH — the Efficient Market Hypothesis.  EMH takes different forms.  But essentially it says that all available information is already reflected in stock prices.  Therefore, it’s not possible for any investor to beat the market except by luck.

Buffett and Munger have maintained that markets are usually efficient, but not always.  If an investor has enough patience and diligence, occasionally she will discover certain stock prices that are far away from intrinsic value.

Moreover, a stock is not just a price that wiggles around.  A stock represents fractional ownership in the underlying business.  Some businesses are simple enough to be understandable.  The dedicated investor can gain enough understanding of certain businesses so that she can know if the stock price is obviously too high or too low.  Modern portfolio theorists have overlooked the fact that a stock represents fractional ownership of a business.

Buffett advises thinking about buying part ownership of a business like you would think about buying a farm.  You’d want to look at how much it produces on average and how much you’d be willing to pay for that.  Only then would you look at the current price.

(Farmland at Moss Landing, California, Photo by Fastily via Wikimedia Commons)

Furthermore, if you owned a farm, you wouldn’t consider selling just because a farm nearby was sold for a lower-than-expected price.  In Chapter 12 of The General Theory of Employment, Interest, and Money, John Maynard Keynes uses a similar example:

But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments.  It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week.



Growth only creates value if the company has a return on invested capital (ROIC) that is higher than the cost of capital.

Also, if a company has a sustainably high ROIC and ROE, then book value is not an important factor in the investment decision.  Book value, Buffett said, is what was put into the business in the past.  What matters is how much cash you can take out of the business in the future.  If the company is high quality — with a sustainably high ROIC and ROE — then it’s hard to pay too high a price if you’re going to hold it for decades.  (In the 1990’s, Buffett and Munger noted that the average ROE for American businesses was about 12-13%.)

However, it’s exceptionally difficult to identify a business that will maintain a high ROIC and ROE for a couple of decades or more.  Buffett and Munger have been able to do it because they are seriously smart and they are learning machines who’ve constantly evolved.  Most investors simply cannot beat the market, regardless of their method.  Most investors would be better off investing in a low-cost index fund or in a quantitative value fund.



(Photo by Alain Lacroix)

At the 1997 meeting, Buffett identified three key business risks.  First, in general, a company with high debt is at risk of bankruptcy.  A good recent example of this is Seadrill Ltd. (NYSE: SDRL).  This company was an industry leader that was started by billionaire John Fredriksen (who started out in shipping, which he continues to do).  Seadrill is an excellent company, but it’s now in serious trouble because of its high debt levels.  Fredriksen has been forced to launch a new offshore drilling company.

The second business risk Buffett mentioned is capital intensity.  The ideal business has a sustainably high ROE and low capital requirements.  That doesn’t necessarily mean that a capital-intensive business can’t be a good investment.  For instance, Berkshire recently acquired the railroad BNSF.  The ROE obviously isn’t nearly as high as that of a company like See’s Candies.  But it’s a solid investment for Berkshire.

  • As Buffett and Munger have explained, if the ROE on a regulated business is 11-12%, but part of Berkshire’s capital is insurance float that costs 3% or less, that’s obviously a good situation because the return on capital exceeds the cost by at least 8-9% per year.  In some years, Berkshire’s insurance float has even had a negative cost, meaning that Berkshire has been paid to hold it.

A third business risk is being in a commodity business.  Because a true commodity business — like an oil producer — has no control over price, it must be a low-cost producer to be a good investment.



Buffett and Munger have explained that they look for .400 hitters in the business world.  Buffett says when he finds one, and can buy the business at a reasonable price while keeping the manager in place, he is thrilled.  He doesn’t then try to tell the .400 hitter how to swing.  Instead, he lets the star continue to run the business as before.

Buffett has also commented that it’s quite difficult to pay a .400 hitter too much.  A great manager can make a world of difference for a business.  For instance, when Robert Goizueta took over Coca-Cola in 1981, its market value was $4 billion.  As of 1997, Buffett remarked, the market value exceeded $150 billion.

Using another analogy, Buffett has said that he loves painting his own canvas and getting applause for it.  So he looks for managers who are wired the same way.  He gives them the freedom to continue to paint their own paintings.  Also, they don’t have to talk with shareholders, lawyers, reporters, etc.



Buffett and Munger look for companies that have a sustainably high ROIC (and ROE).  To maintain a high ROIC (and ROE) requires a sustainable competitive advantage.  Buffett:

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

Buffett and Munger have also used the term moat.  In 1995, Munger said the ideal business is a terrific castle with an honest lord.  The moat is a barrier to competition and can take many forms including low costs, patents, trademarks, technology, or advantages of scale.

(Bodiam Castle in England, Photo by Allen Watkin, via Wikimedia Commons)

A sustainable competitive advantage — a moat — is very rare.  The essence of capitalism is that high returns get competed away.  Generally if a company is experiencing a high ROIC, competitors will enter the market and drive the ROIC down toward the cost of capital.

  • ROIC (return on invested capital) is a more accurate measure of how the business is doing than ROE (return on equity).  Buffett uses return on net tangible assets, which is ROIC.
  • But ROE is close to ROIC for companies with low or no debt, which are the types of companies Berkshire usually prefers.
  • Also, ROE is a bit more intuitive when you’re thinking about the advantages of holding a high-quality business for decades.  In this situation, your returns as an investor will approximate the ROE over time.

When you buy a great business with a sustainably high ROIC, you typically only have to be smart once, says Buffett.  But if it’s a mediocre business, you have to stay smart.

Buffett has also observed that paying a high price for a great business is rarely a mistake.



A superior cost structure is often central to a company’s competitive advantage.  Buffett said in 2001 that he doesn’t care whether the business is raw-material-intensive, people-intensive, or capital-intensive.  What matters is that the business must have a sustainable competitive advantage whereby a relatively high ROIC and ROE can be maintained.

ROIC must stay above the cost of capital.  A superior cost structure is a common way to help achieve this.



The only long-term macro thesis Buffett has is that America will continue to do well and grow over time.  Buffett often points out that in the 20th century, there were wars, a depression, epidemics, recessions, etc., but the Dow went from 66 to 11,000 and GDP per capita increased sixfold.

As long as you believe GDP per capita will continue to increase, even if a bit more slowly, then you want to buy (and hold) good businesses.  For most investors, you should simply buy (and hold) either a quantitative value fund or a low-cost broad market index fund.

Another way Buffett has put it: In 1790, there were four million people in America, 290 million in China, and 100 million in Europe.  But 215 years later — as of 2005 — America has 30% of the world’s GDP.  It’s an unbelievable success story.



Looking historically, there are virtually no top investors or business people who have done well from macro forecasting — which includes trying to predict the stock market, the economy, interest rates, or elections.  As for those investors who have done well from macro forecasting, luck played a key role in most cases.

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.

Consider efforts to forecast what the stock market will do in any given year.  There have always been pundits making such predictions, but no one has been able to do it correctly with any sort of consistency.

(Illustration by Maxim Popov)

Furthermore, if you simply focus on individual businesses, as Buffett and Munger advise and have always done, then what happens to the overall stock market doesn’t matter.  Bear markets occur periodically, but their timing is unpredictable.  Also, even in a bear market, some stocks decline less than the market and some stocks even go up.  If you’re focused on individual businesses, then the only “macro” thesis you need is that the U.S. and global economy will continue to grow over time.

Virtually every top investor and business person has done well by being heavily invested in businesses (often only a few).  As Buffett and Munger have repeatedly observed, understanding a business is achievable, while forecasting the stock market is not.

Indeed, when Buffett started his career as an investor, both Graham and his father told him the Dow was too high.  Buffett had about $10,000.  Buffett has commented since then that if he had listened to Graham and his father, he would still probably have about $10,000.

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.  In other words, the fact that certain pundits turned out to be right during one period tells you virtually nothing about which pundits will turn out to be right in some future period.

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.

Consider Buffett’s recent 10-year bet on index funds versus hedge funds.

Buffett chose a very low-cost Vanguard 500 index fund.  Protégé Partners, Buffett’s counterparty to the bet, selected the five best “funds-of-hedge funds” that it could.  As a group, those funds-of-hedge funds invested in over 200 hedge funds.  Buffett writes in the 2017 annual letter:

Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund.  This assemblage was an elite crew, loaded with brains, adrenaline, and confidence.

Here are the results of the 10-year bet:

Net return after 10 years
Fund of Funds A 21.7%
Fund of Funds B 42.3%
Fund of Funds C 87.7%
Fund of Funds D 2.8%
Fund of Funds E 27.0%
S&P 500 Index Fund 125.8%


Compound Annual Return
Fund of Funds A 2.0%
Fund of Funds B 3.6%
Fund of Funds C 6.5%
Fund of Funds D 0.3%
Fund of Funds E 2.4%
S&P 500 Index Fund 8.5%

To see a more detailed table of the results, go to page 12 of the Berkshire 2017 Letter: http://berkshirehathaway.com/letters/2017ltr.pdf

Many forecasters (including many investors) have predicted, starting in 2012 or 2013 and continuing up until today (April 2018), that the S&P 500 Index was going to be far lower.  One reason the hedge funds involved in Buffett’s bet didn’t do well at all, as a group, is because many of them were hedged against a possible market decline.

  • The timing of bear markets is unpredictable.  Also, the stock market has recovered from every decline and has eventually gone on to new highs.  (As long as humans keep making progress in technology and in other areas, the stock market will keep increasing over the long term.)  For these reasons, it virtually never pays to hedge against market declines.
  • Most of those who successfully hedged against the bear market in 2008 missed the recovery starting in 2009.  Said differently, most of those who “successfully” (mostly by luck) hedged against the bear market in 2008 would have been at least as well off if they’d stayed fully invested without hedging.

Virtually no one predicted 2800+ on the S&P 500, which again shows that forecasting the stock market is just not doable on a repeated basis.

  • Even at 2800+, the S&P 500 Index may not be significantly overvalued because interest rates are low and profit margins are structurally higher, as Professor Bruce Greenwald of Columbia University suggested in this Barron’s interview:  http://www.barrons.com/articles/bruce-greenwald-channeling-graham-and-dodd-1494649404
  • The largest companies include Apple, Alphabet (Google), Microsoft, Amazon, and Facebook, most of which have far higher normalized profit margins and ROE than the vast majority of large companies in history.  Software and related technologies are becoming much more important in the world economy.
  • Moreover, progress in computer science or in other technologies could accelerate.  For instance, a big breakthrough in artificial intelligence could conceivably boost GDP by 5-10% or more.  Historically, it’s never paid to bet against progress, especially technological progress.



In 1994, Munger commented that figuring out the future of an individual business is much more doable — and repeatable — than trying to make a macro forecast — which can’t be done repeatedly.  Munger:

To think about what will happen versus when is a far more efficient way to behave.



In 2010, Buffett discussed Berkshire’s recent investment in capital-intensive businesses.  He noted that for most of its history under current management, Berkshire tried to invest in high ROIC (and ROE) businesses that don’t require much capital, with See’s Candies being the best example.  However, due to its many successful investments, Buffett has had torrents of cash coming to headquarters for many years now.

There simply are not many businesses like See’s, and besides, as Berkshire gets larger, Buffett would need to find hundreds of companies like See’s in order to move the needle.

Buffett started investing in MidAmerican Energy in 1999.  Buffett learned that a regulated, capital-intensive business like this could earn decent returns of 11-12%.  Not brilliant and nothing like See’s.  But still decent, with ROIC above the cost of capital.

Based on his experience with MidAmerican Energy, Buffett reached the decision to acquire Burlington Northern Santa Fe (BNSF) for Berkshire.  Again, a capital-intensive, regulated business, but with a strong competitive position and with decent returns on capital.

(BNSF, Photo by Winnie Chao)

Also remember that Berkshire’s insurance float continues to have low cost — often 3% or less, and sometimes even negative.  Investing such low-cost float at 11-12% returns is quite good.



Most investors don’t invest in cyclical companies because they don’t like earnings that are highly variable and unpredictable.  As a result, many cyclical companies can get very cheap indeed.

Buffett and Munger focus on normalized earnings instead of current earnings.  The volatility and unpredictability of current earnings creates some wonderful opportunities for long-term value investors.

The Boole Microcap Fund had an investment in Atwood Oceanics, which was acquired by Ensco plc. (NYSE: ESV) last year.  The Boole Fund continues to hold Ensco because it’s very cheap.  The current price is $5.43, while book value per share is $26.86.

Just how cheap is Ensco?

  • Low case: If oil prices languish below $60 for the next 3 to 5 years, then Ensco will be a survivor, due to its large fleet, globally diverse customer base, industry leading customer satisfaction ratings, and well-capitalized position.  Ensco is likely worth at least half of book value ($26.86 a share), which would be $13.43 a share, nearly 150% higher than today’s $5.43.
  • Mid case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years – which is likely based on long-term supply and demand – then Ensco is probably worth at least book value ($26.86 a share), nearly 400% higher than today’s $5.43.
  • High case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years – and if global rig utilization normalizes – then Ensco could easily be worth at least 150% of book value, which is $40+ a share, over 640% higher than today’s $5.43.

Note that oil-related companies in general are often excellent long-term investments.  They outperform the broader market over time, especially when they are cheap, as they are today.  And oil-related companies offer notable diversification, inflation protection, and exposure to global growth.

See this paper by Jeremy Grantham and Lucas White (you may have to register, but it’s free): https://www.gmo.com/docs/default-source/research-and-commentary/strategies/equities/global-equities/an-investment-only-a-mother-could-love-the-case-for-natural-resource-equities.pdf

Buffett has pointed out that See’s Candies loses money eight months out of the year.  But the company has been phenomenally profitable over the decades.

(Photo by Cihcvlss, via Wikimedia Commons)


Thinking for Yourself


(Photo by Djama86)

Buffett first learned this lesson from Ben Graham:

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

Focus on what is knowable and important.  Ignore the crowd.  The market is there to serve you, not to instruct you.  Graham:

Basically, price fluctuations have only one significant meaning for the true investor.  They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.  At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Buffett has often suggested, including in 2010, that most investors would be better off if there were no stock market quotations.  Buy a good business and then totally ignore prices.  Just follow the progress of the business over time.  If you don’t want to follow individual businesses, then simply buy a low-cost index fund or a quantitative value fund.



Buffett and Munger have pointed out that you’re better off as an investor not knowing popular opinion.  You’re better off learning as much as you can about businesses that you can understand.  You’re better off insulating yourself from the crowd.

Along these lines, Buffett has also commented that he’s never read an analyst report.  All the information you need can be found in the company’s financial statements.  If you need more information, you can conduct scuttlebutt research by talking with employees, customers, suppliers, competitors, etc.

Munger has said that you should focus only on the intrinsic value of the business.  If it’s a business you can understand, then only after you have a rough estimate of intrinsic value do you look at the current price.  In other words, you figure out the value of the business based on what it does and its financials.  You don’t look to the current price for information (other than as a market consensus).



Buffett and Munger have remarked that they have three boxes for potential investment ideas: in, out, and too hard.

It’s a big advantage if you classify most ideas as “too hard” because that means you can focus only on those businesses that you can understand.  As Buffett said at the 2006 meeting, if you’re fast, you can run the 100 meters for the gold medal.  You don’t have to throw the shot put.

Buffett has also often observed that generally you don’t get paid for degree of difficulty in investing.  Many of the best investment ideas have been rather simple.

At the 2008 meeting, Buffett mentioned that if it’s a worthwhile investment idea, he can usually make a good decision in five minutes.  Buffett said spending five months wouldn’t improve the quality of the decision past the five minute point.  Similarly, if it’s a “no go,” Buffett typically cuts off the proposal mid-sentence.



In 1994, Buffett said good information is far more important than quick information.  His primary source for information is annual reports.  Buffett said if the mail and quotes were delayed three weeks, he would still do just fine.


Lifetime Learning


Buffett and Munger are learning machines.  Buffett always says to read everything you can get your hands on.

Munger observed in 2003 that “Berkshire has been built on criticism.”  The ability to take constructive criticism is a central part of being a rational learning machine.

(Illustration by Hafakot)

Buffett and Munger also indicated in 2003 that their biggest errors have been errors of omission rather than commission.  Buffett said that Berkshire would have made roughly $10 billion if he had finished buying Wal-Mart.  The stock went up a bit when Buffett started buying.  Buffett waited for it to come back down, but it never did.



Buffett and Munger contend that the very best investment you can make is in yourself.  Become a learning machine, and never stop learning about your passions and areas of interest.  You’ve got one brain and one life, so maximize them and have fun along the way.

(Photo by Marek Uliasz)

Do what you love.  Work for people you admire.  You can become, to a large extent, the person you want to be, notes Buffett.  And if you hang around people better than you, you’ll become better.



In 2010, Buffett said the common factor for all of Berkshire’s excellent managers is that they love what they do.  Buffett noted that there’s nothing like following your passion.

Munger again recommended being a learning machine.  If you resolve to go to bed each night wiser than when you got up, you may rise slowly, but you’re sure to rise.

Buffett and Munger also reminded investors: stay in your circle of competence.  The size of the circle isn’t important, but knowing its boundaries is crucial.

For most investors, a quantitative value fund or an index fund is the best option.  (Buffett advises his own friends of modest means to stick with index funds.)

  • The Boole Microcap Fund is a quantitative value fund.



Munger has long argued that in order to be as rational a thinker and decision-maker as you can be, you need to master the primary models in the major disciplines.  Munger noted at the meeting in 2000 that these models include probability in math and break-points and back-up systems in engineering.

Here’s a discussion of big ideas in the major subject areas: http://boolefund.com/lifelong-learning/

If you’ve only mastered one area, that can create many problems.

To a man with a hammer, every problem looks pretty much like a nail.

Moreover, Munger has pointed out that when you’re making a decision — investment or otherwise — your best decision is automatically a function of your next-best decision, which is your “opportunity cost.”



In 1988, Munger recommended reading biographies and “making friends with the eminent dead.”  This is a good way to improve your experience while also improving the quality of your friends.

Biographies are often a good way to learn about a specific subject when the person written about is an expert in that subject.


What is Berkshire Hathaway?

People often think Berkshire Hathaway is like a mutual fund that owns many positions in equities.  But that’s not correct.  See Buffett’s 2016 letter to shareholders:  http://berkshirehathaway.com/letters/2016ltr.pdf

(I focus here on the 2016 letter because it’s the most recent letter that still contains some discussion of the major business areas.  Going forward —including 2017 — you have to go to the annual report to see the discussion.  Here’s the 2017 annual report: http://berkshirehathaway.com/2017ar/2017ar.pdf)


(Berkshire Hathaway logo via Wikimedia Commons)

First, Berkshire Hathaway is one of the largest and most successful insurance companies in the world.  Berkshire owns excellent property/casualty (P/C) insurance companies, including reinsurance and also GEICO.  Berkshire has operated at an underwriting profit for 14 consecutive years — up to but not including 2017 — generating a total pre-tax gain of $28 billion.

Second, Berkshire owns outright many great (and many good) individual businesses.  This includes 44 businesses in manufacturing, services, and retailing.  Buffett refers to this group as a “motley crew,” with a couple earning an unlevered return on net tangible assets in excess of 100%.  Most earn returns in the 12% to 20% range.  As well, some of these businesses have many individual business lines.  For instance, notes Buffett, Marmon has 175 separate business units.

  • Many of these businesses can operate far better being owned by Berkshire than they would if they were independent.  These companies can focus entirely on building long-term intrinsic value, without worrying about shorter term results or capital.  They can make the capital investments that make sense.  If they generate excess capital, it is sent to the parent company level, where Warren Buffett can invest it in the best available opportunities.
  • Viewed as a single business, says Buffett, in 2016 this entity employed $24 billion in net tangible assets and earned 24% after-tax on that capital.
  • Recent additions include Duracell and Precision Castparts.

Third, Berkshire owns regulated businesses such as Berkshire Hathaway Energy — a multi-state, multi-country utility business, including renewable energy projects and gas pipelines.  Buffett:

When it comes to wind energy, Iowa is the Saudi Arabia of America.

The other major regulated business is Burlington Northern Santa Fe.  For BNSF, it takes a single gallon of diesel fuel to move a ton of freight almost 500 miles.  This makes railroads four times as fuel-efficient as trucks, writes Buffett.

Fourth, Berkshire owns businesses Buffett classifies as finance and financial products.  This includes CORT (furniture), XTRA (semi-trailers), and Marmon (primarily tank cars but also freight cars, intermodal tank containers and cranes).  And there’s Clayton Homes.  Most of its revenue comes from the sale of manufactured homes, but most of its earnings result from a large mortgage portfolio.

  • Clayton’s customers are usually lower-income families who would not otherwise be able to own a home.  Monthly payments average only $587, including the cost of insurance and property taxes.  Clayton has programs — such as loan extensions and payment forgiveness — to help borrowers through difficulties.  Clayton foreclosed on only 2.5% of its mortgage portfolio in 2016.

Finally, Berkshire has well over $100 billion in public equities, such as American Express, Apple, Coca-Cola, IBM, Phillips 66, U.S. Bancorp, and Wells Fargo.  Note that Todd Combs and Ted Weschler each manage more than $12 billion of Berkshire’s public equity portfolio.

Buffett and Munger have always been highly ethical leaders, seeking to follow all laws and rules, and also working to treat their partners and employees as they would wish to be treated were their positions reversed.



In 2013, Munger remarked that Buffett was highly successful early in his career, when he managed an investment partnership, because he had very little competition.  This occurred primarily because Buffett focused on microcap companies, where few other investors ever look.

  • Even today, micro caps are overlooked and neglected by the vast majority of investors.  There’s far less competition in microcap investing, especially as compared with mid caps and large caps.  You can usually find a far greater number of undervalued stocks among micro caps.  That’s why I launched the Boole Microcap Fund, to help folks profit in a systematic way from inexpensive micro caps:  http://boolefund.com/best-performers-microcap-stocks/
  • Because Buffett is one of the best investors ever, his returns today, were he starting again, would still be phenomenal.  In fact, Buffett has said on many occasions that if he were starting again today, he could get 50% annual returns by investing in micro caps.

So the key to Buffett’s early success was no real competition.

Similarly, one reason Berkshire Hathaway has become remarkably successful today is lack of competition.  Berkshire is one of the only companies that buys great or good businesses on the condition that those businesses continue to be run as before (ideally by the same manager).  Moreover, Buffett can usually decide in five minutes whether to buy the business in question.  And no seller ever worries about Berkshire’s check clearing.

Berkshire gets many calls no one else gets.  Berkshire has the money, the willingness to act immediately, and the policy that the business be run as before.  Perhaps even more importantly, Munger has noted, Berkshire uses the golden rule in its treatment of subsidiaries:  Berkshire seeks to treat subsidiaries as it would itself like to be treated were the positions reversed.

To illustrate the point, Buffett told the story of a business owner thinking about selling.  He worried that if he sold to competitors, they would fire the people who built the business.  The new owners would behave like Attila the Hun.

If the owner sold the business to a private equity firm, they would load it up with debt with the goal of reselling it.  And when they resold it, the Attila the Hun scenario would occur again.

The owner concluded that selling to Berkshire was not necessarily wonderful, but it was the only real choice.  Buffett then commented that this particular business turned out to be an outstanding acquisition for Berkshire.  The people stayed, and the previous owner is still doing what he loves.  Buffett:

Our competitive advantage is that we have no competitors.

A similar situation happened with Nebraska Furniture Mart (NFM).  Rose Blumkin, known as “Mrs. B”, borrowed $500 from her brother and launched NFM in 1937.  Mrs. B sold products at cheaper prices than her competitors in the furniture business.

(Nebraska Furniture Mart logo, via Wikimedia Commons)

In 1983, at the age of 89, Mrs. B was interested in selling.  Many were interested in buying, but Mrs. B only wanted to sell to “Mr. Buffett”.  She sold him 80% of Nebraska Furniture Mart based on a one-page deal and a handshake.  (Buffett later commented that Mrs. B was the best entrepreneur he’d ever met and could run rings around chief executives of the Fortune 500.)

Finally, Buffett mentioned that Berkshire has a different shareholder base.  Virtually everyone — including owner/managers — thinks like a long-term owner.



In 2001, say Pecaut and Wrenn, Buffett observed that he and Charlie did not have any master plan.  They just were continuing to focus on allocating capital as rationally as they could.

Henry Singleton, CEO of Teledyne, who has been described by Buffett and Munger as the greatest CEO/capital allocator in American business history, also never had a plan.

Furthermore, Buffett and Munger have often remarked that, as a value investor, you only need one good idea a year to do well over time.



In 2015, Buffett talked about developing the right culture.  It takes a long time.  Culture comes from the top.  The leader must consistently set a good example and communicate well.  Good behavior must be rewarded and bad behavior punished.

The Golden Rule

Buffett asserted that always striving to treat people the way you would like to be treated has always been a core value at Berkshire.



People love Munger for his brilliance, wit, and honesty.  He tells it like it is in as few words as possible.  Munger sometimes comes across as a curmudgeon next to Buffett, who’s typically very upbeat and optimistic.

But the truth is that Munger loves science and technology, and is extremely optimistic about the future.  He has said that most problems are technical problems that will be solved.  The future is very bright.

At the same time, Munger recommends low expectations and gratitude — in addition to hard work and honesty — as a recipe for personal happiness.  Be grateful for all the good things and good people in life.  Keep your expectations low, and you’ll often be pleasantly surprised.  Be stoic through the inevitable challenges.

Munger also commented at a Daily Journal meeting in 2016 that what you want to be is stressed and challenged.  Your full potential can only come out if you challenge yourself and if you embrace all the challenges that life throws at you.



In 2011, Munger joked that Warren wanted people to say at his funeral, “That’s the oldest looking corpse I ever saw.”

More seriously, write Pecaut and Wrenn, Munger wanted his own tombstone to read, “Fairly won, wisely used.”

Buffett, for his part, wanted to be remembered as “Teacher.”  Buffett loves teaching.  At every annual meeting, Buffett and Munger spend virtually six hours teaching.  In addition to that, Buffett writes the annual letter as a form of teaching.  Buffett appears in the media frequently.  And Buffett generously hosts many hundreds of business students, who come in groups every year to Omaha for hours of great teaching.

As a young man, Buffett taught at the University of Nebraska:

(via Wikimedia Commons)


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




In 2003, Buffett told the story of how he bought National Indemnity from Jack Ringwalt in 1967.  Buffett had noticed that Ringwalt would get worked up once a year for 15 minutes, threatening to sell the company.  Buffett asked a mutual friend, Charlie Heider, to let Buffett know the next time Ringwalt had an episode.

Heider called Buffett one day to let him know Jack was ready.  Buffett immediately called Ringwalt and was able to buy the company from him.  National Indemnity was the foundation for Berkshire Hathaway, which today is one of the largest and most successful insurance companies in the world.



In 2006, Buffett remarked that Hurricane Katrina was a $60 billion event and Berkshire paid out $3.4 billion.  This brought up the question of whether the preceding two years, or the previous 100 years, was the best way to think about the future.  Buffett announced:

We’re in.  If the last two years hold, we’re not getting enough.  If the last 100 years hold, we’re getting paid plenty.

Buffett imagined that there could be a $250 billion event, and that Berkshire’s exposure would be 4%, or $10 billion.  Pecaut and Wrenn pose the following question.  Berkshire has had about 8-10% of the property/casualty (P/C) insurance market based on their float.  But their exposure is around 4-5%.  How?  Shrewd, it seems.

Berkshire doesn’t care at all about smoothness of earnings, especially in P/C insurance.  Berkshire always has at least $20 billion in cash.  And it’s approaching the point where more cash than that will come in every year from its wide variety of businesses.  Thus, Berkshire is easily able to cover occasional large payments in P/C.

In brief, Berkshire gets larger, though lumpier earnings because it’s designed that way, whereas Berkshire’s competitors need some smoothness in their earnings.  Buffett says this is close to a permanent advantage for Berkshire that increases every year.



In 2011, Buffett said that Ajit Jain built Berkshire’s reinsurance business from scratch.  Buffett pointed out that Ajit is as rational as anyone he’s met and loves what he does.  There’s not a single decision Ajit has made that Buffett thinks he could have done better.

Furthermore, before Ajit came along, Berkshire spent 15 years in reinsurance not making any money.  Ajit turned Berkshire’s reinsurance business into a real profit center.

Buffett also remarked that it’s difficult to differentiate between a long-term trend and a series of random events.  This makes it very challenging to price reinsurance of catastrophes.  Buffett’s tactic is to assume the worst and price from there.

(Photo by Wittayayut Seethong)

Munger observed that P/C is not such a good business in itself.  You must be in the top 10% to do well.  Of course, to the extent that Berkshire maintains its huge float at a very low cost, it gains additional long-term benefits by investing a portion of the float in undervalued or high-quality businesses.

In 2013, Buffett commented that it’s much better to build the reinsurance business — rather than buy — once you’ve got the right people and plenty of capital.

  • As Pecaut and Wrenn record, Buffett has often emphasized that Berkshire is “an unusually rational place.”  Buffett has said that it’s been good that he and Charlie have not had outside influences pushing them in unwanted directions.
  • Specifically in insurance, Berkshire has chosen to write no policies at all (for long stretches of time) if the prices are not right.  This has added to their long-term profitability, even though their earnings are lumpier than most.  (One time National Indemnity shrunk its business by 80% until prices recovered.)
  • Most insurers are pressured by Wall Street to increase premiums every year.  But some years insurance prices don’t make sense and virtually guarantee losses.  As well, many managers do not have much vested interest in the insurer they manage.  This makes them even more likely to give in because they don’t want criticism or pressure.
  • To make matters worse, if other insurers are writing policies and collecting premiums when prices don’t make sense, then there is “social proof” or a “bandwagon effect”:  it appears that many others are doing well at the moment, even if it’s long-term unprofitable.
  • It’s not greed, but envy that drives much human behavior, says Buffett.  Envy is particularly stupid because there’s no upside, adds Munger.  Buffett agrees, joking: “Gluttony is a lot of fun.  Lust has its place, too, but we won’t get into that.”
  • Recently some hedge funds have gotten into reinsurance.  Buffett commented that anything Wall Street can sell, it will.  Munger chimed in, saying Wall Street would “throw in a lot of big words, too.”
  • Buffett concluded that if you own a gas station, and the guy across the street sells below cost, you’ve got a problem.  But insurance works differently.  It pays over time not to write policies when prices don’t make sense.
  • Munger: “With our cranky methods, we probably have the best insurance operation in the world.  So why change?”



Having spent decades in insurance, Buffett and Munger know how to think about risks and probabilities.  In 2004, Buffett said people tend to underestimate risks that haven’t happened for awhile, while overestimating risks when they’ve happened recently.

Buffett also has repeatedly stated that the person who runs Berkshire after Buffett must be able to consider scenarios that have never occurred before.

Here’s something else to keep in mind.  Assume there’s only a 2% chance of some event happening in any given year.  Assume the probability stays unchanged from year to year.  Then after 50 years, there’s a 63.6% chance the event will have occurred.  After 100 years, there’s an 86.7% chance the event will have ocurred.

(Photo by Michele Lombardo)

Berkshire is extremely rigorous in its consideration of various risks.  Buffett quipped at the 2005 meeting:

It’s Armageddon around here every day.

Buffett and Munger say they’ll never lose sleep because they are very careful and conservative in how they’ve structured Berkshire.  As Buffett asks, why have even a tiny risk of failure just to get an extra percentage point of return?  Ironically, write Pecaut and Wrenn, Buffett and Munger’s conservative approach has led to one of the highest multi-decade records of compounding anywhere.


Comments on Specific Investments


In 2010, Munger recounted how he had lost money in a venture capital investment when he was young.  Finally, decades later, Munger came across BYD, a Chinese maker of rechargeable batteries and electric cars, employing over 17,000 top engineers.  Berkshire made an investment in BYD that has worked well.

(BYD logo via Wikimedia Commons)

Munger suggested that BYD is an illustration of Berkshire’s commitment to keep learning.



When Berkshire acquired control of GEICO in 1995, the auto insurer had 2.5% market share.  At the end of 2016, GEICO had reached 12% of industry volume.  GEICO’s low costs — they sell direct without agents — gives it a very sustainable competitive advantage.

(GEICO logo by Dream out loud, via Wikimedia Commons)

Buffett recognized GEICO’s advantage long ago when writing his Columbia grad school thesis on the company.  Since 1995, Berkshire, under Buffett’s direction, has spent annually more on advertising for GEICO than the rest of the auto insurance industry combined.  The net result is that GEICO continues to gobble up market share every year.

  • Pecaut and Wrenn record that in 2013, two-thirds of all new auto policies went to GEICO.

Additionally, GEICO has enjoyed excellent management.  Buffett on Tony Nicely:

Tony became CEO of GEICO in 1993, and since then the company has been flying.  There is no better manager than Tony, who brings his combination of brilliance, dedication and soundness to the job.  (The latter quality is essential to sustained success. As Charlie says, it’s great to have a manager with a 160 IQ – unless he thinks it’s 180.)  Like Ajit, Tony has created tens of billions of value for Berkshire.

See page 10 of Buffett’s 2016 letter:  http://berkshirehathaway.com/letters/2016ltr.pdf



Berkshire recently joined with 3G Capital Partners on some deals, including the $23 billion acquisition of Heinz in 2013.  3G’s Jorge Paulo Lemann and Warren Buffett have known each other since they were both on the board of Gillette.

At the 2015 meeting, a question was asked about 3G’s method of significantly reducing the workforce of recently acquired companies.  Buffett replied that Burger King was now outperforming its competitors by a wide margin, thanks to the cost-cutting methods of 3G.

Buffett then noted that the railroad business had 1.6 million people employed after World War II.  Now the railroad industry has under 200,000 employees, but it is much larger, more efficient, and safer.  In short, Buffett applauds 3G’s achievements.  Ongoing progress and improvement is the nature of capitalism.



In 2013, Buffett announced that Berkshire was buying the final 20% of ISCAR that it didn’t own from the Wertheimer family for roughly $2 billion.

Buffett compared ISCAR to Sandvik, a Swedish company that owns Sandvik Tooling and Seco Tools — competitors of ISCAR.  Buffett stated that Sandvik is very good, but ISCAR — an Israeli company — is much better.

How did ISCAR become so good?  Buffett said the combination of brains and a huge amount of passion is what created ISCAR’s success.  ISCAR has long had talented and extremely hard-working people who constantly improve the product and work to delight customers.  Buffett praised ISCAR as one of the best companies in the world.


Other Topics


In the 1990’s, Buffett and Munger commented that their main job is capital allocation.  Buffett: “Aside from that, we play bridge.”  Bridge is a great game for value investors because you constantly have to make decisions based on probabilities.

www.bridgebase.com is a great site for learning and playing bridge.  Like most games, bridge gets increasingly fun the more you learn how to play.  (I enjoy bridge and chess, though I’m still a novice at both.)

(Image by Otm, via Wikimedia Commons)



In order to create a fair economic and political system, Buffett suggests using a thought experiment called The Ovarian Lottery.  The idea is that you get to write the rules for society.  The catch is that it’s 24 hours before you will be born and you don’t know if you’ll be bright or retarded, female or male, able or disabled, etc.

No one chooses the advantages or disadvantages of one’s birth.  If you go through this thought experiment carefully, you’re likely to set up a fair society.  American political philosopher John Rawls used a similar thought experiment:  https://en.wikipedia.org/wiki/John_Rawls

Warren Buffett’s hero is his father, Howard Buffett.  Warren has called him the best human being he ever knew.  But Howard Buffett was a Republican.  Warren Buffett became a Democrat over time, partly through the influence of his wife, Susie, and partly due to thinking along the lines of The Ovarian Lottery.



Buffett and Munger have generally avoided investing in technology companies because it’s extremely difficult to predict how technology will change.  As Munger commented at the 1999 meeting:

The development of the streetcar led to the rise of the department store.  Since streetcar lines are immovable, it was thought that the department store had an unbeatable position.  Offering revolving credit and a remarkable breadth of merchandise, the department store was king.  Yet in time, while the rails remained, the streetcars disappeared.  People moved to the suburbs, which led to the rise of the shopping center and ended the dominance of department stores.

Now the Internet poses a threat to both.



What’s a better inflation hedge, gold or owning a wonderful business?

When Buffett took over Berkshire, the stock was trading at three-quarters of an ounce of gold.  Now gold is just north of $1,280, while Berkshire is around $250,000.  Berkshire has returned 20x more than gold.  It’s no contest.



In 2015, Buffett remarked that he’d experienced many pieces of good luck, three in particular:  meeting Lorimer Davidson, buying National Indemnity, and hiring Ajit Jain.

  • When Buffett was a young man, he stopped by a GEICO office on a Saturday.  Buffett told the guard he was a student of Ben Graham.  The guard let him in.  Buffett met Lorimer Davidson, a GEICO executive.  Davidson thought he would spend 5 minutes helping a student of Graham.  But when Davidson started talking with Buffett, he recognized how unusually smart and knowledgeable Buffett was.  So Davidson answered Buffett’s questions and educated him on the insurance business for four hours.  Buffett claims that he learned more in those four hours than he could have at any university course.
  • As described earlier, Buffett bought National Indemnity from Jack Ringwalt.  Buffett had noticed that Ringwalt would want to sell for about 15 minutes each year.  Buffett was very patient, and then persuasive and decisive.
  • In the mid 1980’s, Ajit Jain walked in on a Saturday offering to work for Berkshire even though he didn’t have any experience in insurance.

Buffett has marveled at his good luck.  He also observes that maintaining an open mind has been essential.



Buffett has frequently repeated that babies born in America today are the luckiest crop in history.  GDP per capita is higher than ever.  The standard of living is higher than ever.  The average person today lives far better than John D. Rockefeller, for instance.  Innovation and economic growth continue to move forward.

Buffett still says that, if he were given the choice of being born anywhere today, he would choose the U.S. over any other place.




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

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

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

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


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

My e-mail: jb@boolefund.com


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

Made in America

(Image:  Zen Buddha Silence by Marilyn Barbone.)

April 8, 2018

Made in America is the autobiography of Sam Walton, founder of Wal-Mart.  It’s a terrific book.  H. Ross Perot commented:

Every person who dreams of building a great business must read this book.  Sam Walton set the standard for listening to his customers and listening to the people who do the work.  In addition to being a great entrepreneur and business leader, Sam Walton was, above all, a fine, decent, kind, generous man.


  • Learning to Value a Dollar
  • Starting on a Dime
  • Bouncing Back
  • Swimming Upstream
  • Raising a Family
  • Recruiting the Team
  • Taking the Company Public
  • Rolling Out the Formula
  • Building the Partnership
  • Stepping Back
  • Creating a Culture
  • Making the Customer Number One
  • Meeting the Competition
  • Expanding the Circles
  • Thinking Small
  • Giving Something Back
  • Running a Successful Company: Ten Rules That Worked For Me

Sam Walton:

…ours is a story about the kinds of traditional principles that made America great in the first place.  It is a story about entrepreneurship, and risk, and hard work, and knowing where you want to go and being willing to do what it takes to get there.  It’s a story about believing in your idea even when maybe some other folks don’t, and about sticking to your guns.  But I think more than anything it proves there’s absolutely no limit to what plain, ordinary working people can accomplish if they’re given the opportunity and the encouragement and the incentive to do their best.  Because that’s how Wal-Mart became Wal-Mart: ordinary people joined together to accomplish extraordinary things.

(Photo by Sven, via Wikimedia Commons)



Walton says growing up during the Great Depression impacted his views on money.  Walton’s dad – who was a very hard worker – had a number of jobs, including banker, farmer, farm-loan appraiser, insurance agent, and real estate agent.  When he was out of work in the Great Depression, Walton’s dad eventually went to work for his brother’s Walton Mortgage Company.

In twenty-nine, thirty, and thirty-one, he had to repossess hundreds of farms from wonderful people whose families had owned the land forever… All of this must have made an impression on me as a kid…

Walton’s mother started a little milk business.  Young Walton helped his mom.  Walton also started selling magazine subscriptions.  And he had a paper route from the seventh grade through college.

I learned from a very early age that it was important for us kids to help provide for the home, to be contributors rather than just takers.  In the process, of course, we learned how much hard work it took to get your hands on a dollar, and that when you did it was worth something.  One thing my mother and dad shared completely was their approach to money: they just didn’t spend it.

(Image by Hohum, via Wikimedia Commons)

Walton remarks that he didn’t know much about business, even after earning a college degree in the subject.  When he got to know his wife Helen’s family, he learned a great deal from Helen’s father L. S. Robson.  Walton writes:

He influenced me a great deal.  He was a great salesman, one of the most persuasive individuals I have ever met.  And I am sure his success as a trader and a businessman, his knowledge of finance and the law, and his philosophy had a big effect on me.  My competitive nature was such that I saw his success and admired it.  I didn’t envy it.  I admired it.  I said to myself: maybe I will be as successful as he is someday.

Helen’s father organized the family businesses as a partnership.  Walton later adopted this approach, creating what would later be called Walton Enterprises.

How does Walton view money?

Here’s the thing: Money has never meant that much to me, not even in the sense of keeping score.  If we had enough groceries, and a nice place to live, plenty of room to keep and feed my bird dogs, a place to hunt, a place to play tennis, and the means to get the kids good educations – that’s rich.  No question about it.  And we have it.  We’re not crazy.  We don’t live like paupers the way some people depict us.  We all love to fly, and we have nice airplanes, but I’ve owned about eighteen airplanes over the years, and I never bought one of them new.

When it comes to Wal-Mart, Walton has always been very cheap.  Wal-Mart didn’t buy a jet until the company approached $40 billion in sales “and even then they had to practically tie me up and hold me down to do it.”  In the early days of Wal-Mart, when they went on buying trips, they’d pack as many as eight people into one room.

Why did Wal-Mart continue to be cheap even after it had become a behemoth?  Walton:

We exist to provide value to our customers, which means that in addition to quality and service, we have to save them money.  Every time Wal-Mart spends one dollar foolishly, it comes right out of our customers’ pockets.  Every time we save them a dollar, that puts us one more step ahead of the competition – which is where we always plan to be.



Walton was always ambitious:

Mother must have been a pretty special motivator, because I took her seriously when she told me I should always try to be the best I could at whatever I took on.  So, I have always pursued everything I was interested in with a true passion – some would say obsession – to win.  I’ve always held the bar pretty high for myself: I’ve set extremely high personal goals.

(Photo by Travelling-light)

As a kid, Walton was a class officer several years.  He was also a Boy Scout.  And he played football, baseball, and basketball.   In both high school and college (at the intramural level), he continued to play sports.

In high school, Walton was student body president and he was active in many clubs.  He enjoyed basketball and was a “gym rat,” always at the gym playing hoops.  When Walton was a senior, his basketball team went undefeated and won the state championship.  This was one of his “biggest thrills.”

Walton continues:

My high school athletic experience was really unbelievable, because I was also the quarterback on the football team, which went undefeated too – and won the state championship as well… I guess I was just totally competitive as an athlete, and my main talent was probably the same as my best talent as a retailer – I was a good motivator.

Walton comments that his ambition and competitive spirit led him to consider as a distant goal running for President of the United States.  In the meantime, he became president of the student body while at the University of Missouri.  Walton:

I learned early that one of the secrets to campus leadership was the simplest thing of all: speak to people coming down the sidewalk before they speak to you.  I did that in college.  I did it when I carried my papers.  I would always look ahead and speak to the person coming toward me.  If I knew them, I would call them by name, but even if I didn’t I would still speak to them… I ran for every office that came along.

(Illustration by Madmirror)

While in college, Walton continued delivering papers.  He had hired a few helpers by this point, and was making $4,000 to $5,000 a year.  [That’s the equivalent of at least $60,000 to $75,000 in 2018 dollars.]  Walton also waited tables and was a lifeguard.  He graduated from the University of Missouri in June 1940.

Walton thought he was going to be an insurance salesman because his high school girlfriend’s father sold insurance for General American Life Insurance Company.  It seemed like a lucrative career and Walton knew he could sell.

Walton wanted to attend Wharton business school, but he realized that even with his paper route and other jobs, he wouldn’t have enough money to pay for it.  Walton met with two company recruiters who came to the Missouri campus.  One was from J. C. Penney and the other from Sears Roebuck.

Walton says he got into retail – starting at J. C. Penney – simply because he was tired and wanted “a real job.”  Although he was only making $75 a month, Walton loved retail.  That’s where he stayed for the next fifty-two years.

Walton almost lost his job because he had never learned handwriting very well.  Fortunately, the store manager, Duncan Majors, was a great motivator and believed in Walton.  Duncan Majors was proud of having trained more Penney managers than anyone else in the country at that time.  He spent time training and developing all his boys.

By early 1942, as an ROTC graduate, Walton prepared to join the war effort.  But he flunked the physical due to a minor heart irregularity.  Walton wandered south, toward Tulsa, thinking he might like to work in the oil business.  Instead, he got a job at a big Du Pont gunpowder plant in the town of Pryor, outside Tulsa.  That’s where he met his wife Helen Robson at a bowling alley.  She was smart, educated, ambitious, opinionated, strong-willed, and energetic, and she was an athlete who enjoyed the outdoors.

Walton served in the military:

I wish I could recount a valiant military career – like my brother Bud, who was a Navy bomber pilot on a carrier in the Pacific – but my service stint was really fairly ordinary time spent as a lieutenant and then as a captain doing things like supervising security at aircraft plants and POW camps in California and around the country.

By 1945, Walton knew he wanted to go into a retailing and to own his own store.  He read every book he could on retailing.

People today, looking back, know that Wal-Mart initially had a small-town strategy.  This was just luck.  Helen, Sam Walton’s wife, said she wouldn’t live in any town with more than 10,000 people.

Walton discovered that there was a Ben Franklin variety store that he could run in Newport, Arkansas – a cotton and railroad town of 7,000 people.  The current owner was losing money and wanted to sell the store.  Walton bought it for $25,000 – $5,000 of his own money and $20,000 from Helen’s father.  Walton made a mistake, however, by not examining the lease agreement carefully.

(Photo by PenelopeIsMe, via Wikimedia Commons)

Walton set an ambitious goal:

I wanted my little Newport store to be the best, most profitable variety store in Arkansas within five years… Set that as a goal and see if you can’t achieve it.  If it doesn’t work, you’ve had fun trying.

One important lesson Walton grasped early on was that you can learn from everybody.  Walton would spend the rest of his career implementing this principle.  He would visit as many stores as possible and speak with as many people as possible.

At the beginning, Walton’s main competition was across the street: Sterling Store, managed by John Dunham.  Walton spent huge amounts of time visiting Sterling Store in order to absorb as much as he could.

Walton also learned a great deal from the Ben Franklin franchise program.  It was a complete course in how to run a store.  The only trouble was that franchisees weren’t given much discretion.  Walton was told what merchandise to sell and how much to sell it for.  Walton also had to buy the merchandise at set prices.  Soon Walton started buying merchandise directly from manufacturers.  He was always looking for “offbeat suppliers” from whom he could get a good deal.  Walton did a lot of driving.

Walton says he learned a simple lesson that would later change the way retailers sell and customers buy:

…say I bought an item for 80 cents.  I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20.  I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater.  Simple enough.  But this is really the essence of discounting… In retailer language, you can lower your markup but earn more because of the increased volume.

Walton tried many different promotional things.  For instance, they put a popcorn machine and then an ice cream machine out in front of the store.  Both turned out to be profitable.

No matter how well things were going, Walton was a tinkerer:

…I never could leave well enough alone, and, in fact, I think my constant fiddling and meddling with the status quo may have been one of my biggest contributions to the later success of Wal-Mart.

(Illustration by lkonstudio)

When Walton took over the Ben Franklin store, it had done $72,000 in annual sales.  The first year Walton managed the store, it did $105,000 in sales.  The second year was $142,000 and the third year was $175,000.

After five years, Walton ended up reaching his goal:

That Little Ben Franklin store was doing $250,000 in sales a year, and turning $30,000 to $40,000 a year in profit.  It was the number-one Ben Franklin store – for sales and profit – not only in Arkansas, but in the whole six-state region.

Unfortunately, Walton was unable to keep the store because he forgot to include a clause in the lease that gave him an option to renew after the first five years.  Walton notes that it was the low point of his business career.  But he remained determined:

I’ve never been one to dwell on reverses, and I didn’t do so then.  It’s not just a corny saying that you can make a positive out of most any negative if you work at it hard enough.  I’ve always thought of problems as challenges, and this one wasn’t any different… I didn’t dwell on my disappointment.  The challenge at hand was simple enough to figure out: I had to pick myself up and get on with it, do it all over again, only even better this time.



Helen’s father and Walton drove to Bentonville, Arkansas.  They found an old variety store whose owners were looking to sell.  But the two parties couldn’t reach an agreement.  Later, on his own, Helen’s father was able to reach an agreement with the sellers.

Although the store had done only $32,000 in sales before Walton bought it, he had big plans.  Walton had heard about two Ben Franklin stores that were using a new concept: self-service.  All the merchandise was sitting on shelves for the customers to pick out.  The check-out registers were at the front of the store.

(Illustration by Alexmillos)

Walton adopted the self-service concept for his Bentonville store.  He called it Walton’s Five and Dime.  The store did well right away.  Part of the reason was Walton’s friendliness and his habit of yelling at people from a block away.

Walton then started looking for other stores that he could manage in other towns.  He found one in Fayetteville and used the same name: Walton’s Five and Dime.  It, too, was set up using self-service.  Walton comments:

This was the beginning of our way of operating for a long while to come.  We were innovating, experimenting, and expanding.  Somehow over the years, folks have gotten the impression that Wal-Mart was something I dreamed up out of the blue as a middle-aged man, and that it was just this great idea that turned into an overnight success.  It’s true that I was forty-four when we opened our first Wal-Mart in 1962, but the store was totally an outgrowth of everything we’d been doing since Newport – another case of me being unable to leave well enough alone, another experiment.  And like most other overnight successes, it was twenty years in the making.

Walton made his first real hire at the manager level: Willard Walker.  Walton found Willard by looking in competitors’ stores.  He would continue using this approach to finding talent going forward.  Also, Walton offered Willard equity in the business.

Meanwhile, Walton’s brother Bud had bought his own Ben Franklin store in Versailles, Missouri.  So Walton asked his brother if he wanted to go fifty-fifty on a new Ben Franklin store that was going to be part of a shopping center in Kansas City.  Bud agreed.

Based on what he saw in Kansas City, Walton got the notion of going into shopping center development.  He persisted with the idea for two years.  But it didn’t work.

I probably lost $25,000, and that was at a time when Helen and I were counting every dollar.  It was probably the biggest mistake of my business career.  I did learn a heck of a lot about the real estate business from the experience, and maybe it paid off somewhere down the line – though I would rather have learned it some cheaper way.

Wal-Mart executive David Glass:

Two things about Sam Walton distinguish him from almost everyone else I know.  First, he gets up every day bound and determined to improve something.  Second, he is less afraid of being wrong than anyone I’ve ever known.  And once he sees he’s wrong, he just shakes it off and heads in another direction.

Walton developed a love of flying.  His first plane, a two-seater, only went 100 miles an hour, but it allowed him to get places in a straight line.  One time, the motor cut off for about a minute.  Walton thought he was done.  But he was able to circle around and land with a dead engine.

(Photo by TSRL, via Wikimedia Commons)

As Walton proceeded to open up new stores, he created business partnerships that included – along with other partners – himself, Bud, Sam’s dad, Helen’s two brothers, and even Sam and Helen’s kids, who invested their paper route money.

John Walton (one of Sam and Helen’s four kids):

This is hard to believe, but between my paper route money and the money I made in the Army – both of which I invested in those stores – that investment is worth about $40 million today.

In less than fifteen years, they had become the largest independent variety store operator.  But in 1960, they were still only doing $1.4 million a year.  Walton continued to look for ways to improve.

Soon he learned that if they built a huge store, they could sell as much as $2 million a year from one location.  Walton traveled the country to look at the “early discounters.”  For example, in California, Sol Price had started Fed-Mart.  Closer to Arkansas, there was Herb Gibson, who sold cheaper than anyone else, but also sold higher volume than anyone else.

Soon Walton built his first discount store – what would become the first Wal-Mart.  Because they couldn’t use Ben Franklin at all, Walton had to make arrangements with a distributor in Springfield, Missouri.  Since nobody wanted to take a chance on the first Wal-Mart, Sam and Helen had to borrow even more than they already had:

We pledged houses and property, everything we had.  But in those days, we were always borrowed to the hilt.

By the time they had three Wal-Marts up and running, Walton knew that it would work.



Wal-Mart’s challenges strengthened it:

Many of our best opportunities were created out of necessity.  The things that we were forced to learn and do, because we started out underfinanced and undercapitalized in these remote, small communities, contributed mightily to the way we’ve grown as a company.  Had we been capitalized, or had we been the offshoot of a large corporation the way I wanted to be, we might not ever have tried the Harrisons or the Rogers or the Springdales and all those other little towns we went into in the early days.

(Illustration by Miaoumiaou)

Early on, Wal-Mart didn’t have systems or computers.  Walton recalls that much of what they did was poorly done.  But they stayed focused on low prices:

The idea was simple: when customers thought of Wal-Mart, they should think of low prices and satisfaction guaranteed.  They could be pretty sure they wouldn’t find it cheaper anywhere else, and if they didn’t like it, they could bring it back.

Wal-Mart lacked established distributors.  Salesmen would randomly show up.  It was difficult to get the bigger companies like Proctor & Gamble to show any interest.

The basic discounter’s strategy was to sell health products – toothpaste, mouthwash, headache remedies, soap, shampoo – at cost.  This brought people into the store.  The discounter would price everything else also at low prices, but with a 30 percent markup.

Gradually, Walton phased out his variety stores until all the stores were Wal-Marts.

Headquarters would give a profit and loss statement to each individual Wal-Mart store.  Problems could be handled immediately.  Most store managers owned a piece of their stores, so they were incentivized to maximize profit over time.  Walton:

For several years the company was just me and the managers in the stores.  Most of them came to us from variety stores, and they turned into the greatest bunch of discount merchants anybody ever saw.  We all worked together, but each of them had lots of freedom to try all kinds of crazy things themselves.

Walton mentions Don Whitaker as being like an operations manager.  Claude Harris was the first buyer.

Walton talks about the importance of merchandising:

…there hasn’t been a day in my adult life when I haven’t spent time thinking about merchandising.  I suspect I have emphasized item merchandising and the importance of promoting items to a greater degree than most any other retail management person in this country.  It has been an absolute passion of mine.  It is what I enjoy doing as much as anything in the business.  I really love to pick an item – maybe the most basic merchandise – and then call attention to it.  We used to say you could sell anything if you hung it from the ceiling.  So we would buy huge quantities of some thing and dramatize it.  We would blow it out of there when everybody knew we would have only sold a few had we just left it in the normal store position.  It is one of the things that has set our company apart from the very beginning and really made us difficult to compete with.  And, man, in the early days of Wal-Mart it really got crazy sometimes.

(Illustration by Beststock Images)

For instance, one of Wal-mart’s managers, Phil Green, created the world’s largest display of Tide.  It was eighteen cases high, 75 or 100 feet long, and 12 feet wide.  Everyone thought Phil was crazy, but he sold all of it at deeply discounted prices.

Wal-Mart executive David Glass comments:

The philosophy it teaches, which rubs off on all the associates and the store managers and the department heads, is that your stores are full of items that can explode into big volume and big profits if you are just smart enough to identify them and take the trouble to promote them.

Glass explains that in retail, you’re either operations driven or merchandise driven.  If a retailer is merchandise driven, they can always improve operations.  But retailers that are operations driven often don’t learn merchandising.  Early every Saturday morning, Wal-Mart managers would meet and critique their own and others’ merchandising.  Walton:

We wanted everybody to know what was going on and everybody to be aware of the mistakes we made.  When somebody made a bad mistake – whether it was myself or anybody else – we talked about it, admitted it, tried to figure out how to correct it, and then moved on to the next day’s work.

Wal-Mart associates also continued Walton’s practice of constantly checking out the competition in order to find ways to improve.



On family vacations, it was a given that Walton would visit as many stores as possible.

Walton never pressured his kids at all to go into retailing.  But they got involved anyway.  Rob became the first company lawyer for Wal-Mart.  Jim got involved with locating and buying store sites.  John became the second company pilot.  (John was a Green Beret medic who later created a business that builds boats.)  Alice was a buyer for Wal-Mart and then developed her own investment company.

Walton worries that his grandchildren might join the “idle rich.”

Maybe it’s time for a Walton to start thinking about going into medical research and working on cures for cancer, or figuring out new ways to bring culture and education to the underprivileged…



Walton notes that he has the personality of a promoter but the soul of an operator.  He never stops trying to improve things.  When the idea of discounting began to catch on, Walton visited every store and every headquarters he could.  He gleaned something from each visit.  He may have gotten the most from his study of Sol Price, an excellent operator who had started Fed-Mart in southern California in 1955.  Walton:

I guess I’ve stolen – I actually prefer the word “borrowed” – as many ideas from Sol Price as from anybody else in the business.

Most discounters failed.  Walton explains:

It all boils down to not taking care of their customers, not minding their stores, not having folks in their stores with good attitudes, and that was because they never even really tried to take care of their own people.  If you want the people in the stores to take care of the customers, you have to make sure you’re taking care of the people in the stores.  That’s the most important single ingredient of Wal-Mart’s success.

As Wal-Mart continued to expand, it had to hire more executives.  Ferold Arend was the company’s first vice president of operations (and later president).

Logistics also became increasingly important.  Walton got the idea of using computers long before they were very useful.  But computers kept improving.  Abe Marks comments on Walton:

He was really ten years away from the computer world coming.  But he was preparing himself.  And this is a very important point: without the computer, Sam Walton could not have done what he’s done.  He could not have built a retailing empire the size of what he’s built, the way he built it.  He’s done a lot of other things right, too, but he could not have done it without the computer.  It would have been impossible.

A warehouse was long overdue.  But Walton had already borrowed heavily and the company also had borrowed heavily.  Walton:

…We were generating as much financing for growth as we could from the profits of the stores, but we were also borrowing everything we could.  I was taking on a lot of personal debt to grow the company – it approached $2 million [over $14 million in 2018 dollars]… The debt was beginning to weigh on me.

(Photo by Adonis1969)

Wal-Mart needed someone to run operations.  Walton hired a fellow named Ron Mayer.  Walton says 1968 to 1976 – the time Ron was in charge of operations – was the most important period in Wal-Mart’s history.  Walton:

We were forced to be ahead of our time in distribution and in communication because our stores were sitting out there in tiny little towns and we had to stay in touch and keep them supplied.  Ron started the programs that eventually improved our in-store communications system.  Building on the groundwork already laid by Ferold Arend, Ron also took over distribution and began to design and build a system that would enable us to grow as fast as we could come up with the money.  He was the main force that moved us away from the old drop shipment method, in which a store ordered directly from the manufacturer and had the merchandise delivered directly to the store by common carrier.  He pushed us in some new directions, such as merchandise assembly, in which we would order centrally for every store and then assemble their orders at the distribution center, and also cross-docking, in which preassembled orders for individual stores would be received on one side of our warehouse and leave out the other.



The company’s cash shortage forced it to give up five sites where they were going to build new stores.  Going public could solve the cash problem.  Thus far, there were a number of different partnership agreements for the various stores.

So Rob started to work on the plan, which was to consolidate all these partnerships into one company and then sell about 20 percent of it to the public.  At the time, our family owned probably 75 percent of the company, Bud owned 15 percent or so, some other relatives owned a percentage…

(Photo by Designer491)

Anybody who bought stock in Wal-Mart’s first public offering in late 1970 – at a price of $16.50 per share – and who held it, did extraordinarily well.  Walton:

…let’s say you bought 100 shares back in that original public offering, for $1,650.  Since then, we’ve had nine two-for-one stock splits, so you would have 51,200 shares today.  Within the last year, it’s traded at right under $60 a share.  So your investment would have been worth right around $3 million…

An investment of $1,650 in late 1970 would have turned into $3 million over the ensuing two decades.  An investment of $16,500 would have become $30 million.  Since then, Wal-Mart has continued to grow, albeit more slowly.

Going public allowed Walton to pay off all his debts.

Walton never worried about market expectations, especially over the short term:

If we fail to live up to somebody’s hypothetical projection for what we should be doing, I don’t care.  It may knock our stock back a little, but we’re in it for the long run.  We couldn’t care less about what is forecast or what the market says we ought to do.  If we listened very seriously to that sort of stuff, we never would have gone into small-town discounting in the first place.



Jack Shewmaker, later president and COO, made this remark about working at Wal-Mart in 1970:

It would be safe to say that in those days we all worked a minimum of sixteen hours  day.

(Illustration by Roman Doroshenko)

Kmart was expanding rapidly, but wouldn’t go into towns with below 50,000 population.  Gibson’s, another prominent discounter, wouldn’t go into towns much below 10,000.  But Wal-Mart knew it could be profitable even in towns with under 5,000.  As for big cities:

We never planned on actually going into the cities.  What we did instead was build our stores in a ring around a city – pretty far out – and wait for the growth to come to us.  That strategy worked practically everywhere.

The airplane became a useful tool for looking at real estate.  When Walton was flying, he would get low and turn the plane on its side when he passed over real estate of interest.

Walton would visit individual stores as often as possible, and he expected his executives to do the same.  But much of the day-to-day operations Walton left to folks like Ferold Arend and Ron Mayer, then later Jack Shewmaker, and after that David Glass and Don Soderquist.  Walton sees his role as picking good people and then giving them maximum authority and responsibility.  Many have pointed out that Walton is extremely good at picking the right people.

Every Saturday morning, Walton would go to work at 2 or 3 a.m.  He would spend several hours examining data for many of the stores.  This allowed him to be prepared for the Saturday morning meeting at 7:30 a.m.  Walton:

But if you asked me am I an organized person, I would have to say flat no, not at all.  Being organized would really slow me down.  In fact, it would probably render me helpless.  I try to keep track of what I’m supposed to do, and where I’m supposed to be, but it’s true I don’t keep much of a schedule.

Walton fondly recalls this initial period:

Managing that whole period of growth was the most exciting time of all for me personally.  Really, there has never been anything quite like it in the history of retailing.  It was the retail equivalent of a real gusher: the whole thing, as they say in Oklahoma and Texas, just sort of blowed.  We were bringing great folks on board to help make it happen, but at that time, I was involved in every phase of the business: merchandising, real estate, construction, studying the competition, arranging the financing, keeping the books – everything.  We were all working untold hours, and we were tremendously excited about what was going on.

(Photo by Bjørn Hovdal)

Wal-Mart’s phenomenal growth:

Year Stores Sales
1970 32 $31 million
1972 51 $78 million
1974 78 $168 million
1976 125 $340 million
1978 195 $678 million
1980 276 $1.2 billion

Walton observes:

On paper, we really had no right to do what we did.  We were all pounding sand, and stretching our people and our talents to the absolute maximum.

Walton would hire people who lacked experience but showed potential.  He believed that a lack of knowledge and experience could be overcome with passion and a willingness to work extremely hard.

Distribution continued to be challenging:

…I don’t think our distribution system ever really got under complete control until David Glass finally relented and came on board in 1976.  More than anybody else, he’s responsible for building the sophisticated and efficient system we use today.



Giving associates a stake in the business, and giving them the chance to participate in decisions that would impact profitability, was an essential part of Wal-Mart’s growth and success.

(Photo by Adonis1969)

Walton realized that the more you share profits with associates, the more profitable the company can become.  Walton explains:

…the way management treats the associates is exactly how the associates will then treat the customers.  And if the associates treat the customers well, the customers will return again and again, and that is where the real profit in this business lies, not in trying to drag strangers into your stores for one-time purchases based on splashy sales or expensive advertising.  Satisfied, loyal, repeat customers are at the heart of Wal-Mart’s spectacular profit margins, and those customers are loyal to us because our associates treat them better than salespeople in other stores do.

Walton says this biggest regret is not including associates in the initial profit-sharing plan when the company went public in 1970.  But in 1971, Walton started giving associates part ownership of the business.  Many associates realized they were better off working at Wal-Mart – which is non-unionized – than they would be working somewhere that is unionized.  Why?  Both because associates can become part owners and because Wal-Mart executives have a policy of always listening to any associate with an issue or idea.



One of Walton’s hobbies was tennis, which he preferred to golf since golf takes too long.  Walton’s tennis partner George Billingsley says about Walton:

He loved the game.  He never gave you a point, and he never quit.  But he is a fair man.  To him, the rules of tennis, the rules of business, and the rules of life are all the same, and he follows them.  As competitive as he is, he was a wonderful tennis opponent – always gracious in losing and in winning.  If he lost, he would say, ‘I just didn’t have it today, but you played marvelously.’

Walton also enjoyed training his dogs:

I pride myself on being able to train my own dogs, and I’ve never had a dog handler, like some of these country gentlemen friends of mine.  I enjoy picking out ordinary setter or pointer pups and working with them…

Walton nearly always had his dogs with him when he drove around.  He loved the outdoors and was a believer in conservation.  Also, he liked to hunt birds.  Some of his best friends were bird hunters.

(Photo by Cynoclub)

Walton stepped back somewhat from Wal-Mart in 1976.  Unfortunately, two factions in the company developed and they began to compete fiercely.  The old guard, including many store managers, were loyal to Ferol.  The new guard lined up behind Ron.  (Many in the new guard had been hired by Ron.)  Soon everybody began taking sides.  It was very unhealthy.

Walton made the problem much worse by appointing Ron CEO.  Walton thought things might run OK this way.  But Walton couldn’t stay out of things.  He continued doing everything he was doing before.

The truth is, I failed at retirement worse than just about anything else I’ve ever tried.

Walton didn’t think the company was going in the right direction, so he decided to step back in as CEO.  He asked Ron to stay as vice chairman and CFO.  But Ron had wanted to run the company, so he decided to leave.

Before he left, Ron told Walton that Wal-Mart had such a strong organization that it would continue to do well.  But Ron’s faith in Wal-Mart didn’t prevent roughly one third of senior managers from leaving after Ron left.

Walton believes most setbacks can be turned into opportunities.  He promoted Jack Shewmaker to executive vice president of operations, personnel, and merchandise.  And Walton hired David Glass as executive vice president in charge of finance and distribution.

These two guys are completely different in personality, but they are both whip smart.  And with us up against it like we were, everybody had to head in the same direction.  Once again, Wal-Mart proved everybody wrong, and we just blew the doors off our previous performances.  David made us a stronger company almost immediately.  Ron Mayer may have been the architect of our original distribution systems, but David Glass, frankly, was much better than Ron at distribution, and that was one of the big areas of expertise I had been afraid of losing.  David also was much better at fine-tuning and honing our accounting systems.  He, along with Jack, was a powerful advocate for much of the high technology that keeps us operating and growing today.  And not only did he turn out to be a great chief financial officer, he also proved to be a fine talent with people.  This new team was even more talented, more suited for the job at hand than the previous one.



(Photo by Maurizio Distefano)

Saturday morning meetings often began with a cheer.  Walton:

It’s sort of a “whistle while you work” philosophy, and we not only have a heck of a good time with it, we were better because of it.  We build spirit and excitement.  We capture the attention of our folks and keep them interested, simply because they never know what’s coming next.  We break down barriers, which helps us communicate better with one another.  And we make our people feel part of a family in which no one is too important or too puffed up to lead a cheer or be the butt of a joke…

In 1984, Walton lost a bet to David Glass and “had to pay up by wearing a grass skirt and doing the hula on Wall Street.”  (Glass bet that the company would achieve a pretax profit of more than 8 percent; Walton bet against it.)  While outsiders might have viewed it as a publicity stunt, Walton observes that it’s a part of Wal-Mart’s culture to make things interesting, unpredictable, and fun.

…we thrive on a lot of the traditions of small-town America, especially parades with marching bands, cheerleaders, drill teams, and floats.  Most of us grew up with it, and we’ve found that it can be even more fun when you’re an adult who usually spends all your time working.  We love all kinds of contests, and we hold them all the time for everything from poetry to singing to beautiful babies.  We like theme days, where everyone in the store dresses up in costume.

Wal-Mart turned its annual meeting for shareholders into a fun, two-day event.

One potential problem for nearly all large companies is resistance to change.  Walton writes:

So I’ve made it my own personal mission to ensure that constant change is a vital part of the Wal-Mart culture itself… In fact, I think one of the greatest strengths of Wal-Mart’s ingrained culture is its ability to drop everything and turn on a dime.

Ongoing education is also important.  Associates can go to the Wal-Mart Institute at the University of Arkansas.  Or they can, with the company’s help, earn college degrees.



(Photo by Feelfree777)

For my whole career in retailing, I have stuck with one guiding principle… the secret of successful retailing is to give your customers what they want.  And really, if you think about it from your point of view as a customer, you want everything: a wide assortment of good quality merchandise; the lowest possible prices; guaranteed satisfaction with what you buy; friendly, knowledgeable service; convenient hours; free parking; a pleasant shopping experience.

Walton defends Wal-Mart:

Of all the notions I’ve heard about Wal-Mart, none has ever baffled me more than this idea that we are somehow the enemy of small-town America.  Nothing could be further from the truth: Wal-Mart has actually kept quite a number of small towns from becoming practically extinct by offering low prices and saving literally billions of dollars for the people who live there, as well as by creating hundreds of thousands of jobs in our stores.

Beyond its direct economic impact – customers vote with their feet and have saved huge amounts of money – Wal-Mart is committed to creating a sense of community in its managers and associates.  Community involvement is important.

In the early days of Wal-Mart, department stores put pressure on Wal-Mart.  The department stores didn’t like the fact that many of their customers were switching to Wal-Mart simply because Wal-Mart’s prices were much lower.  The department stores even tried to use “fair trade” laws to block discounters from doing business.

Furthermore, Wal-Mart’s vendors weren’t all happy about Wal-Mart’s determination to get the lowest possible prices from them.  Walton spells out his company’s reasoning:

…we are the agents for our customers.  And to do the best job possible, we’ve got to become the most efficient deliverer of merchandise that we can.  Sometimes that can best be accomplished by purchasing goods directly form the manufacturer.  And other times, direct purchase simply doesn’t work.  In those cases, we need to use middlemen to deal with smaller manufacturers and make the process more efficient.  What we believe in strongly is our right to make that decision – whether to buy directly or from a rep – based on what it takes to best serve our customers.




…We decided that instead of avoiding our competitors, or waiting for them to come to us, we would meet them head-on.  It was one of the smartest strategic decisions we ever made… Our competitors have honed and sharpened us to an edge we wouldn’t have without them.

(Photo by Nataliia Shcherbyna)

Bud Walton:

Competition is very definitely what made Wal-Mart – from the very beginning.  There’s not an individual in these whole United States who has been in more retail stores – all types of retail stores, too, not just discount stores – than Sam Walton.  Make that all over the world.  He’s been in stores in Australia and South America, Europe and Asia and South Africa.  His mind is just so inquisitive when it comes to this business.  And there may not be anything he enjoys more than going into a competitor’s store trying to learn something from it.

At a regional meeting of discounters, competitors went through Wal-Mart’s stores and offered their critiques.  Wal-Mart executives were surprised at how many things they weren’t doing well.  But they listened carefully and made adjustments accordingly.  Those adjustments were crucial in preparing Wal-Mart to begin competing more broadly with Kmart.  (Kmart had 1,000 stores while Wal-Mart only had 150 at that time.)

Many discounters were driven out of business in the mid-1970s when the economy weakened.  Wal-Mart began to buy struggling retailers.  In 1981, Wal-Mart had almost no stores east of the Mississippi.  But Kuhn’s Big K stores – with 112 locations – was faltering.  Wal-Mart had a difficult time deciding what to do, but they finally acquired Kuhn’s.  After working through some problems related to the acquisition, Wal-Mart was now in a position to keep growing amazingly fast.  Walton:

We exploded from that point on, almost always opening 100 new stores a year, and more than 150 in some years…

I don’t know how the folks around executive offices see me, and I know they get frustrated with the way I make everybody go back and forth on so many issues that come up.  But I see myself as being a little more inclined than most of them are to take chances.  On something like the Kuhn’s decision, I try to play a “what-if” game with the numbers – but it’s generally my gut that makes the final decision.



…one of the main reasons we’ve been able to roll this company out nationally was all the pressure put on me by guys like David Glass and, earlier, Jack Shewmaker and Ron Mayer, to invest so heavily in technology.  Yes, I argued and resisted, but I eventually signed the checks.  And we have been able to move way out front of the industry in both communications and distribution… I would go so far as to say, in fact, that the efficiencies and economies of scale we realize from our distribution system give us one of our greatest competitive advantages.

Many people have contributed over the years, but David Glass has to get the lion’s share of the credit for where we are today in distribution.  David had a vision for automated distribution centers – linked by computer both to our stores and to our suppliers – and he set about building such a system, beginning in 1978 at Searcy, Arkansas.

Wal-Mart’s warehouses reached a point where they could directly replenish nearly 85 percent of inventory compared to 50 to 65 percent for competitors.  When in-store merchants place computer orders, the orders arrive at the store in about two days.  Most competitors had to wait five or more days for their orders to arrive.

Wal-Mart has a private fleet of trucks.  Walton would regularly meet in the drivers’ break room at 4 a.m. with a bunch of doughnuts.  He would ask them all sorts of questions about the stores.  Most truck drivers were very candid, which gave Walton another way to gain store-level intelligence.

(Wal-Mart distribution center, Photo by Redwood8)

Walton describes a distribution center:

Start with a building of around 1.1 million square feet, which is about as much floor space as twenty-three football fields, sitting out somewhere on some 150 acres.  Fill it high to the roof with every kind of merchandise you can imagine, from toothpaste to TV’s, toilet paper to toys, bicycles to barbecue grills.  Everything in it is bar-coded, and a computer tracks the location and movement of every case of merchandise, while it’s stored and when it’s shipped out.  Some six hundred to eight hundred associates staff the place, which runs around the clock, twenty-four hours a day.  On one side of the building is a shipping dock with loading doors for around thirty trucks at a time – usually full.  On the other side is the receiving dock, which may have as many as 135 doors for unloading merchandise.

These goods move in and out of the warehouse on some 8 1/2 miles of laser-guided conveyor belts, which means that the lasers read the bar codes on the cases and then direct them to whatever truck is filling the order placed by one of the stores it’s servicing that night… When the thing is running full speed, it’s just a blur of boxes and crates flying down those belts, red lasers flashing everywhere, directing this box to that truck, or that box to this truck.  Out in the parking lot, whole packs of Wal-Mart trucks rumble in and out all day.



Walton on thinking small:

…the bigger Wal-Mart gets, the more essential it is that we think small.  Because that’s exactly how we have become a huge corporation – by not acting like one… If we ever forget that looking a customer in the eye, and greeting him or her, and asking politely if we can be of help is just as important in every Wal-Mart today as it was in that little Ben Franklin in Newport, then we just ought to go into a different business because we’ll never survive in this one.

In a giant, centrally driven company, there’s no place for creativity, no room for the maverick merchant, no need for the entrepreneur or the promoter.

Walton shares six principles for how to think small:

  • Think One Store at a Time
  • Communicate, Communicate, Communicate
  • Keep Your Ear to the Ground
  • Push Responsibility – and Authority – Down
  • Force Ideas to Bubble Up
  • Stay Lean, Fight Bureaucracy

Think One Store at a Time

The focus always has to be on lowering prices, improving service, and making things better for customers who shop in the stores.  Similarly, getting the right merchandising mix requires merchandisers at the store level, who deal with customers face to face, day in and day out.

When managers meet at the end of the week, the discussion of sales is at the individual store level.  No other large retailer does that.

Communicate, Communicate, Communicate

Walton says:

If you had to boil down the Wal-Mart system to one single idea, it would probably be communication, because it is one of the real keys to our success.


That’s why we’ve spent hundreds of millions of dollars on computers and satellites – to spread all the little details around the company as fast as possible.

Sometimes Walton would get a message to everyone by doing a TV recording.  One time, he had all the associates pledge to follow “the ten-foot rule.”  If you come within 10 feet of a customer, look her in the eye, greet her, and ask her if you can help her.  Walton told all the associates that, if they did this, not only would it be better for customers, but the associates themselves would become better leaders in the process.

Keep Your Ear to the Ground

Both district managers and regional managers are expected to travel around to individual stores, just as Walton himself used to do all the time.  Valuable intelligence is always available using this approach.

As with any retailer, there’s always a head-to-head confrontation between operations and merchandising.  At Wal-Mart, there are some enormous arguments.  But they have a rule never to leave an item hanging in the weekly meeting.  They always make a decision.  Sometimes it’s wrong and gets corrected ASAP.  But once the decision is made, everyone is on board as long as the decision stands.

Push Responsibility – and Authority – Down

As much as possible, every level of manager is given responsibility and authority – and is rewarded with equity.  Many Wal-Mart managers who never went to college end up performing very well.

Force Ideas to Bubble Up

This goes with pushing responsibility down.  Any associate can have a good idea about how to improve something.  It’s happened countless times at Wal-Mart.

Stay Lean, Fight Bureaucracy

Bureaucracy builds up naturally unless the culture is to eliminate or limit bureaucracy as much as possible.  Walton is committed to not letting egos get out of control because, in his view, much bureaucracy is the result of some empire builder’s ego.



  • RULE 1: COMMIT to your business.  Believe in it more than anybody else.  I think I overcame every single one of my personal shortcomings by the sheer passion I brought to my work.
  • RULE 2: SHARE your profits with all your associates, and treat them as partners.  In turn, they will treat you as a partner, and together you will all perform beyond your wildest expectations.
  • RULE 3: MOTIVATE your partners.  Money and ownership alone aren’t enough.  Constantly, day by day, think of new and more interesting ways to motivate and challenge your partners.  Set high goals, encourage competition, and then keep score.  If things get stale, cross-polinate; have managers switch jobs with one another to stay challenged… Don’t become too predictable.
  • RULE 4: COMMUNICATE everything you possibly can to your partners.  The more they know, the more they’ll understand.  The more they understand, the more they’ll care.
  • RULE 5: APPRECIATE everything your associates do for the business… all of us like to be told how much somebody appreciates what we do for them.
  • RULE 6: CELEBRATE your successes.  Find some humor in your failures.  Don’t take yourself so seriously.  Loosen up, and everybody around you will loosen up.  Have fun.  Show enthusiasm – always.
  • RULE 7: LISTEN to everyone in your company.  And figure out ways to get them talking.  The folks on the front lines – the ones who actually talk to the customer – are the only ones who really know what’s going on out there.
  • RULE 8: EXCEED your customers’ expectations.  If you do, they’ll come back over and over.  Give them what they want – and a little more.  Let them know you appreciate them.  Make good on all your mistakes, and don’t make excuses – apologize.  Stand behind everything you do.
  • RULE 9: CONTROL your expenses better than your competition.  This is where you can always find the competitive advantage.
  • RULE 10: SWIM upstream.  Go the other way.  Ignore the conventional wisdom.  If everybody else is doing it one way, there’s a good chance you can find your niche by going in exactly the opposite direction.  But be prepared for a lot of folks to wave you down and tell you you’re headed the wrong way.



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

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

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

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


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

My e-mail: jb@boolefund.com




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

Grinding It Out

(Image:  Zen Buddha Silence by Marilyn Barbone.)

April 1, 2018

I was an overnight success all right, but thirty years is a long, long night.

In Grinding It Out, Ray Kroc tells the story of how he created McDonald’s.  Kroc launched the company in 1954 when he was 52 years old.  Twenty-two years later McDonald’s topped one billion in total revenue.

(Photo by Ruslan Gilmanshin)



Kroc spent seventeen years selling paper cups before he discovered a five-spindled milk-shake machine called the Multimixer.  Kroc:

It wasn’t easy to give up security and a well-paying job to strike out on my own… I plunged gleefully into my campaign to sell a Multimixer to every drug store soda fountain and dairy bar in the nation.  It was a rewarding struggle.  I loved it.  Yet I was alert to other opportunities.

(Multimixer, Photo by Visitor7, via Wikimedia Commons)

Kroc began to hear about the McDonald brothers.  They had not just one Multimixer.  Nor just two or three.  They had eight Multimixers.  This peaked Kroc’s curiosity, so he went to look at the McDonald brothers’ operation in San Bernardino, California.

At first, Kroc wasn’t impressed.  But then he saw all the helpers arriving and setting up.  Soon they were moving really fast.  And flocks of people were in line getting hamburgers.  Each hamburger was only 15 cents, and there was almost no wait between the customer placing an order and the order being filled.

Kroc spoke with several customers and learned that they just loved the food.  Kroc was captivated by the system.  He asked the McDonald brothers to join him for dinner, which they did:

I was fascinated by the simplicity and effectiveness of the system they described that night.  Each step in producing the limited menu was stripped down to its essence and accomplished with a minimum of effort.  They sold hamburgers and cheeseburgers only.  The burgers were a tenth of a pound of meat, all fried the same way, for fifteen cents.  You got a slice of cheese on it for four cents more.  Soft drinks were ten cents, sixteen-ounce milk shakes were twenty cents, and coffee was a nickel.

The McDonald brothers showed Kroc the design of a new drive-in building.  It was red and white with touches of yellow.  There was a set of arches that went through the roof.  There was also a tall sign out front with arches illuminated by neon tubes.

Kroc’s excitement grew:

That night in my motel room I did a lot of heavy thinking about what I’d seen during the day.  Visions of McDonald’s restaurants dotting crossroads all over the country paraded through my brain.  In each store, of course, were eight Multimixers whirring away and paddling a steady flow of cash into my pockets.

The next day, Kroc returned to see the operation in action again.  He paid particular attention to how the french fries were made.  McDonald’s french fries were outstanding and a key to the store’s success.  Kroc observed carefully and thought that he had memorized the process for making terrific french fries.  Kroc admits this was a mistake because he missed a few things.

Kroc met with Mac and Dick McDonald again.  This time, Kroc asked them why they didn’t expand into a chain.  The brothers demurred.  When pressed, they pointed to their house on a hill.  They said they were leading a peaceful existence and didn’t want any more problems.  Eventually, Kroc said that he himself could open up the new locations.




When I flew back to Chicago that fateful day in 1954, I had a freshly signed contract with the McDonald brothers in my briefcase.  I was a battle-scared veteran of the business wars, but I was still eager to go into action.  I was 52 years old.  I had diabetes and incipient arthritis.  I had lost my gall bladder and most of my thyroid gland in earlier campaigns.  But I was convinced the best was ahead of me.  I was still green and growing, and I was flying along at an altitude slightly higher than a plane.

Kroc recounts that he was born in Oak Park, just west of Chicago, in 1902.  Kroc’s parents were of Czech origin Bohemians, as Ray says.  His father, Louis Kroc, had gone to work for Western Union at age twelve and had worked his way up.  Ray Kroc’s mother, Rose, was “a loving soul.”  She gave piano lessons to make extra money.

(Czech Republic on map with flag pin, Photo by Sjankauskas)

Ray Kroc’s brother, Bob, became a professor and medical researcher, but Ray wasn’t much interested in school.  Ray wasn’t even interested in reading books:

I was never much of a reader when I was a boy.  Books bored me.  I liked action.  But I spent a lot of time thinking about things.  I’d imagine all kinds of situations and how I would handle them.

They called me Danny Dreamer a lot, even later when I was in high school and would come home all excited about some scheme I’d thought up.  I never considered my dreams wasted energy; they were invariably linked to some form of action.  When I dreamed about having a lemonade stand, for example, it wasn’t long before I set up a lemonade stand.  I worked hard at it, and I sold a lot of lemonade.  I worked at a grocery store one summer when I was still in grammar school.  I worked at my uncle’s drug store.  I worked in a tiny music store I’d started with two friends.  I worked at something whenever possible.  Work is the meat in the hamburger of life.  There is an old saying that all work and no play makes Jack a dull boy.  I never believed it because, for me, work was play.  I got as much pleasure out of it as I did from playing baseball.

Kroc went with his father to see many Chicago Cubs games.  The Cubs were contenders then.

Kroc enjoyed working for his uncle Earl Edmund Sweet’s drug store soda fountain in Oak Park.

That was where I learned that you could influence people with a smile and enthusiasm and sell them a sundae when what they’d come for was a cup of coffee.

Kroc learned to play the piano well.  He thought he could make money as a piano man.  He ended up going into the music store business with two friends.  But it didn’t really work.

Though Kroc didn’t like school — one reason being that the progress felt much too slow — there was one school activity he did like: debating.

When World War I came, Kroc got a job selling coffee beans and novelties door-to-door.  He thought he wouldn’t need to go back to school.  Soon Kroc felt he should be a part of the war effort.  Kroc:

My parents objected strenuously, but I finally talked them into letting me join up as a Red Cross ambulance driver.  I had to lie about my age, of course, but even my grandmother could accept that.  In my company, which assembled in Connecticut for training, was another fellow who had lied about his age to get in.  He was regarded as a strange duck, because whenever we had time off and went out on the town to chase girls, he stayed in camp drawing pictures.  His name was Walt Disney.

Kroc writes that he wanted to be a salesman, and also to play the piano.  For a time, he sold novelty ribbons.  Kroc was doing well:

In 1919 anyone making twenty-five or thirty dollars a week was doing well, and it wasn’t long before — on good weeks with a lot of musical jobs — I was making more money than my father.

Kroc had several jobs as a piano man, including playing in a band at Paw-Paw Lake, Michigan.  That’s where he met his first wife, Ethel Flemming, of Scottish background.

Kroc continues:

My next job was in Chicago’s financial district as a board marker on the New York Curb, as the market that became the American Stock Exchange used to be called.  My employer was a firm named Wooster-Thomas.  A substantial sound to that, I thought.  My job was to read the ticker tape and translate the symbols from it into prices that I posted on the blackboard for the scrutiny of the gentlemen who frequented our office.  I later learned that the impressive-sounding name fronted a bucket-shop operation that was selling watered stock all over the place.

A bit later, Kroc got a job selling Lily brand paper cups.



Kroc was selling Lily paper cups from early in the morning until 5:00 or 5:30pm.  He says he would have worked longer, but he had a job playing piano at radio station WGES in Oak Park.  Kroc worked at WGES 6pm to 8pm, and then 10pm to 2am.  Kroc:

I was driven by ambition.  I hated to be idle for a minute.

(Photo of paper cups by Fedoseeva Galina)

Kroc again:

My cup sales kept growing as I learned how to plan my work and work my plan.  My confidence grew at the same rate.  I found that my customers appreciated a straightforward approach.  They would buy if I made my pitch and asked for their order without a lot of beating around the bush.  Too many salesmen, I found, would make a good presentation and convince the client, but they couldn’t recognize that critical moment when they should have stopped talking.  If I ever notice my prospect starting to fidget, glancing at his watch or looking out the window or shuffling the papers on his desk, I would stop talking right then and ask for his order.

Winter of 1924 was tough for the paper cup business.  Kroc notes that one reason he didn’t do well was because he put the customer first:

My philosophy was one of helping my customer, and if I couldn’t sell him by helping him improve his own sales, I felt I wasn’t doing my job.

Kroc started doing well in the paper cup business.  But knowing how things slowed down in the winter, Kroc took a 5-month leave of absence.  He got a job in Fort Lauderdale, Florida, selling real estate for W. F. Morang & Son.  Kroc quickly became a top salesman.

The property was underwater, but there was a solid bed of coral rock beneath, and the dredging for the intercoastal raised all the lots high and dry, with permanent abutments.  People who purchased those lots really got a bargain, even though the prices were astronomical for those times, because the area is now one of the most beautiful in all of Florida, and lots there are worth many times what they sold for then.

Of course, there were many lots sold at that time that didn’t turn out to be good investments at all.  There was a great deal of chicanery.  After a crackdown, Kroc got a job playing piano before returning to Chicago.



From 1927 to 1937, Kroc focused entirely on selling paper cups.  The paper container industry was undergoing several changes.  But then the stock market crashed in 1929, which ushered in the Great Depression.  Kroc’s father, who had been successfully speculating in real estate, was hit hard.

In 1930, Kroc saw an opportunity at the soda fountains in Walgreen’s Drug Company.

(Soda fountain, Photo by Bigapplestock)

At Walgreen’s, customers could buy sodas “to go.”  Kroc tried to convince the food service man for Walgreen’s, a man named McNamarra.  No go.  But then Kroc got McNamarra to try it for one month using free cups.

Finally he agreed.  I brought him the cups, and we set the thing up at one end of the soda fountain.  It was a big success from the first day.  It wasn’t long before McNamarra was more excited about the idea of takeouts than I was.  We went in to see Fred Stoll, the Walgreen purchasing agent, and set up what was to be a highly satisfactory arrangement for both of us.  The best part of it for me personally was that every time I saw a new Walgreen’s store going up it meant new business.  This sort of multiplication was clearly the way to go.  I spent less and less time chasing pushcart vendors around the West Side and more time cultivating large accounts where big turnover would automatically winch in sales in the thousands and hundreds of thousands.  I went after Beatrice Creamery, Swift, Armour, and big plants with in-factory food service systems such as U.S. Steel.

Soon Kroc had roughly fifteen salesmen working for him.

I loved to see one of these young fellows catch hold and grow in his job.  It was the most rewarding thing I’d ever experienced.

Kroc counselled his salesmen to sell themselves first, which would make it easier to sell paper cups.

Kroc mentions one of his customers, Ralph Sullivan in Battle Creek, Michican, who invented a new way to make milk shakes:

Ralph had come up with the idea of reducing butterfat content in a milk shake by making it with frozen milk.  The traditional method of making a shake was to put eight ounces of milk into a metal container, drop in two small scoops of ice cream, add flavoring, and put the concoction onto a spindle mixer.  Ralph’s formula was to take regular milk, add a stabilizer, sugar, corn starch, and a bit of vanilla flavoring and freeze it.  The result was ice milk.  He would put four ounces of milk into a metal container, drop in four scoops of this ice milk, and finish it off in the traditional way.  The result was a much colder, much more viscous drink, and people loved it.  The lines around his store in the summertime were nothing less than amazing.  This ice milk shake had a lot of advantages over regular milk shakes.  Instead of being a thin, semicool drink, it was thick and very cold.

The Multimixer was a piece of equipment that could make five milk shakes at once.  It was a game changer.  Kroc ended up leaving the paper cup business in order to sell Multimixers.  Kroc formed a partnership with the inventor of the Multimixer, Earl Prince.



Kroc encountered a great deal of adversity in his life, especially when he was trying to sell Multimixers.

For me, this was the first phase of grinding it out   building my personal monument to capitalism.  I paid tribute… for many years before I was able to rise with McDonald’s on the foundation I had laid.  Perhaps without that adversity I might not have been able to persevere later on when my financial burdens were redoubled.

(Illustration by Chris Dorney)

Kroc successfully marketed Multimixers at restaurant and dairy association conventions.  Soon Kroc was so busy that he had to hire a bookkeeper.  Partly by luck, he found Mrs. June Martino.  She was warm and compassionate, but also focused and able.  June studied electronics at Northwestern University.  Because higher mathematics was difficult for her, she had a tutor.  She was determined and “no challenge was too big for her,” notes Kroc.



In Southern California in the early 1930s, the drive-in restaurant came into existence.  Mac and Dick McDonald were New Englanders who moved to Southern California to work on movies.  At one point, they ran their own movie theatre.  Sometimes they only ate on meal a day in order to save money.  They would have a hot dog from a nearby stand.

Dick McDonald later recalled that he and his brother noticed that the hot dog stand was the only business doing well then.  That probably gave the brothers the idea of launching a drive-in restaurant.

The McDonald brothers’ first restaurant in San Bernardino was doing a great deal of business, but it still wasn’t very profitable.  Kroc:

So they did a courageous thing.  They closed that successful restaurant in 1948 and reopened it a short time later with a radically different kind of operation.  It was a restaurant stripped down to the minimum in service and menu, the prototype for legions of fast-food units that later would spread across the land.  Hamburgers, fries, and beverages were prepared on an assembly line basis, and, to the amazement of everyone, Mac and Dick included, the thing worked!  Of course, the simplicity of the procedure allowed the McDonalds to concentrate on quality in every step, and that was the trick.

(Original McDonald’s fast food restaurant, Photo by Cogart Strangehill, via Wikimedia Commons)

Kroc reached an agreement with the McDonald brothers.  Kroc would be able to franchise copies of McDonald’s everywhere in the United States.  He admits he made a mistake in the contract with the McDonalds: any changes to Kroc’s units would have to be put in writing, signed by both brothers, and sent by registered mail.  The McDonalds had an affable openness and Kroc trusted them.  But there would be problems later.

The agreement stipulated that Kroc would receive 1.9 percent of gross sales from franchisees.  Of that, 0.5 percent would go to the McDonald brothers.  Kroc also could charge an initial franchise fee of $950 for each license.

Making great french fries was essential:

…I had explained to Ed MacLuckie with great pride the McDonald’s secret for making french fries.  I showed him how to peel the potatoes, leaving just a bit of the skin to add flavor.  Then I cut them into shoestring strips and dumped them into a sink of cold water.  The ritual captivated me.  I rolled my sleeves to the elbows and, after scrubbing down in proper hospital fashion, I immersed my arms and gently stirred the potatoes until the water went white with starch.  Then I rinsed them thoroughly and put them into a basket for deep frying in fresh oil.

The only trouble was that, after following this process, the french fries tasted like mush.  Something had gone wrong or there was a missing step.  Eventually Kroc learned that potatoes taste better if they’re allowed to dry out.  (Without knowing it, the McDonald brothers had been letting their potatoes dry in the desert breeze.)  It took Kroc and associates three months before they perfected the process of making french fries.

Kroc’s first store was in a mediocre location, but it did well.  Many of Kroc’s golfing friends from Rolling Green became successful McDonald’s operators.

Kroc frequently helped prepare a McDonald’s for opening.  He didn’t mind mopping or cleaning the restrooms, even if he was in his suit.



Harry Sonneborn resigned as vice-president of Tastee-Freeze and sold all his stock because he wanted to work in Ray Kroc’s organization.  Sonneborn had noticed how exceptionally well a McDonald’s restaurant nearby was doing.  Kroc told him that McDonald’s couldn’t afford to hire him.  However, the company needed the help and Harry was persistent.  McDonald’s ended up hiring him.

Kroc envisioned Sonneborn dealing with finance, June Martino running the office, and he himself managing operations and new development.  Kroc, Sonneborn, and Martino worked extremely hard, but it was also fun:

We were breaking new ground, and we had to make a lot of fundamental decisions that we live with for years to come.  This is the most joyous kind of executive experience.  It’s thrilling to see your creation grow.

(Old style McDonald’s, Photo by Wahkeenah, via Wikimedia Commons)

Kroc writes that one fundamental decision he made was that the corporation would not be a supplier for its operators.  Kroc explains:

My belief was that I had to help the individual operator succeed in every way I could.  His success would ensure my success.  But I couldn’t do that and, at the same time, treat him as a customer.  There is a basic conflict in trying to treat a man as a partner on the one hand while selling him something at a profit on the other.  Once you get into the supply business, you become more concerned about what you are making on sales to your franchisee than with how his sales are doing… Our method enabled us to build a sophisticated system of purchasing that allows the operator to get his supplies at rock-bottom prices.

Opening new locations was slow and painful work.  Kroc describes what they were trying to build:

We wanted to build a restaurant system that would be known for food of consistently high quality and uniform methods of preparation.

(Photo by Ben Garney, via Wikimedia Commons)

Kroc and associates also realized that McDonald’s should go into the restaurant development business.  The idea came from Harry Sonneborn.  They started Franchise Realty Corporation with $1,000 paid-in capital.  Harry turned that into $170 million worth of real estate.  The idea was to get a property owner to lease his land on a subordinated basis.  Kroc observes:

This was the beginning of real income for McDonald’s.  Harry devised a formula for the monthly payments being made by our operators that paid our own mortgage and other expenses plus a profit.  We received this monthly minimum or a percentage of the volume the operator did, whichever was greater.

Harry succeeded in getting life insurance companies to invest, which gave McDonald’s the capital they needed to keep growing rapidly.

Kroc notes the gratitude he felt toward Harry Sonneborn and June Martino:

…June later told me that all the while her two boys were growing up, she never made it to one of their birthday parties or graduation ceremonies, and there were several times that she had to be in the office on Christmas.  I knew what she and Harry were doing, because I was in the same boat… I couldn’t give them raises to compensate them for their past efforts, but I could make sure that they would be rewarded when McDonald’s became one of the country’s major companies, which I never doubted it would.  I gave them stock ten percent to June and twenty percent to Harry and ultimately it would make them rich.



Fred Turner was a terrific worker and natural leader, says Kroc.  At first, Turner was going to be a franchisee.  To get experience, he started out as a worker in an already established McDonald’s.  But Kroc realized that Turner should be in charge of corporate operations.  Turner started at headquarters in January 1957.  The company opened twenty-five new locations that year, and Turner was involved in every one.

Also involved in each opening in 1957 was Jim Schindler, a stainless-steel supplier from Leitner Equipment Company.  At June’s suggestion, Kroc hired Schindler.  Kroc had to pay him $12,000 a year, more than Harry, June, or Ray himself was getting.  Kroc remarks that Schindler might not have come on board for that salary had he not had a Bohemian background like Kroc.

Kroc comments on a difference between Sonneborn and himself:

Harry was the scholarly type.  He analyzed situations on the basis of management theory and economic principles.  I proceeded on the strength of my salesman’s instinct and my subjective assessment of people.

(Illustration by Airdone)

Although he wasn’t perfect, Kroc excelled at picking the right people, which was central to McDonald’s success.  But Kroc couldn’t explain exactly how he did it.

Sonneborn and Kroc complemented each other in many ways.  And Fred Turner added another dimension.  For instance, the hamburger bun was an object of close attention for McDonald’s.  Fred Turner had some ideas:

We were buying our buns in the midwest from Louis Kuchuris’ Mary Ann Bakery.  At first they were cluster buns, meaning that the buns were attached to each other in clusters of four to six, and they were only partially sliced.  Fred pointed out that it would be much easier and faster for a griddle man if we had individual buns instead of clusters and if they were sliced all the way through.  The baker could afford to do it our way because of the large quantities of buns we were ordering.  Fred also worked with a cardboard box manufacturer on the design of a sturdy, reusable box for our buns.  Handling these boxes instead of the customary packages of twelve reduced the baker’s packaging cost, so he was able to give us a better price on the buns.  It also reduced our shipping costs and streamlined our operations.  With the old packages, it didn’t take long for a busy griddle man to find himself buried in paper.  Then there was the time spent opening packages, pulling buns from the cluster, and halving them.  These fractions of seconds added up to wasted minutes.  A well-run restaurant is like a winning baseball team, it makes the most of every crew member’s talents and takes advantage of every split-second opportunity to speed up service.

Many suppliers were getting the chance of a lifetime to grow with McDonald’s.  For example, Mary Ann Bakery went from being a small company to having a plant with a quarter-mile long conveyor belt.

Keep in mind that headquarters set the standards for quality, and also made recommendations for packaging.  But each franchisee did the purchasing for itself.  Headquarters also helped suppliers figure out ways to lower their costs.  These cost savings were passed to the franchisees.

Kroc describes the close attention paid to the hamburger patty:

We decided that our patties would be ten to the pound, and that soon became the standard for the industry.  Fred did a lot of experimenting in the packaging of patties, too.  There was a kind of paper that was exactly right, he felt, and he tested and tested until he found out what it was.  It had to have enough wax on it so that the patty would pop off without sticking when you slapped it onto the griddle.  But it couldn’t be too stiff or the patties would slide and refuse to stack up.  There also was a science in stacking patties.  If you made the stack too high, the ones on the bottom would be misshapen and dried out.  So we arrived at the optimum stack, and that determined the height of our meat suppliers’ packages.  The purpose of all these refinements, and we never lost sight of it, was to make our griddle man’s job easier to do quickly and well.  All the other considerations of cost cutting, inventory control, and so forth were important to be sure, but they were secondary to the critical detail of what happened there at that smoking griddle.  This was the vital passage in our assembly line, and the product had to flow through it smoothly or the whole plant would falter.



In 1960, three life insurance companies agreed to lend the company $1.5 million in exchange for 22.5 percent of the stock.  The insurance companies did well when they sold their stock a few years later for $7 to $10 million.  Had they held their stock until 1973, however, they would have gotten over $500 million dollars.  In any case, the loan was vital to the company’s rapid expansion in the 1960s.

McDonald’s hired people and paid them as little as possible, but also gave them stock.  Those who stayed did very well.  Bob Papp became vice-president in charge of construction.  John Haran helped Harry with real estate.  Dick Boylan helped Harry with finances.

One study showed that Ray Kroc had made more millionaires than any other person in history.  Kroc comments:

I don’t know about that… I’d rather say I gave a lot of men the opportunity to become millionaires.  They did it themselves.  I merely provided the means.  But I certainly do know a powerful number of success stories.

(Photo by Bjørn Hovdal)

McDonald’s doesn’t confer success on anyone.  It takes guts and staying power to make it with one of our restaurants.  At the same time, it doesn’t require any unusual aptitude or intellect.  Any man with common sense, dedication to principles, and a love of hard work can do it.  And I have stood flatfooted before big crowds of our operators and asserted that any man who gets a McDonald’s store today and works at it relentlessly will become a success, and many will become millionaires no question.

Some people go out of their way to give the competition a bad name.  Some even suggest planting spies.  Kroc has a different view, although he readily admits going through the garbage cans of competitors.

My way of fighting the competition is the positive approach.  Stress your own strengths, emphasize quality, service, cleanliness, and value

QSC and V are core values for McDonald’s:

  • Quality
  • Service
  • Cleaniness
  • Value



The McDonald brothers offered to sell McDonald’s  all the rights, the name, and the San Bernardino store — to Kroc and associates for $2.7 million, which would give each brother a million dollars after taxes.  Harry designed a brilliant way to finance the purchase.

Kroc on the formation of Hamburger University:

The idea of holding classes for new operators and managers had occurred to me when I first brought Fred Turner into headquarters.  He was enthusiastic about it, too, and it was one of those goals that keep coming up in meetings but are put aside to make room for more pressing things.  Fred refused to let the idea get buried, though.  He collaborated with Art Bender and one of our field consultants named Nick Karos to compile a training manual for operators…

(Public domain photo)

Kroc notes the growing public attention on McDonald’s:

Ours was the kind of story the American public was longing to hear.  They’d had enough of doom and gloom and cold war politics.

Dick Boylan hired a young accountant named Gerry Newman, who was brilliant.  At the time, the company had huge revenue but no cash flow.  Newman helped the situation by changing the pay period from weekly to bimonthly.

Kroc on integrity:

…I’ve worked out many a satisfactory deal on the strength of a handshake.  On the other hand, I’ve been taken to the cleaners often enough to make me a certified cynic.  But I’m just too naturally cheerful to play that role for long…



Kroc had a hard time getting Harold Freund to come out of retirement and build a bakery to serve McDonald’s operators.  But finally Freund agreed.

Kroc was also looking for a meat supplier.  He wanted Bill Moore of Golden State Foods to do it.  But Moore’s plant and equipment were outdated, and needed an infusion of capital.  When Moore told Kroc about the problem, Kroc told him to hang in there because McDonald’s was going to keep growing rapidly.  Moore hung in there.  A few years later, Moore had enough money to build a large manufacturing and warehouse complex in City of Industry, California.  Kroc:

His meat plant there now processes 300 million hamburger patties a year for McDonald’s restaurants, and in addition, he makes syrup for soft drinks and manufactures milk-shake mix.  He also has gone into distribution for McDonald’s units.  He perfected the one-stop service idea, in which a truck pulls up to one of our stores and fills all its needs, like an old-fashioned grocery store delivery truck, with a single call.  This results in great savings for both parties….

I could tell the same story about most of the suppliers who started with us in the early days and grew right along with us.



In 1963, the company built 110 stores.  Revenue was $129.6 million [over $1 billion in 2018 dollars] and net income was $2.1 million [over $17 million in 2018 dollars].  Kroc believed in decentralized management:

We had 637 stores now, and it was unwieldy to supervise them all from Chicago.  It has always been my belief that authority should be placed at the lowest possible level.  I wanted the man closest to the stores to be able to make decisions without seeking directives from headquarters.

(Illustration by ibreakstock)

Kroc writes:

…for its size [1977], McDonald’s today is the most unstructured corporation I know, and I don’t think you could find a happier, more secure, harder working group of executives anywhere.

Back to 1966:

This was in July 1966, a year in which we broke through the top of our charts again with $200 million in sales, and the scoreboards on the golden arches in front of all our stores flipped to “OVER 2 BILLION SOLD.”  Cooper and Golin sent out a blitz of press releases interpreting the magnitude of this event for a space-conscious public.  “If laid end-to-end,” they enthused, “two billion hamburgers would circle the earth 5.4 times!”  Great fun.  Even Harry Sonneborn got caught up in the spirit of promoting McDonald’s, and he pulled off a stunt that made me proud of him.  He wanted to have us represented in the big Macy’s Thanksgiving Day parade in New York, and he approved the concept of McDonald’s All-American High School Band, made up of the two best musicians from each state and the District of Columbia.  Then he hired the world’s biggest drum and had it shipped by flatcar from a university in Texas… It was a huge success.  So was the introduction of our clown, Ronald McDonald, who made his national television debut in the parade.



Harry Sonneborn listened to forecasters telling him in 1967 that the country was headed into recession.  If true, it perhaps made sense to conserve cash and not expand much (or at all).  But such forecasts are notoriously unreliable, especially as a guide to business.  No one knows when bears markets or recessions will come.

Warren Buffett puts it best:

  • 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.
  • 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?

(Illustration by Maxim Popov)

To quote 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.

Also, different individual businesses have different reactions to bear markets and recessions.  Perhaps McDonald’s could do well enough during a recession, given its cheap prices.

In any case, Harry put a moratorium on all new store development because he thought business activity was going to slow down.  But there were many dozens of new locations in the works.  Why not proceed?  Kroc thought McDonald’s should continue opening new locations.  Kroc argued with Harry and forced the issue, with the result that Harry resigned.

McDonald’s Canada did even better than McDonald’s in the United States.  There was less competition in Canada.  McDonald’s Canada achieved an average of a million dollars in sales for all their locations.  This put them ahead of the U.S. locations.



Additions to McDonald’s menu over the years usually came from ideas that operators had.  Filet-O-Fish, Big Mac, Hot Apple Pie, and Egg McMuffin, for example.  Kroc:

I keep a number of experimental menu additions in the works all the time.  Some of them now being tested in selected stores may find their way into general use.  Others, for a variety of reasons, will never make it.  We have a complete test kitchen and experimental lab on my ranch, where all of our products are tested; this is in addition to the creative facility in Oak Brook.

(Illustration by lkonstudio)

Kroc loves looking for new locations for McDonald’s stores:

Finding locations for McDonald’s is the most creatively fulfilling thing I can imagine.  I go out and check out a piece of property.  It’s nothing but bare ground, not producing a damned thing for anybody.  I put a building on it, and the operator gets into business there employing fifty or a hundred people, and there is new business for the garbage man, the landscape man, and the people who sell the meat and buns and potatoes and other things.  So out of that bare piece of ground comes a store that does, say, a million dollars a year in business.  Let me tell you, it’s great satisfaction to see that happen.



Kroc bought the San Diego Padres baseball team:

I was greeted like a hero in San Diego.  Old men and little boys stopped me in the street to thank me for saving baseball for the city.  The mayor presented me with an award in the opening ceremonies of our first home game.  The sportswriters also gave me an award…

During the first home game, Kroc grabbed the microphone in the public address booth.  He apologized to the crowd for the poor performance of the team.  He said he was “disgusted.”  This led to a new rule that no one but the official announcer can use the public address system during a game.  Kroc explains that it’s no crime to lose unless you fail to do your best.



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

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

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

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


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

My e-mail: jb@boolefund.com




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