Seeking Wisdom

(Image:  Zen Buddha Silence by Marilyn Barbone)

December 2, 2018

In his pursuit of wisdom, Peter Bevelin was inspired by Charlie Munger’s idea:

I believe in the discipline of mastering the best of what other people have ever figured out.

Bevelin was also influenced by Munger’s statement that Charles Darwin was one of the best thinkers who ever lived.  Despite the fact that many others had much higher IQ’s.  Bevelin:

Darwin’s lesson is that even people who aren’t geniuses can outthink the rest of mankind if they develop certain thinking habits.

(Photo by Maull and Polyblank (1855), via Wikimedia Commons)

In the spirit of Darwin and Munger, and with the goal of gaining a better understanding of human behavior, Bevelin read books in biology, psychology, neuroscience, physics, and mathematics.  Bevelin took extensive notes.  The result is the book, Seeking Wisdom: From Darwin to Munger.

Here’s the outline:

PART ONE:  WHAT INFLUENCES OUR THINKING

  • Our anatomy sets the limits for our behavior
  • Evolution selected the connections  that produce useful behavior for survival and reproduction
  • Adaptive behavior for survival and reproduction

PART TWO:  THE PSYCHOLOGY OF MISJUDGMENTS

  • Misjudgments explained by psychology
  • Psychological reasons for mistakes

PART THREE:  THE PHYSICS AND MATHEMATICS OF MISJUDGMENTS

  • Systems thinking
  • Scale and limits
  • Causes
  • Numbers and their meaning
  • Probabilities and number of possible outcomes
  • Scenarios
  • Coincidences and miracles
  • Reliability of case evidence
  • Misrepresentative evidence

PART FOUR:  GUIDELINES TO BETTER THINKING

  • Models of reality
  • Meaning
  • Simplification
  • Rules and filters
  • Goals
  • Alternatives
  • Consequences
  • Quantification
  • Evidence
  • Backward thinking
  • Risk
  • Attitudes

(Photo by Nick Webb)

 

Part One:  What Influences Our Thinking

OUR ANATOMY SETS THE LIMITS FOR OUR BEHAVIOR

Bevelin quotes Nobel Laureate Dr. Gerald Edelman:

The brain is the most complicated material object in the known universe.  If you attempted to count the number of connections, one per second, in the mantle of the brain (the cerebral cortex), you would finish counting 32 million years later.  But that is not the whole story.  The way the brain is connected—its neuroanatomical pattern—is enormously intricate.  Within this anatomy a remarkable set of dynamic events take place in hundredths of a second and the number of levels controlling these events, from molecules to behavior, is quite large.

Neurons can send signals—electrochemical pulses—to specific target cells over long distances.  These signals are sent by axons, thin fibers that extend from neurons to other parts of the brain.  Axons can be quite long.

(Illustration by ustas)

Some neurons emit electrochemical pulses constantly while other neurons are quiet most of the time.  A single axon can have several thousand synaptic connections.  When an electrochemical pulse travels along an axon and reaches a synapse, it causes a neurotransmitter (a chemical) to be released.

The human brain contains approximately 100 trillion synapses.  From wikipedia:

The functions of these synapses are very diverse: some are excitatory (exciting the target cell); others are inhibitory; others work by activating second messenger systems that change the internal chemistry of their target cells in complex ways.  A large number of synapses are dynamically modifiable; that is, they are capable of changing strength in a way that is controlled by the patterns of signals that pass through them.  It is widely believed that activity-dependent modification of synapses is the brain’s primary mechanism for learning and memory.

Most of the space in the brain is taken up by axons, which are often bundled together in what are called nerve fiber tracts.  A myelinated axon is wrapped in a fatty insulating sheath of myelin, which serves to greatly increase the speed of signal propagation.  (There are also unmyelinated axons).  Myelin is white, making parts of the brain filled exclusively with nerve fibers appear as light-colored white matter, in contrast to the darker-colored grey matter that marks areas with high densities of neuron cell bodies.

Genes, life experiences, and randomness determine how neurons connect.

Also, everything that happens in the brain involves many areas at once (the left brain versus right brain distinction is not strictly accurate).  This is part of why the brain is so flexible.  There are different ways for the brain to achieve the same result.

 

EVOLUTION SELECTED THE CONNECTIONS THAT PRODUCE USEFUL BEHAVIOR FOR SURVIVAL AND REPRODUCTION

Bevelin writes:

If certain connections help us interact with our environment, we use them more often than connections that don’t help us.  Since we use them more often, they become strengthened.

Evolution has given us preferences that help us classify what is good or bad.  When these values are satisfied (causing either pleasure or less pain) through the interaction with our environment, these neural connections are strengthened.  These values are reinforced over time because they give humans advantages for survival and reproduction in dealing with their environment.

(Illustration by goce risteski)

If a certain behavior is rewarding, the neural connections associated with that behavior get strengthened.  The next time the same situation is encountered, we feel motivated to respond in the way that we’ve learned brings pleasure (or reduces pain).  Bevelin:

We do things that we associate with pleasure and avoid things that we associate with pain.

 

ADAPTIVE BEHAVIOR FOR SURVIVAL AND REPRODUCTION

Bevelin:

The consequences of our actions reinforce certain behavior.  If the consequences were rewarding, our behavior is likely to be repeated.  What we consider rewarding is individual specific.  Rewards can be anything from health, money, job, reputation, family, status, or power.  In all of these activities, we do what works.  This is how we adapt.  The environment selects our future behavior.

Illustration by kalpis

Especially in a random environment like the stock market, it can be difficult to figure out what works and what doesn’t.  We may make a good decision based on the odds, but get a poor outcome.  Or we may make a bad decision based on the odds, but get a good outcome.  Only over the course of many decisions can we tell if our investment process is probably working.

 

Part Two:  The Psychology of Misjudgments

MISJUDGMENTS EXPLAINED BY PSYCHOLOGY

Illustration by intheskies

Bevelin lists 28 reasons for misjudgments and mistakes:

  1. Bias from mere association—automatically connecting a stimulus with pain or pleasure; including liking or disliking something associated with something bad or good.  Includes seeing situations as identical because they seem similar.  Also bias from Persian Messenger Syndrome—not wanting to be the carrier of bad news.
  2. Underestimating the power of incentives (rewards and punishment)—people repeat actions that result in rewards and avoid actions that they are punished for.
  3. Underestimating bias from own self-interest and incentives.
  4. Self-serving bias—overly positive view of our abilities and future.  Includes over-optimism.
  5. Self-deception and denial—distortion of reality to reduce pain or increase pleasure.  Includes wishful thinking.
  6. Bias from consistency tendency—being consistent with our prior commitments and ideas even when acting against our best interest or in the face of disconfirming evidence.  Includes Confirmation Bias—looking for evidence that confirms our actions and beliefs and ignoring or distorting disconfirming evidence.
  7. Bias from deprival syndrome—strongly reacting (including desiring and valuing more) when something we like and have (or almost have) is (or threatens to be) taken away or “lost.”  Includes desiring and valuing more what we can’t have or what is (or threatens to be) less available.
  8. Status quo bias and do-nothing syndrome—keeping things the way they are.  Includes minimizing effort and a preference for default options.
  9. Impatience—valuing the present more highly than the future.
  10. Bias from envy and jealousy.
  11. Distortion by contrast comparison—judging and perceiving the absolute magnitude of something not by itself but based only on its difference to something else presented closely in time or space or to some earlier adaptation level.  Also underestimating the consequences over time of gradual changes.
  12. The anchoring effect—People tend to use any random number as a baseline for estimating an unknown quantity, despite the fact that the unknown quantity is totally unrelated to the random number.  (People also overweigh initial information that is non-quantitative.)
  13. Over-influence by vivid or the most recent information.
  14. Omission and abstract blindness—only seeing stimuli we encounter or that grabs our attention, and neglecting important missing information or the abstract.  Includes inattentional blindness.
  15. Bias from reciprocation tendency—repaying in kind what others have done for or to us like favors, concessions, information, and attitudes.
  16. Bias from over-influence by liking tendency—believing, trusting, and agreeing with people we know and like.  Includes bias from over-desire for liking and social acceptance and for avoiding social disapproval.  Also bias from disliking—our tendency to avoid and disagree with people we don’t like.
  17. Bias from over-influence by social proof—imitating the behavior of many others or similar others.  Includes crowd folly.
  18. Bias from over-influence by authority—trusting and obeying a perceived authority or expert.
  19. The Narrative Fallacy (Bevelin uses the term “Sensemaking”)—constructing explanations that fit an outcome.  Includes being too quick in drawing conclusions.  Also Hindsight Bias: Thinking events that have happened were more predictable than they were.
  20. Reason-respecting—complying with requests merely because we’ve been given a reason.  Includes underestimating the power in giving people reasons.
  21. Believing first and doubting later—believing what is not true, especially when distracted.
  22. Memory limitations—remembering selectively and wrong.  Includes influence by suggestions.
  23. Do-something syndrome—acting without a sensible reason.
  24. Mental confusion from say-something syndrome—feeling a need to say something when we have nothing to say.
  25. Emotional arousal—making hasty judgments under the influence of intense emotions.  Includes exaggerating the emotional impact of future events.
  26. Mental confusion from stress.
  27. Mental confusion from physical or psychological pain, and the influence of chemicalsa li.
  28. Bias from over-influence by the combined effect of many psychological tendencies operating together.

 

PSYCHOLOGICAL REASONS FOR MISTAKES

Bevelin notes that his explanations for the 28 reasons for misjudgments is based on work by Charles Munger, Robert Cialdini, Richard Thaler, Robyn Dawes, Daniel Gilbert, Daniel Kahneman, and Amos Tversky.  All are psychologists except for Thaler (economist) and Munger (investor).

1. Mere Association

Bevelin:

Association can influence the immune system.  One experiment studied food aversion in mice.  Mice got saccharin-flavored water (saccharin has incentive value due to its sweet taste) along with a nausea-producing drug.  Would the mice show signs of nausea the next time they got saccharin water alone?  Yes, but the mice also developed infections.  It was known that the drug in addition to producing nausea, weakened the immune system, but why would saccharin alone have this effect?  The mere paring of the saccharin with the drug caused the mouse immune system to learn the association.  Therefore, every time the mouse encountered the saccharin, its immune system weakened making the mouse more vulnerable to infections.

If someone brings us bad news, we tend to associate that person with the bad news—and dislike them—even if the person didn’t cause the bad news.

2. Incentives (Reward and Punishment)

Incentives are extremely important.   Charlie Munger:

I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.  Never a year passes that I don’t get some surprise that pushes my limit a little farther.

Munger again:

From all business, my favorite case on incentives is Federal Express.  The heart and soul of their system—which creates the integrity of the product—is having all their airplanes come to one place in the middle of the night and shift all the packages from plane to plane.  If there are delays, the whole operation can’t deliver a product full of integrity to Federal Express customers.  And it was always screwed up.  They could never get it done on time.  They tried everything—moral suasion, threats, you name it.  And nothing worked.  Finally, somebody got the idea to pay all these people not so much an hour, but so much a shift—and when it’s all done, they can all go home.  Well, their problems cleared up over night.

People can learn the wrong incentives in a random environment like the stock market.  A good decision based on the odds may yield a bad result, while a bad decision based on the odds may yield a good result.  People tend to become overly optimistic after a success (even if it was good luck) and overly pessimistic after a failure (even if it was bad luck).

3. Self-interest and Incentives

“Never ask the barber if you need a haircut.”

Munger has commented that commissioned sales people, consultants, and lawyers have a tendency to serve the transaction rather than the truth.  Many others—including bankers and doctors—are in the same category.  Bevelin quotes the American actor Walter Matthau:

“My doctor gave me six months to live.  When I told him I couldn’t pay the bill, he gave me six more months.”

If they make unprofitable loans, bankers may be rewarded for many years while the consequences of the bad loans may not occur for a long time.

When designing a system, careful attention must be paid to incentives.  Bevelin notes that a new program was put in place in New Orleans: districts that showed improvement in crime statistics would receive rewards, while districts that didn’t faced cutbacks and firings.  As a result, in one district, nearly half of all serious crimes were re-classified as minor offences and never fully investigated.

4. Self-serving Tendencies and Overoptimism 

We tend to overestimate our abilities and future prospects when we are knowledgeable on a subject, feel in control, or after we’ve been successful.

Bevelin again:

When we fail, we blame external circumstances or bad luck.  When others are successful, we tend to credit their success to luck and blame their failures on foolishness.  When our investments turn into losers, we had bad luck.  When they turn into winners, we are geniuses.  This way we draw the wrong conclusions and don’t learn from our mistakes.  We also underestimate luck and randomness in outcomes.

5. Self-deception and Denial

Munger likes to quote Demosthenes:

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

People have a strong tendency to believe what they want to believe.  People prefer comforting illusions to painful truths.

Richard Feynman:

The first principle is that you must not fool yourself—and you are the easiest person to fool.

6. Consistency

Bevelin:

Once we’ve made a commitment—a promise, a choice, taken a stand, invested time, money, or effort—we want to remain consistent.  We want to feel that we’ve made the right decision.  And the more we have invested in our behavior the harder it is to change.

The more time, money, effort, and pain we invest in something, the more difficulty we have at recognizing a mistaken commitment.  We don’t want to face the prospect of a big mistake.

For instance, as the Vietnam War became more and more a colossal mistake, key leaders found it more and more difficult to recognize the mistake and walk away.  The U.S. could have walked away years earlier than it did, which would have saved a great deal of money and thousands of lives.

Bevelin quotes Warren Buffett:

What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.

Even scientists, whose job is to be as objective as possible, have a hard time changing their minds after they’ve accepted the existing theory for a long time.  Physicist Max Planck:

A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die and a new generation grows up that is familiar with it.

7. Deprival Syndrome

Bevelin:

When something we like is (or threatens to be) taken away, we often value it higher.  Take away people’s freedom, status, reputation, money, or anything they value, and they get upset… The more we like what is taken away or the larger the commitment we’ve made, the more upset we become.  This can create hatreds, revolts, violence, and retaliations.

Fearing deprival, people will be overly conservative or will engage in cover-ups.

A good value investor is wrong roughly 40 percent of the time.  However, due to deprival syndrome and loss aversion—the pain of a loss is about 2 to 2.5 times greater than the pleasure of an equivalent gain—investors have a hard time admitting their mistakes and moving on.  Admitting a mistake means accepting a loss of money and also recognizing our own fallibility.

Furthermore, deprival syndrome makes us keep trying something if we’ve just experienced a series of near misses.  We feel that “we were so close” to getting some reward that we can’t give up now, even if the reward may not be worth the expected cost.

Finally, the harder it is to get something, the  more value we tend to place on it.

8. Status Quo and Do-Nothing Syndrome

We feel worse about a harm or loss if it results from our action than if it results from our inaction.  We prefer the default option—what is selected automatically unless we change it.  However, as Bevelin points out, doing nothing is still a decision and the cost of doing nothing could be greater than the cost of taking an action.

In countries where being an organ donor is the default choice, people strongly prefer to be organ donors.  But in countries where not being an organ donor is the default choice, people prefer not to be organ donors.  In each case, most people simply go with the default option—the status quo.  But society is better off if most people are organ donors.

9. Impatience

We value the present more than the future.  We often seek pleasure today at the cost of a potentially better future.  It’s important to understand that pain and sacrifice today—if done for the right reasons—can lead to greater happiness in the future.

10. Envy and Jealousy

Charlie Munger and Warren Buffett often point out that envy is a stupid sin because—unlike other sins like gluttony—there’s no upside.  Also, jealousy is among the top three motives for murder.

It’s best to set goals and work towards them without comparing ourselves to others.  Partly by chance, there are always some people doing better and some people doing worse.

11. Contrast Comparison

The classic demonstration of contrast comparison is to stick one hand in cold water and the other hand in warm water.  Then put both hands in a buck with room temperature water.  Your cold hand will feel warm while your warm hand will feel cold.

Bevelin writes:

We judge stimuli by differences and changes and not absolute magnitudes.  For example, we evaluate stimuli like temperature, loudness, brightness, health, status, or prices based on their contrast or difference from a reference point (the prior or concurrent stimuli or what we have become used to).  This reference point changes with new experiences and context.

How we value things depends on what we compare them with.

Salespeople, after selling the main item, often try to sell add-ons, which seem cheap by comparison.  If you buy a car for $50,000, then adding an extra $1,000 for leather doesn’t seem like much.  If you buy a computer for $1,500, then adding an extra $50 seems inconsequential.

Bevelin observes:

The same thing may appear attractive when compared to less attractive things and unattractive when compared to more attractive things.  For example, studies show that a person of average attractiveness is seen as less attractive when compared to more attractive others.

One trick some real estate agents use is to show the client a terrible house at an absurdly high price first, and then show them a merely mediocre house at a somewhat high price.  The agent often makes the sale.

Munger has remarked that some people enter into a bad marriage because their previous marriage was terrible.  These folks make the mistake of thinking that what is better based on their own limited experience is the same as what is better based on the experience of many different people.

Another issue is that something can gradually get much worse over time, but we don’t notice it because each increment is small.  It’s like the frog in water where the water is slowly brought to the boiling point.  For instance, the behavior of some people may get worse and worse and worse.  But we fail to notice because the change is too gradual.

12. Anchoring

The anchoring effect:  People tend to use any random number as a baseline for estimating an unknown quantity, despite the fact that the unknown quantity is totally unrelated to the random number.  (People also overweigh initial information that is non-quantitative.)

Daniel Kahneman and Amos Tversky did one experiment where they spun a wheel of fortune, but they had secretly programmed the wheel so that it would stop on 10 or 65.   After the wheel stopped, participants were asked to estimate the percentage of African countries in the UN.   Participants who saw “10” on the wheel guessed 25% on average, while participants who saw “65” on the wheel guessed 45% on average, a huge difference.

Behavioral finance expert James Montier has run his own experiment on anchoring.   People are asked to write down the last four digits of their phone number.   Then they are asked whether the number of doctors in their capital city is higher or lower than the last four digits of their phone number.   Results:  Those whose last four digits were greater than 7000 on average report 6762 doctors, while those with telephone numbers below 2000 arrived at an average 2270 doctors.  (James Montier, Behavioural Investing, Wiley 2007, page 120)

Those are just two experiments out of many.  The anchoring effect is “one of the most reliable and robust results of experimental psychology,” says Kahneman.  Furthermore, Montier observes that the anchoring effect is one reason why people cling to financial forecasts, despite the fact that most financial forecasts are either wrong, useless, or impossible to time.

When faced with the unknown, people will grasp onto almost anything.  So it is little wonder that an investor will cling to forecasts, despite their uselessness. 

13. Vividness and Recency

Bevelin explains:

The more dramatic, salient, personal, entertaining, or emotional some information, event, or experience is, the more influenced we are.  For example, the easier it is to imagine an event, the more likely we are to think that it will happen.

We are easily influenced when we are told stories because we relate to stories better than to logic or fact.  We love to be entertained.  Information we receive directly, through our eyes or ears has more impact than information that may have more evidential value.  A vivid description from a friend or family member is more believable than true evidence.  Statistical data is often overlooked.  Studies show that jurors are influenced by vivid descriptions.  Lawyers try to present dramatic and memorable testimony.

The media capitalizes on negative events—especially if they are vivid—because negative news sells.  For instance, even though the odds of being in a plane crash are infinitesimally low—one in 11 million—people become very fearful when a plane crash is reported in the news.  Many people continue to think that a car is safer than a plane, but you are over 2,000 times more likely to be in a car crash than a plane crash.  (The odds of being in a car crash are one in 5,000.)

14. Omission and Abstract Blindness

We see the available information.  We don’t see what isn’t reported.  Missing information doesn’t draw our attention.  We tend not to think about other possibilities, alternatives, explanations, outcomes, or attributes.  When we try to find out if one thing causes another, we only see what happened, not what didn’t happen.  We see when a procedure works, not when it doesn’t work.  When we use checklists to find out possible reasons for why something doesn’t work, we often don’t see that what is not on the list in the first place may be the reason for the problem.

Often we don’t see things right in front of us if our attention is focused elsewhere.

15. Reciprocation

Munger:

The automatic tendency of humans to reciprocate both favors and disfavors has long been noticed as it is in apes, monkeys, dogs, and many less cognitively gifted animals.  The tendency facilitates group cooperation for the benefit of members.

Unfortunately, hostility can get extreme.  But we have the ability to train ourselves.  Munger:

The standard antidote to one’s overactive hostility is to train oneself to defer reaction.  As my smart friend Tom Murphy so frequently says, ‘You can always tell the man off tomorrow, if it is such a good idea.’

Munger then notes that the tendency to reciprocate favor for favor is also very intense.  On the whole, Munger argues, the reciprocation tendency is a positive:

Overall, both inside and outside religions, it seems clear to me that Reciprocation Tendency’s constructive contributions to man far outweigh its destructive effects…

And the very best part of human life probably lies in relationships of affection wherein parties are more interested in pleasing than being pleased—a not uncommon outcome in display of reciprocate-favor tendency.

Guilt is also a net positive, asserts Munger:

…To the extent the feeling of guilt has an evolutionary base, I believe the most plausible cause is the mental conflict triggered in one direction by reciprocate-favor tendency and in the opposite direction by reward superresponse tendency pushing one to enjoy one hundred percent of some good thing… And if you, like me… believe that, averaged out, feelings of guilt do more good than harm, you may join in my special gratitude for reciprocate-favor tendency, no matter how unpleasant you find feelings of guilt.

16. Liking and Disliking

Munger:

One very practical consequence of Liking/Loving Tendency is that it acts as a conditioning device that makes the liker or lover tend (1) to ignore faults of, and comply with wishes of, the object of his affection, (2) to favor people, products, and actions merely associated with the object of his affection [this is also due to Bias from Mere Association] and (3) to distort other facts to facilitate love.

We’re naturally biased, so we have to be careful in some situations.

On the other hand, Munger points out that loving admirable persons and ideas can be very beneficial.

…a man who is so constructed that he loves admirable persons and ideas with a special intensity has a huge advantage in life.  This blessing came to both Buffett and myself in large measure, sometimes from the same persons and ideas.  One common, beneficial example for us both was Warren’s uncle, Fred Buffett, who cheerfully did the endless grocery-store work that Warren and I ended up admiring from a safe distance.  Even now, after I have known so many other people, I doubt if it is possible to be a nicer man than Fred Buffett was, and he changed me for the better.

Warren Buffett:

If you tell me who your heroes are, I’ll tell you how you’re gonna turn out.  It’s really important in life to have the right heroes.  I’ve been very lucky in that I’ve probably had a dozen or so major heroes.  And none of them have ever let me down.  You want to hang around with people that are better than you are.  You will move in the direction of the crowd that you associate with.

Disliking: Munger notes that Switzerland and the United States have clever political arrangements to “channel” the hatreds and dislikings of individuals and groups into nonlethal patterns including elections.

But the dislikings and hatreds never go away completely…  And we also get the extreme popularity of very negative political advertising in the United States.

Munger explains:

Disliking/Hating Tendency also acts as a conditioning device that makes the disliker/hater tend to (1) ignore virtues in the object of dislike, (2) dislike people, products, and actions merely associated with the object of dislike, and (3) distort other facts to facilitate hatred.

Distortion of that kind is often so extreme that miscognition is shockingly large…

17. Social Proof

Munger comments:

The otherwise complex behavior of man is much simplified when he automatically thinks and does what he observes to be thought and done around him.  And such followership often works fine…

Psychology professors love Social-Proof Tendency because in their experiments it causes ridiculous results.  For instance, if a professor arranges for some stranger to enter an elevator wherein ten ‘compliance practitioners’ are all standing so that they face the rear of the elevator, the stranger will often turn around and do the same.

Of course, like the other tendencies, Social Proof has an evolutionary basis.  If the crowd was running in one direction, typically your best response was to follow.

But, in today’s world, simply copying others often doesn’t make sense.  Munger:

And in the highest reaches of business, it is not at all uncommon to find leaders who display followership akin to that of teenagers.  If one oil company foolishly buys a mine, other oil companies often quickly join in buying mines.  So also if the purchased company makes fertilizer.  Both of these oil company buying fads actually bloomed, with bad results.

Of course, it is difficult to identify and correctly weigh all the possible ways to deploy the cash flow of an oil company.  So oil company executives, like everyone else, have made many bad decisions that were triggered by discomfort from doubt.  Going along with social proof provided by the action of other oil companies ends this discomfort in a natural way.

Munger points out that Social Proof can sometimes be constructive:

Because both bad and good behavior are made contagious by Social-Proof Tendency, it is highly important that human societies (1) stop any bad behavior before it spreads and (2) foster and display all good behavior.

It’s vital for investors to be able to think independently.  As Ben Graham says:

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

18. Authority

A disturbingly significant portion of copilots will not correct obvious errors made by the pilot during simulation exercises.  There are also real world examples of copilots crashing planes because they followed the pilot mindlessly.  Munger states:

…Such cases are also given attention in the simulator training of copilots who have to learn to ignore certain really foolish orders from boss pilots because boss pilots will sometimes err disastrously.  Even after going through such a training regime, however, copilots in simulator exercises will too often allow the simulated plane to crash because of some extreme and perfectly obvious simulated error of the chief pilot.

Psychologist Stanley Milgram wanted to understand why so many seemingly normal and decent people engaged in horrific, unspeakable acts during World War II.  Munger:

[Milgram] decided to do an experiment to determine exactly how far authority figures could lead ordinary people into gross misbehavior.  In this experiment, a man posing as an authority figure, namely a professor governing a respectable experiment, was able to trick a great many ordinary people into giving what they had every reason to believe were massive electric shocks that inflicted heavy torture on innocent fellow citizens…

Almost any intelligent person with my checklist of psychological tendencies in his hand would, by simply going down the checklist, have seen that Milgram’s experiment involved about six powerful psychological tendencies acting in confluence to bring about his extreme experimental result.  For instance, the person pushing Milgram’s shock lever was given much social proof from presence of inactive bystanders whose silence communicated that his behavior was okay…

Bevelin quotes the British novelist and scientist Charles Percy Snow:

When you think of the long and gloomy history of man, you will find more hideous crimes have been committed in the name of obedience than have ever been committed in the name of rebellion.

19. The Narrative Fallacy (Sensemaking)

(Bevelin uses the term “sensemaking,” but “narrative fallacy” is better, in my view.)  In The Black Swan, Nassim Taleb writes the following about the narrative fallacy:

The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship, upon them.  Explanations bind facts together.  They make them all the more easily remembered;  they help them make more sense.  Where this propensity can go wrong is when it increases our impression of understanding.

The narrative fallacy is central to many of the biases and misjudgments mentioned by Charlie Munger.  (In his great book, Thinking, Fast and Slow, Daniel Kahneman discusses the narrative fallacy as a central cognitive bias.)  The human brain, whether using System 1 (intuition) or System 2 (logic), always looks for or creates logical coherence among random data.  Often System 1 is right when it assumes causality; thus, System 1 is generally helpful, thanks to evolution.  Furthermore, System 2, by searching for underlying causes or coherence, has, through careful application of the scientific method over centuries, developed a highly useful set of scientific laws by which to explain and predict various phenomena.

The trouble comes when the data or phenomena in question are highly random—or inherently unpredictable (at least for the time being).  In these areas, System 1 makes predictions that are often very wrong.  And even System 2 assumes necessary logical connections when there may not be any—at least, none that can be discovered for some time.

Note:  The eighteenth century Scottish philosopher (and psychologist) David Hume was one of the first to clearly recognize the human brain’s insistence on always assuming necessary logical connections in any set of data or phenomena.

If our goal is to explain certain phenomena scientifically, then we have to develop a testable hypothesis about what will happen (or what will happen with probability x) under specific, relevant conditions.  If our hypothesis can’t accurately predict what will happen under specific, relevant conditions, then our hypothesis is not a valid scientific explanation.

20. Reason-respecting

We are more likely to comply with a request if people give us a reason—even if we don’t understand the reason or if it’s wrong.  In one experiment, a person approaches people standing in line waiting to use a copy machine and says, “Excuse me, I have 5 pages.  May I use the Xerox machine because I have to make some copies?”  Nearly everyone agreed.

Bevelin notes that often the word “because” is enough to convince someone, even if no actual reason is given.

21. Believe First and Doubt Later

We are not natural skeptics.  We find it easy to believe but difficult to doubt.  Doubting is active and takes effort.

Bevelin continues:

Studies show that in order to understand some information, we must first accept it as true… We first believe all information we understand and only afterwards and with effort do we evaluate, and if necessary, un-believe it.

Distraction, fatigue, and stress tend to make us less likely to think things through and more likely to believe something that we normally might doubt.

When it comes to detecting lies, many (if not most) people are only slightly better than chance.  Bevelin quotes Michel de Montaigne:

If falsehood, like truth, had only one face, we would be in better shape.  For we would take as certain the opposite of what the liar said.  But the reverse of truth has a hundred thousand shapes and a limitless field.

22. Memory Limitations

Bevelin:

Our memory is selective.  We remember certain things and distort or forget others.  Every time we recall an event, we reconstruct our memories.  We only remember fragments of our real past experiences.  Fragments influenced by what we have learned, our experiences, beliefs, mood, expectations, stress, and biases.

We remember things that are dramatic, fearful, emotional, or vivid.  But when it comes to learning in general—as opposed to remembering—we learn better when we’re in a positive mood.

Human memory is flawed to the point that eyewitness identification evidence has been a significant cause of wrongful convictions.  Moreover, leading and suggestive questions can cause misidentification.  Bevelin:

Studies show that it is easy to get a witness to believe they saw something when they didn’t.  Merely let some time pass between their observation and the questioning.  Then give them false or emotional information about the event.

23. Do-something Syndrome

Activity is not the same thing as results.  Most people feel impelled by boredom or hubris to be active.  But many things are not worth doing.

If we’re long-term investors, then nearly all of the time the best thing for us to do is nothing at all (other than learn).  This is especially true if we’re tired, stressed, or emotional.

24. Say-something Syndrome

Many people have a hard time either saying nothing or saying, “I don’t know.”  But it’s better for us to say nothing if we have nothing to say.  It’s better to admit “I don’t know” rather than pretend to know.

25. Emotions

Bevelin writes:

We saw under loss aversion and deprival that we put a higher value on things we already own than on the same things if we don’t own them.  Sadness reverses this effect, making us willing to accept less money to sell something than we would pay to buy it.

It’s also worth repeating: If we feel emotional, it’s best to defer important decisions whenever possible.

26. Stress

A study showed that business executives who are committed to their work and who have a positive attitude towards challenges—viewing them as opportunities for growth—do not get sick from stress.  Business executives who lack such commitment or who lack a positive attitude towards challenges are more likely to get sick from stress.

Stress itself is essential to life.  We need challenges.  What harms us is not stress but distress—unnecessary anxiety and unhelpful trains of thought.  Bevelin quotes the stoic philosopher Epictetus:

Happiness and freedom begin with a clear understanding of one principle: Some things are within our control, and some things are not.  It is only after you have faced up to this fundamental rule and learned to distinguish between what you can and can’t control that inner tranquility and outer effectiveness become possible.

27. Pain and Chemicals

People struggle to think clearly when they are in pain or when they’re drunk or high.

Munger argues that if we want to live a good life, first we should list the things that can ruin a life.  Alcohol and drugs are near the top of the list.  Self-pity and a poor mental attitude will also be on that list.  We can’t control everything that happens, but we can always control our mental attitude.  As the Austrian psychiatrist and Holocaust survivor Viktor Frankl said:

Everything can be taken from a man but one thing: the last of the human freedoms—to choose one’s attitude in any given set of circumstances, to choose one’s own way.

28. Multiple Tendencies

Often multiple psychological tendencies operate at the same time.  Bevelin gives an example where the CEO makes a decision and expects the board of directors to go along without any real questions.  Bevelin explains:

Apart from incentive-caused bias, liking, and social approval, what are some other tendencies that operate here?  Authority—the CEO is the authority figure whom directors tend to trust and obey.  He may also make it difficult for those who question him.  Social proof—the CEO is doing dumb things but no one else is objecting so all directors collectively stay quiet—silence equals consent; illusions of the group as invulnerable and group pressure (loyalty) may also contribute.  Reciprocation—unwelcome information is withheld since the CEO is raising the director fees, giving them perks, taking them on trips or letting them use the corporate jet.  Association and Persian Messenger Syndrome—a single director doesn’t want to be the carrier of bad news.  Self-serving tendencies and optimism—feelings of confidence and optimism: many boards also select new directors who are much like themselves; that share similar ideological viewpoints.  Deprival—directors don’t want to lose income and status.  Respecting reasons no matter how illogical—the CEO gives them reasons.  Believing first and doubting later—believing what the CEO says even if not true, especially when distracted.  Consistency—directors want to be consistent with earlier decisions—dumb or not.

 

Part Three:  The Physics and Mathematics of Misjudgments

SYSTEMS THINKING

  • Failing to consider that actions have both intended and unintended consequences.  Includes failing to consider secondary and higher order consequences and inevitable implications.
  • Failing to consider the whole system in which actions and reactions take place, the important factors that make up the system, their relationships and effects of changes on system outcome.
  • Failing to consider the likely reaction of others—what is best to do may depend on what others do.
  • Failing to consider the implications of winning a bid—overestimating value and paying too much.
  • Overestimating predictive ability or using unknowable factors in making predictions.

 

SCALE AND LIMITS

  • Failing to consider that changes in size or time influence form, function, and behavior.
  • Failing to consider breakpoints, critical thresholds, or limits.
  • Failing to consider constraints—that a system’s performance is constrained by its weakest link.

 

CAUSES

  • Not understanding what causes desired results.
  • Believing cause resembles its effect—that a big effect must have a big or complicated cause.
  • Underestimating the influence of randomness in bad or good outcomes.
  • Mistaking an effect for its cause.  Includes failing to consider that many effects may originate from one common root cause.
  • Attributing outcome to a single cause when there are multiple causes.
  • Mistaking correlation for cause.
  • Failing to consider that an outcome may be consistent with alternative explanations.
  • Drawing conclusions about causes from selective data.  Includes identifying the wrong cause because it seems the obvious one based on a single observed effect.  Also failing to consider information or evidence that is missing.
  • Not comparing the difference in conditions, behavior, and factors between negative and positive outcomes in similar situations when explaining an outcome.

 

NUMBERS AND THEIR MEANING

  • Looking at isolated numbers—failing to consider relationships and magnitudes.  Includes not using basic math to count and quantify.  Also not differentiating between relative and absolute risk.
  • Underestimating the effect of exponential growth.
  • Underestimating the time value of money.

 

PROBABILITIES AND NUMBER OF POSSIBLE OUTCOMES

  • Underestimating risk exposure in situations where relative frequency (or comparable data) and/or magnitude of consequences is unknown or changing over time.
  • Underestimating the number of possible outcomes for unwanted events.  Includes underestimating the probability and severity of rate or extreme events.
  • Overestimating the chance of rare but widely publicized and highly emotional events and underestimating the chance of common but less publicized events.
  • Failing to consider both probabilities and consequences (expected value).
  • Believing events where chance plays a role are self-correcting—that previous outcomes of independent events have predictive value in determining future outcomes.
  • Believing one can control the outcome of events where chance is involved.
  • Judging financial decisions by evaluating gains and losses instead of final state of wealth and personal value.
  • Failing to consider the consequences of being wrong.

 

SCENARIOS

  • Overestimating the probability of scenarios where all of a series of steps must be achieved for a wanted outcome.  Also underestimating opportunities for failure and what normally happens in similar situations.
  • Underestimating the probability of systems failure—scenarios composed of many parts where system failure can happen one way or another.  Includes failing to consider that time horizon changes probabilities.  Also assuming independence when it is not present and/or assuming events are equally likely when they are not.
  • Not adding a factor of safety for known and unknown risks.  Size of factor depends on the consequences of failure, how well the risks are understood, systems characteristics, and degree of control.

 

COINCIDENCES AND MIRACLES

  • Underestimating that surprises and improbable events happen, somewhere, sometime, to someone, if they have enough opportunities (large enough size or time) to happen.
  • Looking for meaning, searching for causes, and making up patterns for chance events, especially events that have emotional implications.
  • Failing to consider cases involving the absence of a cause or effect.

 

RELIABILITY OF CASE EVIDENCE

  • Overweighing individual case evidence and under-weighing the prior probability (probability estimate of an event before considering new evidence that might change it) considering for example, the base rate (relative frequency of an attribute or event in a representative comparison group), or evidence from many similar cases.  Includes failing to consider the probability of a random match, and the probability of a false positive and a false negative.  Also failing to consider a relevant comparison population that bears the characteristic we are seeking.

 

MISREPRESENTATIVE EVIDENCE

  • Failing to consider changes in factors, context, or conditions when using past evidence to predict likely future outcomes.  Includes not searching for explanations to why a past outcome happened, what is required to make the past record continue, and what forces can change it.
  • Overestimating evidence from a single case or small or unrepresentative samples.
  • Underestimating the influence of chance in performance (success and failure)
  • Only seeing positive outcomes—paying little or no attention to negative outcomes and prior probabilities.
  • Failing to consider variability of outcomes and their frequency.
  • Failing to consider regression—in any series of events where chance is involved, unique outcomes tend to regress back to the average outcome.

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Buffett’s Best: Microcap Cigar Butts

(Image:  Zen Buddha Silence by Marilyn Barbone)

November 25, 2018

Warren Buffett, the world’s greatest investor, earned the highest returns of his career from microcap cigar butts.  Buffett wrote in the 2014 Berkshire Letter:

My cigar-butt strategy worked very well while I was managing small sums.  Indeed, the many dozens of free puffs I obtained in the 1950’s made the decade by far the best of my life for both relative and absolute performance.

Even then, however, I made a few exceptions to cigar butts, the most important being GEICO.  Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares.  Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices.  Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent:  Cigar-butt investing was scalable only to a point.  With large sums, it would never work well…

Before Buffett led Berkshire Hathaway, he managed an investment partnership from 1957 to 1970 called Buffett Partnership Ltd. (BPL).  While running BPL, Buffett wrote letters to limited partners filled with insights (and humor) about investing and business.  Jeremy C. Miller has written a great book— Warren Buffett’s Ground Rules (Harper, 2016)—summarizing the lessons from Buffett’s partnership letters.

This blog post considers a few topics related to microcap cigar butts:

  • Net Nets
  • Dempster: The Asset Conversion Play
  • Liquidation Value or Earnings Power?
  • Mean Reversion for Cigar Butts
  • Focused vs. Statistical
  • The Rewards of Psychological Discomfort
  • Conclusion

 

NET NETS

Here Miller quotes the November 1966 letter, in which Buffett writes about valuing the partnership’s controlling ownership position in a cigar-butt stock:

…Wide changes in the market valuations accorded stocks at some point obviously find reflection in the valuation of businesses, although this factor is of much less importance when asset factors (particularly when current assets are significant) overshadow earnings power considerations in the valuation process…

Ben Graham’s primary cigar-butt method was net nets.  Take net current asset value minus ALL liabilities, and then only buy the stock at 2/3 (or less) of that level.  If you buy a basket (at least 20-30) of such stocks, then given enough time (at least a few years), you’re virtually certain to get good investment results, predominantly far in excess of the broad market.

A typical net-net stock might have $30 million in cash, with no debt, but have a market capitalization of $20 million.  Assume there are 10 million shares outstanding.  That means the company has $3/share in net cash, with no debt.  But you can buy part ownership of this business by paying only $2/share.  That’s ridiculously cheap.  If the price remained near those levels, you could effectively buy $1 million in cash for $667,000—and repeat the exercise many times.

Of course, a company that cheap almost certainly has problems and may be losing money.  But every business on the planet, at any given time, is in either one of two states:  it is having problems, or it will be having problems.  When problems come—whether company-specific, industry-driven, or macro-related—that often causes a stock to get very cheap.

The key question is whether the problems are temporary or permanent.  Statistically speaking, many of the problems are temporary when viewed over the subsequent 3 to 5 years.  The typical net-net stock is so extremely cheap relative to net tangible assets that usually something changes for the better—whether it’s a change by management, or a change from the outside (or both).  Most net nets are not liquidated, and even those that are still bring a profit in many cases.

The net-net approach is one of the highest-returning investment strategies ever devised.  That’s not a surprise because net nets, by definition, are absurdly cheap on the whole, often trading below net cash—cash in the bank minus ALL liabilities.

Buffett called Graham’s net-net method the cigar-butt approach:

…I call it the cigar-butt approach to investing.  You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free – it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant.  But it works.  Those are low return businesses.

Link: http://intelligentinvestorclub.com/downloads/Warren-Buffett-Florida-Speech.pdf

(Photo by Sky Sirasitwattana)

When running BPL, Buffett would go through thousands of pages of Moody’s Manuals (and other such sources) to locate just one or a handful of microcap stocks trading at less than liquidation value.  Other leading value investors have also used this technique.  This includes Charlie Munger (early in his career), Walter Schloss, John Neff, Peter Cundill, and Marty Whitman, to name a few.

The cigar-butt approach is also called deep value investing.  This normally means finding a stock that is available below liquidation value, or at least below net tangible book value.

When applying the cigar-butt method, you can either do it as a statistical group approach, or you can do it in a focused manner.  Walter Schloss achieved one of the best long-term track records of all time—near 21% annually (gross) for 47 years—using a statistical group approach to cigar butts.  Schloss typically had a hundred stocks in his portfolio, most of which were trading below tangible book value.

At the other extreme, Warren Buffett—when running BPL—used a focused approach to cigar butts.  Dempster is a good example, which Miller explores in detail in his book.

 

DEMPSTER: THE ASSET CONVERSION PLAY

Dempster was a tiny micro cap, a family-owned company in Beatrice, Nebraska, that manufactured windmills and farm equipment.  Buffett slowly bought shares in the company over the course of five years.

(Photo by Digikhmer)

Dempster had a market cap of $1.6 million, about $13.3 million in today’s dollars, says Miller.

  • Note:  A market cap of $13.3 million is in the $10 to $25 million range—among the tiniest micro caps—which is avoided by nearly all investors, including professional microcap investors.

Buffett’s average price paid for Dempster was $28/share.  Buffett’s estimate of liquidation value early on was near $35/share, which is intentionally conservative.  Miller quotes one of Buffett’s letters:

The estimated value should not be what we hope it would be worth, or what it might be worth to an eager buyer, etc., but what I would estimate our interest would bring if sold under current conditions in a reasonably short period of time.

To estimate liquidation value, Buffett followed Graham’s method, as Miller explains:

  • cash, being liquid, doesn’t need a haircut
  • accounts receivable are valued at 85 cents on the dollar
  • inventory, carried on the books at cost, is marked down to 65 cents on the dollar
  • prepaid expenses and “other” are valued at 25 cents on the dollar
  • long-term assets, generally less liquid, are valued using estimated auction values

Buffett’s conservative estimate of liquidation value for Dempster was $35/share, or $2.2 million for the whole company.  Recall that Buffett paid an average price of $28/share—quite a cheap price.

Even though the assets were clearly there, Dempster had problems.  Stocks generally don’t get that cheap unless there are major problems.  In Dempster’s case, inventories were far too high and rising fast.  Buffett tried to get existing management to make needed improvements.  But eventually Buffett had to throw them out.  Then the company’s bank was threatening to seize the collateral on the loan.  Fortunately, Charlie Munger—who later became Buffett’s business partner—recommended a turnaround specialist, Harry Bottle.  Miller:

Harry did such an outstanding job whipping the company into shape that Buffett, in the next year’s letter, named him “man of the year.”  Not only did he reduce inventories from $4 million to $1 million, alleviating the concerns of the bank (whose loan was quickly repaid), he also cut administrative and selling expenses in half and closed five unprofitable branches.  With the help of Buffett and Munger, Dempster also raised prices on their used equipment up to 500% with little impact to sales volume or resistance from customers, all of which worked in combination to restore a healthy economic return in the business.

Miller explains that Buffett rationally focused on maximizing the return on capital:

Buffett was wired differently, and he achieves better results in part because he invests using an absolute scale.  With Dempster he wasn’t at all bogged down with all the emotional baggage of being a veteran of the windmill business.  He was in it to produce the highest rate of return on the capital he had tied up in the assets of the business.  This absolute scale allowed him to see that the fix for Dempster would come by not reinvesting back into windmills.  He immediately stopped the company from putting more capital in and started taking the capital out.

With profits and proceeds raised from converting inventory and other assets to cash, Buffett started buying stocks he liked.  In essence, he was converting capital that was previously utilized in a bad (low-return) business, windmills, to capital that could be utilized in a good (high-return) business, securities.

Bottle, Buffett, and Munger maximized the value of Dempster’s assets.  Buffett took the further step of not reinvesting cash in a low-return business, but instead investing in high-return stocks.  In the end, on its investment of $28/share, BPL realized a net gain of $45 per share.  This is a gain of a bit more than 160% on what was a very large position for BPL—one-fifth of the portfolio.  Had the company been shut down by the bank, or simply burned through its assets, the return after paying $28/share could have been nothing or even negative.

Miller nicely summarizes the lessons of Buffett’s asset conversion play:

Buffett teaches investors to think of stocks as a conduit through which they can own their share of the assets that make up a business.  The value of that business will be determined by one of two methods: (1) what the assets are worth if sold, or (2) the level of profits in relation to the value of assets required in producing them.  This is true for each and every business and they are interrelated…

Operationally, a business can be improved in only three ways: (1) increase the level of sales; (2) reduce costs as a percent of sales; (3) reduce assets as a percentage of sales.  The other factors, (4) increase leverage or (5) lower the tax rate, are the financial drivers of business value.  These are the only ways a business can make itself more valuable.

Buffett “pulled all the levers” at Dempster…

 

LIQUIDATION VALUE OR EARNINGS POWER?

For most of the cigar butts that Buffett bought for BPL, he used Graham’s net-net method of buying at a discount to liquidation value, conservatively estimated.  However, you can find deep value stocks—cigar butts—on the basis of other low “price-to-a-fundamental” ratio’s, such as low P/E or low EV/EBITDA.  Even Buffett, when he was managing BPL, used a low P/E in some cases to identify cigar butts.  (See an example below: Western Insurance Securities.)

Tobias Carlisle and Wes Gray tested various measures of cheapness from 1964 to 2011.  Quantitative Value (Wiley, 2012)—an excellent book—summarizes their results.  James P. O’Shaughnessy has conducted one of the broadest arrays of statistical backtests.  See his results in What Works on Wall Street (McGraw-Hill, 4th edition, 2012), a terrific book.

(Illustration by Maxim Popov)

  • Carlisle and Gray found that low EV/EBIT was the best-performing measure of cheapness from 1964 to 2011.  It even outperformed composite measures.
  • O’Shaughnessy learned that low EV/EBITDA was the best-performing individual measure of cheapness from 1964 to 2009.
  • But O’Shaughnessy also discovered that a composite measure—combining low P/B, P/E, P/S, P/CF, and EV/EBITDA—outperformed low EV/EBITDA.

Assuming relatively similar levels of performance, a composite measure is arguably better because it tends to be more consistent over time.  There are periods when a given individual metric might not work well.  The composite measure will tend to smooth over such periods.  Besides, O’Shaughnessy found that a composite measure led to the best performance from 1964 to 2009.

Carlisle and Gray, as well as O’Shaughnessy, didn’t include Graham’s net-net method in their reported results.  Carlisle wrote another book, Deep Value (Wiley, 2014)—which is fascinating—in which he summarizes several tests of net nets:

  • Henry Oppenheimer found that net nets returned 29.4% per year versus 11.5% per year for the market from 1970 to 1983.
  • Carlisle—with Jeffrey Oxman and Sunil Mohanty—tested net nets from 1983 to 2008.  They discovered that the annual returns for net nets averaged 35.3% versus 12.9% for the market and 18.4% for a Small Firm Index.
  • A study of the Japanese market from 1975 to 1988 uncovered that net nets outperformed the market by about 13% per year.
  • An examination of the London Stock Exchange from 1981 to 2005 established that net nets outperformed the market by 19.7% per year.
  • Finally, James Montier analyzed all developed markets globally from 1985 to 2007.  He learned that net nets averaged 35% per year versus 17% for the developed markets on the whole.

Given these outstanding returns, why didn’t Carlisle and Gray, as well as O’Shaughnessy, consider net nets?  Primarily because many net nets are especially tiny microcap stocks.  For example, in his study, Montier found that the median market capitalization for net nets was $21 million.  Even the majority of professionally managed microcap funds do not consider stocks this tiny.

  • Recall that Dempster had a market cap of $1.6 million, or about $13.3 million in today’s dollars.
  • Unlike the majority of microcap funds, the Boole Microcap Fund does consider microcap stocks in the $10 to $25 million market cap range.

In 1999, Buffett commented that he could get 50% per year by investing in microcap cigar butts.  He was later asked about this comment in 2005, and he replied:

Yes, I would still say the same thing today.  In fact, we are still earning those types of returns on some of our smaller investments.  The best decade was the 1950s;  I was earning 50% plus returns with small amounts of capital.  I would do the same thing today with smaller amounts.  It would perhaps even be easier to make that much money in today’s environment because information is easier to access.  You have to turn over a lot of rocks to find those little anomalies.  You have to find the companies that are off the map—way off the map.  You may find local companies that have nothing wrong with them at all.  A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!!  I tried to buy up as much of it as possible.  No one will tell you about these businesses.  You have to find them.

Although the majority of microcap cigar butts Buffett invested in were cheap relative to liquidation value—cheap on the basis of net tangible assets—Buffett clearly found some cigar butts on the basis of a low P/E.  Western Insurance Securities is a good example.  It had a P/E of 0.15.

 

MEAN REVERSION FOR CIGAR BUTTS

Warren Buffett commented on high quality companies versus statistically cheap companies in his October 1967 letter to partners:

The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors.  At the one extreme, the analyst exclusively oriented to qualitative factors would say, “Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.”  On the other hand, the quantitative spokesman would say, “Buy at the right price and the company (and stock) will take care of itself.”  As is so often the pleasant result in the securities world, money can be made with either approach.  And, of course, any analyst combines the two to some extent—his classification in either school would depend on the relative weight he assigns to the various factors and not to his consideration of one group of factors to the exclusion of the other group.

Interestingly enough, although I consider myself to be primarily in the quantitative school… the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”.  This is what causes the cash register to really sing.  However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat.  So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Buffett and Munger acquired See’s Candies for Berkshire Hathaway in 1972.  See’s Candies is the quintessential high quality company because of its sustainably high ROIC (return on invested capital) of over 100%.

Truly high quality companies—like See’s—are very rare and difficult to find.  Cigar butts are much easier to find by comparison.

Furthermore, it’s important to understand that Buffett got around 50% annual returns from cigar butts because he took a focused approach, like BPL’s 20% position in Dempster.

The vast majority of investors, if using a cigar-butt approach like net nets, should implement a group—or statistical—approach, and regularly buy and hold a basket of cigar butts (at least 20-30).  This typically won’t produce 50% annual returns.  But net nets, as a group, clearly have produced very high returns, often 30%+ annually.  To do this today, you’d have to look globally.

As an alternative to net nets, you could implement a group approach using one of O’Shaughnessy’s composite measures—such as low P/B, P/E, P/S, P/CF, EV/EBITDA.  Applying this to micro caps can produce 15-20% annual returns.  Still excellent results.  And much easier to apply consistently.

You may think that you can find some high quality companies.  But that’s not enough.  You have to find a high quality company that can maintain its competitive position and high ROIC.  And it has to be available at a reasonable price.

Most high quality companies are trading at very high prices, to the extent that you can’t do better than the market by investing in them.  In fact, often the prices are so high that you’ll probably do worse than the market.

Consider this observation by Charlie Munger:

The model I like to sort of simplify the notion of what goes o­n in a market for common stocks is the pari-mutuel system at the racetrack.  If you stop to think about it, a pari-mutuel system is a market.  Everybody goes there and bets and the odds change based o­n what’s bet.  That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on.  But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2.  Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal.  The prices have changed in such a way that it’s very hard to beat the system.

(Illustration by Nadoelopisat)

A horse with a great record (etc.) is much more likely to win than a horse with a terrible record.  But—whether betting on horses or betting on stocks—you don’t get paid for identifying winners.  You get paid for identifying mispricings.

The statistical evidence is overwhelming that if you systematically buy stocks at low multiples—P/B, P/E, P/S, P/CF, EV/EBITDA, etc.—you’ll almost certainly do better than the market over the long haul.

A deep value (cigar-butt) approach has always worked, given enough time.  Betting on “the losers” has always worked eventually, whereas betting on “the winners” hardly ever works.

Classic academic studies showing “the losers” doing far better than “the winners” over subsequent 3- to 5-year periods:

That’s not to say deep value investing is easy.  When you put together a basket of statistically cheap companies, you’re buying stocks that are widely hated or neglected.  You have to endure loneliness and looking foolish.  Some people can do it, but it’s important to know yourself before using a deep value strategy.

In general, we extrapolate the poor performance of cheap stocks and the good performance of expensive stocks too far into the future.  This is the mistake of ignoring mean reversion.

When you find a group of companies that have been doing poorly for at least several years, those conditions typically do not persist.  Instead, there tends to be mean reversion, or a return to “more normal” levels of revenues, earnings, or cash flows.

Similarly for a group of companies that have been doing exceedingly well.  Those conditions also do not continue in general.  There tends to be mean reversion, but in this case the mean—the average or “normal” conditions—is below recent activity levels.

Here’s Ben Graham explaining mean reversion:

It is natural to assume that industries which have fared worse than the average are “unfavorably situated” and therefore to be avoided.  The converse would be assumed, of course, for those with superior records.  But this conclusion may often prove quite erroneous.  Abnormally good or abnormally bad conditions do not last forever.  This is true of general business but of particular industries as well.  Corrective forces are usually set in motion which tend to restore profits where they have disappeared or to reduce them where they are excessive in relation to capital.

With his taste for literature, Graham put the following quote from Horace’s Ars Poetica at the beginning of Security Analysis—the bible for value investors:

Many shall be restored that now are fallen and many shall fall than now are in honor.

Tobias Carlisle, while discussing mean reversion in Deep Value, smartly (and humorously) included this image of Albrecht Durer’s Wheel of Fortune:

(Albrecht Durer’s Wheel of Fortune from Sebastien Brant’s Ship of Fools (1494) via Wikimedia Commons)

 

FOCUSED vs. STATISTICAL

We’ve already seen that there are two basic ways to do cigar-butt investing: focused vs. statistical (group).

Ben Graham usually preferred the statistical (group) approach.  Near the beginning of the Great Depression, Graham’s managed accounts lost more than 80 percent.  Furthermore, the economy and the stock market took a long time to recover.  As a result, Graham had a strong tendency towards conservatism in investing.  This is likely part of why he preferred the statistical approach to net nets.  By buying a basket of net nets (at least 20-30), the investor is virtually certain to get the statistical results of the group over time, which are broadly excellent.

Graham also was a polymath of sorts.  He had wide-ranging intellectual interests.  Because he knew net nets as a group would do quite well over the long term, he wasn’t inclined to spend much time analyzing individual net nets.  Instead, he spent time on his other interests.

Warren Buffett was Graham’s best student.  Buffett was the only student ever to be awarded an A+ in Graham’s class at Columbia University.  Unlike Graham, Buffett has always had an extraordinary focus on business and investing.  After spending many years learning everything about virtually every public company, Buffett took a focused approach to net nets.  He found the ones that were the cheapest and that seemed the surest.

Buffett has asserted that returns can be improved—and risk lowered—if you focus your investments only on those companies that are within your circle of competence—those companies that you can truly understand.  Buffett also maintains, however, that the vast majority of investors should simply invest in index funds: http://boolefund.com/warren-buffett-jack-bogle/

Regarding individual net nets, Graham admitted a danger:

Corporate gold dollars are now available in quantity at 50 cents and less—but they do have strings attached.  Although they belong to the stockholder, he doesn’t control them.  He may have to sit back and watch them dwindle and disappear as operating losses take their toll.  For that reason the public refuses to accept even the cash holdings of corporations at their face value.

Graham explained that net nets are cheap because they “almost always have an unsatisfactory trend in earnings.”  Graham:

If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price.  The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.

(Image by Preecha Israphiwat)

Value investor Seth Klarman warns:

As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors.  Ongoing business losses can, however, quickly erode net-net working capital.  Investors must therefore always consider the state of a company’s current operations before buying.

Even Buffett—nearly two decades after closing BPL—wrote the following in his 1989 letter to Berkshire shareholders:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the “cigar butt” approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish.  First, the original “bargain” price probably will not turn out to be such a steal after all.  In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.  For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.  But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost…

Based on these objections, you might think that Buffett’s focused approach is better than the statistical (group) method.  That way, the investor can figure out which net nets are more likely to recover instead of burn through their assets and leave the investor with a low or negative return.

However, Graham’s response was that the statistical or group approach to net nets is highly profitable over time.  There is a wide range of potential outcomes for net nets, and many of those scenarios are good for the investor.  Therefore, while there are always some individual net nets that don’t work out, a group or basket of net nets is nearly certain to work well eventually.

Indeed, Graham’s application of a statistical net-net approach produced 20% annual returns over many decades.  Most backtests of net nets have tended to show annual returns of close to 30%.  In practice, while around 5 percent of net nets may suffer a terminal decline in stock price, a statistical group of net nets has done far better than the market and has experienced fewer down years.  Moreover, as Carlisle notes in Deep Value, very few net nets are actually liquidated or merged.  In the vast majority of cases, there is a change by management, a change from the outside, or both, in order to restore earnings to a level more in line with net asset value.  Mean reversion.

 

THE REWARDS OF PSYCHOLOGICAL DISCOMFORT

We noted earlier that it’s far more difficult to find a company like See’s Candies, at a reasonable price, than it is to find statistically cheap stocks.  Moreover, if you buy a basket of statistically cheap stocks, you don’t have to possess an ability to analyze individual businesses in great depth.

That said, in order to use a deep value strategy, you do have to be able to handle the psychological discomfort of being lonely and looking foolish.

(Illustration by Sangoiri)

John Mihaljevic, author of The Manual of Ideas (Wiley, 2013), writes:

Comfort can be expensive in investing.  Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations….

…Misery loves company, so it makes sense that rewards may await those willing to be miserable in solitude…

Mihaljevic explains:

If we owned nothing but a portfolio of Ben Graham-style bargain equities, we may become quite uncomfortable at times, especially if the market value of the portfolio declined precipitously.  We might look at the portfolio and conclude that every investment could be worth zero.  After all, we could have a mediocre business run by mediocre management, with assets that could be squandered.  Investing in deep value equities therefore requires faith in the law of large numbers—that historical experience of market-beating returns in deep value stocks and the fact that we own a diversified portfolio will combine to yield a satisfactory result over time.  This conceptually sound view becomes seriously challenged in times of distress…

Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows.  In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values.  After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow?

Deep value investors often find some of the best investments in cyclical areas.  A company at a cyclical low may have multi-bagger potential—the prospect of returning 300-500% (or more) to the investor.

A good current example is Ensco plc (NYSE: ESV), an offshore oil driller.  Ensco is a leading offshore driller with a high-specification, globally diverse fleet.  The company also has one of the lowest cost structures, and relatively low debt levels (with the majority of debt due in 2024 or later).  In addition, Ensco has a long history of safety and operational excellence.  Ensco has been rated #1 for eight consecutive years in the leading independent customer satisfaction survey.

Intrinsic value scenarios for Ensco:

  • Low case: If oil prices languish below $60 (WTI) for the next 3 to 5 years, then Ensco will be a survivor, due to its large fleet, globally diverse customer base, industry leading performance, and well-capitalized position.  In this scenario, Ensco is likely worth at least $12 a share, over 90% higher than today’s $6.26.  (Current book value is $19.30 a share.)
  • Mid case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years—which is likely based on long-term supply and demand—then Ensco is probably worth at least $25 a share, about 300% higher than today’s $6.26.
  • High case: If oil prices average $85 or more over the next 3 to 5 years, then Ensco could easily be worth $37 a share, over 490% higher than today’s $6.26.

Mihaljevic comments on a central challenge of deep value investing in cyclical companies:

The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation.  Even if a business has been cyclical in the past, analysts generally adopt a “this time is different” attitude.  As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus.

Consider the following industries that have been pronounced permanently impaired in the past, only to rebound strongly in subsequent years:  Following the financial crisis of 2008-2009, many analysts argued that the banking industry would be permanently negatively affected, as higher capital requirements and regulatory oversight would compress returns on equity.  The credit rating agencies were seen as impaired because the regulators would surely alter the business model of the industry for the worse following the failings of the rating agencies during the subprime mortgage bubble.  The homebuilding industry would fail to rebound as strongly as in the past, as overcapacity became chronic and home prices remained tethered to building costs.  The refining industry would suffer permanently lower margins, as those businesses were capital-intensive and driven by volatile commodity prices.

Are offshore oil drillers in a cyclical or a secular decline?  It’s likely that oil will return to $65-85 in the next 3 to 5 years.  But no one knows for sure.

Ongoing improvements in technology allow oil producers to get more oil—more cheaply—out of existing fields.  Also, growth in transport demand for oil will slow significantly at some point, due to ongoing improvements in fuel efficiency.  See: https://www.spe.org/en/jpt/jpt-article-detail/?art=3286

Transport demand is responsible for over 50% of daily oil consumption, and it’s inelastic—typically people have to get where they’re going, so they’re not very sensitive to fuel price increases.

But even if oil never returns to $65+, oil will be needed for many decades.  At least some offshore drilling will still be needed.

What’s great about an investment in Ensco is that even in worst case, the company will survive and the stock would likely be worth at least $12 a share, almost double today’s $6.26.  Recall that book value is $19.30 a share, and that the company has a low cost structure.  Also note that because of its safety, reliability, high-spec assets, and well-capitalized position, Ensco has continued to win a disproportionate share of new contracts.

If the worst-case scenario means that you’ll double your money—over a 3- to 5-year holding period—that’s an interesting investment.  And if the base case scenario means that you’ll quadruple your money (or better), well…

Notes:

  • The Boole Fund had an investment in Atwood Oceanics.  Because Ensco acquired Atwood in 2017, the Boole Fund now own shares in Ensco.
  • The Boole Fund holds positions for 3 to 5 years.  The fund doesn’t sell an investment that is still cheap, even if the stock in question is no longer a micro cap.
  • On October 8, Ensco plc (ESV) and Rowan Companies plc (RDC) announced that they are merging in an all-stock transaction.  The new entity is probably even more undervalued than Ensco was prior to the announcement.  That’s based partly on projected cost savings of $150 million a year—which is credible based on track record.  In addition, besides being a leader in ultra-harsh and modern harsh environment jackups, Rowan has a groundbreaking partnership (ARO Drilling) with Saudi Aramco that will likely create billions of dollars in value for shareholders.

 

CONCLUSION

Buffett has made it clear, including in his 2014 letter to shareholders, that the best returns of his career came from investing in microcap cigar butts.  Most of these were mediocre businesses (or worse).  But they were ridiculously cheap.  And, in some cases like Dempster, Buffett was able to bring about needed improvements when required.

When Buffett wrote about buying wonderful businesses in his 1989 letter, that’s chiefly because investable assets at Berkshire Hathaway had grown far too large for microcap cigar butts.

Even in recent years, Buffett invested part of his personal portfolio in a group of cigar butts he found in South Korea.  So he’s never changed his view that an investor can get the highest returns from microcap cigar butts, either by using a statistical group approach or by using a more focused method.

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Capitalism without Capital

(Image:  Zen Buddha Silence by Marilyn Barbone.)

November 11, 2018

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

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

(Photo by W. Scott McGill)

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

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

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

The Dark Matter of Investment

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

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

(Photo by tashatuvango)

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

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

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

Why Intangible Investment is Different

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

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

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

Outline for this blog post:

Part I  The Rise of the Intangible Economy

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

Part II  The Consequences of the Rise of the Intangible Economy

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

 

Part I  The Rise of the Intangible Economy

CAPITAL’S VANISHING ACT

Investment has changed:

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

Investment, assets, and capital all have multiple meanings.

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

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

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

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

Haskel and Westlake offer some examples of intangible investments:

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

(Photo by magele-picture)

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

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

Intangible Investment Has Steadily Grown

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

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

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

Reasons for the Growth of Intangible Investment

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

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

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

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

 

HOW TO MEASURE INTANGIBLE INVESTMENT

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

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

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

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

(Photo by Krisana Antharith)

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

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

What Sorts of Intangibles Are There?

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

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

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

Measuring Investment in Intangibles

Haskel and Westlake:

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

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

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

 

WHAT’S DIFFERENT ABOUT INTANGIBLE INVESTMENT?

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

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

Scalability

Why Are Intangibles Scalable?

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

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

(Illustration by Aquir)

Why Does Scalability Matter?

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

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

Sunkenness

Why Are Intangibles Sunk Costs?

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

(Image by OpturaDesign)

Why Does Sunkenness Matter?

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

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

Spillovers

Why Do Intangibles Generate Spillovers?

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

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

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

Why Do Spillovers Matter?

(Photo by Vs1489)

Haskel and Westlake remark that spillovers matter for three reasons:

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

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

Haskel and Westlake:

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

Synergies

Why Do Intangibles Exhibit Synergies?

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

Haskel and Westlake write:

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

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

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

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

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

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

Why Do the Synergies of Intangible Assets Matter?

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

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

(Illustration by mindscanner)

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

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

 

Part II  The Consequences of the Rise of the Intangible Economy

INTANGIBLES, INVESTMENT, PRODUCTIVITY, AND SECULAR STAGNATION

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

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

(Illustration by ibreakstock)

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

There are three more aspects to secular stagnation.

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

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

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

Intangibles can help explain these facts.

Mismeasurement:  Intangibles and Apparently Low Investment

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

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

Haskel and Westlake state:

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

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

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

Are Intangibles Generating Fewer Spillovers?

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

 

INTANGIBLES AND THE RISE OF INEQUALITY

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

Standard explanations for inequality

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

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

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

(Illustration by manakil)

How Intangibles Affect Income, Wealth, and Esteem Inequality

Intangibles, Firms, and Income Inequality

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

Who is Benefiting from Intangible-Based Firm Inequality?

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

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

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

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

Housing Prices, Cities, Intangibles, and Wealth Inequality

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

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

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

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

 

INFRASTRUCTURE FOR INTANGIBLES, AND INTANGIBLE INFRASTRUCTURE

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

(Illustration by Panimoni)

Haskel and Westlake comment:

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

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

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

 

THE CHALLENGE OF FINANCING AN INTANGIBLE ECONOMY

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

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

Banking:  The Problem of Lending in a World of Intangibles

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

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

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

Haskel and Westlake on how equity markets impact intangible investing:

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

Why VC Works for Intangibles

(Photo by designer491)

Haskel and Westlake observe:

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

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

 

COMPETING, MANAGING, AND INVESTING IN THE INTANGIBLE ECONOMY

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

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

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

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

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

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

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

Leadership is important in an intangible economy.

(Photo by Raywoo)

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

Investing

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

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

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

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

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

What Should Investors Do?

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

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

Haskel and Westlake sum up the chapter:

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

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

 

PUBLIC POLICY IN AN INTANGIBLE ECONOMY:  FIVE HARD QUESTIONS

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

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

Clearer Rules and Norms about the Ownership of Intangibles

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

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

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

Helping Ideas Combine:  Maximizing the Benefits of Synergies

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

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

A Financial Architecture for Intangible Investment

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

Solving the Intangible Investment Gap

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

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

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

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

 

BOOLE MICROCAP FUND

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

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

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

The 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 Outsiders: Radically Rational CEOs

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 21, 2018

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(Illustration by yiorgosgr)

Here are the sections in the blog post:

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

 

INTRODUCTION

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

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

Thorndike describes how the outsider CEOs were iconoclasts:

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

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

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

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

(Photo by mbridger68)

 

TOM MURPHY AND CAPITAL CITIES BROADCASTING

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thorndike concludes his discussion of Capital Cities:

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

 

HENRY SINGLETON AND TELEDYNE

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

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

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

(Photo of Teledyne logo by Piotr Trojanowski)

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

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

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

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

FCF = net income + DDA – capex

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

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

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

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

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

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

 

BILL ANDERS AND GENERAL DYNAMICS

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

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

(General Dynamics logo, via Wikimedia Commons)

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

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

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

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

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

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

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

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

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

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

 

JOHN MALONE AND TCI

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

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

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

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

(TCI logo, via Wikimedia Commons)

The industry had excellent tax characteristics:

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

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

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

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

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

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

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

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

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

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

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

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

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

 

KATHARINE GRAHAM AND THE WASHINGTON POST COMPANY

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

(The Washington Post logo, via Wikimedia Commons)

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

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

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

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

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

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

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

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

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

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

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

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

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

 

BILL STIRITZ AND RALSTON PURINA

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

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

(Purina logo, via Wikimedia Commons)

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

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

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

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

Thorndike continues:

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

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

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

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

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

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

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

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

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

 

DICK SMITH AND GENERAL CINEMA

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

(General Cinema logo, via Wikimedia Commons)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thorndike continues:

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

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

 

WARREN BUFFETT AND BERKSHIRE HATHAWAY

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(Coca-Cola Company logo, via Wikimedia Commons)

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

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

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

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

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

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

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

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

The Nuts and Bolts

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

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

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

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

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

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

Thorndike:

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

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

 

 

RADICAL RATIONALITY:  THE OUTSIDER’S MINDSET

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

Thorndike sums up the outsider’s mindset:

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

Always Do the Math

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

The Denominator Matters

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

A Feisty Independence

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

Charisma Is Overrated

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

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

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

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

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

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

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

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

A Long-Term Perspective

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

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

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

 

BOOLE MICROCAP FUND

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

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

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

The 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.

Quantitative Deep Value Investing

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 14, 2018

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

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

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

Buffett has called deep value investing the cigar butt approach:

…You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free—it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant.  But it works.  Those are low return businesses.

(Photo by Sensay)

Outline for this blog post:

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

 

RARE TEMPERAMENT

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

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

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

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

(Photo by Nikki Zalewski)

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

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

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

Comfort can be expensive in investing.  Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations.

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

 

EARLY BUFFETT: DEEP VALUE INVESTOR

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

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

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

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

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

 

INVESTORS MUCH PREFER INCOME OVER ASSETS

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

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

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

(Illustration by Teguh Jati Prasetyo)

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

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

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

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

 

COMPANIES AT CYCLICAL LOWS

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

(Illustration by Prairat Fhunta)

Mihaljevic:

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

The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation.  Even if a business has been cyclical in the past, analysts generally adopt a ‘this time is different’ attitude.  As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus.

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

Example: Ensco plc (ESV)

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

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

Here are intrinsic value scenarios:

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

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

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

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

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

 

BOOLE MICROCAP FUND

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

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

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

The 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.

Quantitative Microcap Value

(Image:  Zen Buddha Silence by Marilyn Barbone.)

October 7, 2018

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

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

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

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

(Photo by USA International Trade Administration)

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

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

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

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

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

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

What’s the catch?

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

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

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

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

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

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

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

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

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

Bottom Line

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

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

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

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

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

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

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

 

BOOLE MICROCAP FUND

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

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

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

The 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.

Think Twice

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 23, 2018

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

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

 

RQ vs IQ

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

Illustration by hafakot

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

“We try more to profit from always remembering the obvious than from grasping the esoteric. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” — Charlie Munger

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

 

THE OUTSIDE VIEW

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

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

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

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

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

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

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

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

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

Illustration by OptureDesign

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

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

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

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

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

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

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

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

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

Illustration by OpturaDesign

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

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

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

 

OPEN TO OPTIONS

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

Anchoring is an important example of this mistake.  Mauboussin:

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

(Illustration by Olga Vainshtein)

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

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

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

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

The Representativeness Heuristic

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

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

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

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

Another example Kahneman gives:

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

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

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

Availability Bias, Vividness Bias, Recency Bias

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

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

Extrapolating the Recent Past

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

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

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

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

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

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

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

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

Illustration by intheskies

Doubt Avoidance

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

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

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

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

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

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

Inconsistency Avoidance and Confirmation Bias

Munger on the Inconsistency-Avoidance Tendency:

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

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

Photo by Marek

Munger continues:

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

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

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

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

Selective Attention and Inattentional Blindness

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

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

Struggles and Stresses

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

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

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

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

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

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

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

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

Incentives

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

Incentives are extremely important:

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

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

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

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

 

THE EXPERT SQUEEZE

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I’ve written before about how simple quant models outperform experts in a wide variety of areas: http://boolefund.com/simple-quant-models-beat-experts-in-a-wide-variety-of-areas/

 

SITUATIONAL AWARENESS

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

(Photo by D-janous, via Wikimedia Commons)

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

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

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

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

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

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

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

Priming

Mauboussin:

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

(Subconscious as brain under water, Illustration by Agawa288)

Scientists did the following experiment:

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

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

Mauboussin gives some examples of priming:

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

The Fault of the Default

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

Illustration by hafakot

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

The Power of Inertia

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

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

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

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

 

MORE IS DIFFERENT

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

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

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

 

EVIDENCE OF CIRCUMSTANCE

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

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

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

What’s especially important, writes Mauboussin:

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

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

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

The Colonel Blotto Game

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

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

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

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

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

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

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

Bottom Line on Attributes vs. Circumstances

Mauboussin sums up the  main lesson on attributes versus circumstances:

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

 

PHASE TRANSITIONS—“GRAND AH-WHOOMS”

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

(Illustration by Designua)

Critical Points, Extremes, and Surprise

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

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

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

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

Mauboussin continues:

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

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

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

The Problem of Induction, Reductive Bias, and Bad Predictions

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

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

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

Black swan, Photo by Dr. Jürgen Tenckhoff

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

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

Most people would rather die than think;  many do.

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

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

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

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

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

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

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

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

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

Music Lab

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

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

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

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

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

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

(Illustration by Mindscanner)

Mauboussin summarizes the lessons:

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

 

SORTING LUCK FROM SKILL

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

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

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

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

Skill, Luck, and Outcomes

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

Success = Some talent + luck

Great success = Some talent + a lot of luck

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

Illustration by iQoncept

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

 

TIME TO THINK TWICE

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

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

Raise Your Awareness

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

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

Put Yourself in the Shoes of Others

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

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

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

Finally, leaders must develop empathy for people.

Recognize the Role of Skill and Luck

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

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

Get Feedback

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

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

 

(Photo by Vinay_Mathew)

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

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

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

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

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

Create a Checklist

Mauboussin:

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

Photo by Andrey Popov

Mauboussin again:

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

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

Perform a Premortem

Mauboussin explains:

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

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

Know What You Can’t Know

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

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

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

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Kahneman and Tversky

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 2, 2018

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

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

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

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

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

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

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

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

(Illustration by Alain Lacroix)

 

INTRODUCTION

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

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

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

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

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

 

MAN BOOBS

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

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

Lewis continues:

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

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

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

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

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

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

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

(Illustration by fotomek)

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

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

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

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

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

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

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

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

 

THE OUTSIDER

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

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

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

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

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

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

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

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

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

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

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

Lewis continues:

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

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

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

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

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

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

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

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

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

 

THE INSIDER

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(Transitivity illustration by Thuluviel, Wikimedia Commons)

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

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

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

This line of thinking led to some interesting insights:

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

 

ERRORS

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

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

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

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

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

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

Illustration by intheskies

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

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

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

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

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

 

THE COLLISION

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

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

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

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

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

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

Were human beings good intuitive statisticians?

(Image by Honina, Wikimedia Commons)

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

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

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

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

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

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

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

Lewis later writes:

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

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

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

 

THE MIND’S RULES

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

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

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

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

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

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

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

(Algorithm illustration by Blankstock)

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

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

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

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

“We were sharing a mind.”

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

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

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

(Image by Argus)

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

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

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

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

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

 

THE RULES OF PREDICTION

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

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

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

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

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

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

As Amos said:

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

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

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

Image by Zerophoto

 

GOING VIRAL

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

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

[…]

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

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

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

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

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

Photo by airdone

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

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

Amos and Redelmeier ended up doing a paper:

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

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

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

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

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

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

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

 

BIRTH OF THE WARRIOR PSYCHOLOGIST

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

THE ISOLATION EFFECT

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

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

Which of the following do you prefer?

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

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

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

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

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

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

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

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

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

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

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

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

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

Which of the two programs would you favor?

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

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

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

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

 

THIS CLOUD OF POSSIBILITY

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

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

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

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

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

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

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

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

Which of the two alternatives is more probable?

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

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

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

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

Lewis:

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

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

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

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

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

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Shoe Dog

(Image:  Zen Buddha Silence by Marilyn Barbone.)

August 19, 2018

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

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

 

DAWN

Knight introduces his story:

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

Worse, like the same shy, pale, rail-thin kid I’d always been.

Maybe because I still hadn’t experienced anything of life.  Least of all its many temptations and excitements.  I hadn’t smoked a cigarette, hadn’t tried a drug.  I hadn’t broken a rule, let alone a law.  The 1960s were just underway, the age of rebellion, and I was the only person in America who hadn’t yet rebelled.  I couldn’t think of one time I’d cut loose, done the unexpected.

I’d never even been with a girl.

If I tended to dwell on all the things I wasn’t, the reason was simple.  Those were the things I knew best.  I’d have found it difficult to see who or what exactly I was, or might become.  Like all my friends I wanted to be successful.  Unlike my friends I didn’t know what that meant.  Money?  Maybe.  Wife?  Kids?  House?  Sure, if I was lucky.  These were the goals I was taught to aspire to, and part of me did aspire to them, instinctively.  But deep down I was searching for something else, something more.  I had an aching sense that our time is short, shorter than we ever know, short as a morning run, and I wanted mine to be meaningful.  And purposeful.  And creative.  And important.  Above all… different.

I wanted to leave a mark on the world…

And then it happened.  As my young heart began to thump, as my pink lungs expanded like the wings of a bird, as the trees turned to greenish blurs, I saw it all before me, exactly what I wanted my life to be.  Play.

Yes, I thought.  That’s it.  That’s the word.  The secret of happiness, I’d always suspected, the essence of beauty or truth, or all we ever need to know of either, lay somewhere in that moment when the ball is in midair, when both boxers sense that approach of the bell, when the runners near the finish line and the crowd rises as one.  There’s a kind of exuberant clarity in that pulsing half second before winning and losing are decided.  I wanted that, whatever that was, to be my life, my daily life.

(Sweet Sixteen Syracuse vs. Gonzaga, March 25, 2016, Photo by Ryan Dickey, Wikimedia Commons)

Knight continues:

At different times, I’d fantasized about becoming a great novelist, a great journalist, a great statesman.  But the ultimate dream was always to be a great athlete.  Sadly, fate had made me good, not great.  At twenty-four, I was finally resigned to that fact.  I’d run track at Oregon, and I’d distinguished myself, lettering three of four years.  But that was that, the end.  Now, as I began to clip off one brisk six-minute mile after another, as the rising sun set fire to the lowest needles of the pines, I asked myself:  What if there were a way, without being an athlete, to feel what athletes feel?  To play all the time, instead of working?  Or else to enjoy work so much that it becomes essentially the same thing.

I was suddenly smiling.  Almost laughing.  Drenched in sweat, moving as gracefully and effortlessly as I ever did, I saw my Crazy Idea shining up ahead, and it didn’t look all that crazy.  It didn’t even look like an idea.  It looked like a place.  It looked like a person, or some life force that existed long before I did, separate from me, but also part of me.  Waiting for me, but also hiding from me.  That might sound a little high-flown, a little crazy.  But that’s how I felt back then.

…At twenty-four, I did have a crazy idea, and somehow, despite being dizzy with existential angst, and fears about the future, and doubts about myself, as all young men and women in their midtwenties are, I did decide that the world is made up of crazy ideas.  History is one long processional of crazy ideas.  The things I loved most – books, sports, democracy, free enterprise – started as crazy ideas.

For that matter, few ideas are as crazy as my favorite thing, running.  It’s hard.  It’s painful.  It’s risky.  The rewards are few and far from guaranteed… Whatever pleasures or gains you drive from the act of running, you must find them within.  It’s all in how you frame it, how you sell it to yourself.

(Runner silhouette, Illustration by Msanca)

Knight:

So that morning in 1962 I told myself:  Let everyone else call your idea crazy… just keep going.  Don’t stop.  Don’t even think about stopping until you get there, and don’t give much thought to where ‘there’ is.  Whatever comes, just don’t stop.

That’s the precocious, prescient, urgent advice I managed to give myself, out of the blue, and somehow managed to take.  Half a century later, I believe it’s the best advice – maybe the only advice – any of us should ever give.

 

1962

Knight explains that his crazy idea started as a research paper for a seminar on entrepreneurship at Stanford.  He became obsessed with the project.  As a runner, he knew about shoes.  He also knew that some Japanese products, such as cameras, had recently gained much market share.  Perhaps Japanese running shoes might do the same thing.

When Knight presented his idea to his classmates, everyone was bored.  No one asked any questions.  But Knight held on to his idea.  He imagined pitching it to a Japanese shoe company.  Knight also conceived of the idea of seeing the world on his way to Japan.  He wanted to see “the world’s most beautiful and wondrous places.”

And its most sacred.  Of course I wanted to taste other foods, hear other languages, dive into other cultures, but what I really craved was connection with a capital C.  I wanted to experience what the Chinese call Tao, the Greeks call Logos, the Hindus call Jnana, the Buddhists call Dharma.  What the Christians call Spirit.  Before setting out on my own personal life voyage, I thought, let me first understand the greater voyage of humankind.  Let me explore the grandest temples and churches and shrines, the holiest rivers and mountaintops.  Let me feel the presence of… God?

Yes, I told myself, yes.  For lack of a better word, God.

But Knight needed his father’s blessing and cash in order to make the trip around the world.

At the time, most people had never been on an airplane.  Also, Knight’s father’s father had died in an air crash.  As for the shoe company idea, Knight was keenly aware that twenty-six out of twenty-seven new companies failed.  Knight then notes that his father, besides being a conventional Episcopalian, also liked respectability.  Traveling around the world just wasn’t done except by beatniks and hipsters.

Knight then adds:

Possibly, the main reason for my father’s respectability fixation was a fear of his inner chaos.  I felt this, viscerally, because every now and then that chaos would burst forth.

Knight tells about having to pick his father up from his club.  On these evenings, Knight’s father had had too much to drink.  But father and son would pretend nothing was wrong.  They would talk sports.

Knight’s mom’s mom, “Mom Hatfield” – from Roseburg, Oregon – warned “Buck” (Knight’s nickname) that the Japanese would take him prisoner and gouge out his eyeballs.  Knight’s sisters, four years younger (twins), Jeanne and Joanne, had no reaction.  His mom didn’t say anything, as usual, but seemed proud of his decision.

Knight asked a Stanford classmate, Carter, a college hoops star, to come with him.  Carter loved to read good books.  And he liked Buck’s idea.

The first stop was Honolulu.  After seeing Hawaiian girls, then diving into the warm ocean, Buck told Carter they should stay.  What about the plan?  Plans change.  Carter liked the new idea and grinned.

They got jobs selling Encyclopedias door-to-door.  But their main mission was learning how to surf.  “Life was heaven.”  Except that Buck couldn’t sell encyclopedias.  He thought he was getting shier as he got older.

So he tried a job selling securities.  Specifically, Dreyfus funds for Investors Overseas Services, Bernard Cornfeld’s firm.  Knight had better luck with this.

Eventually, the time came for Buck and Carter to continue on their trip around the world.  However, Carter wasn’t sure.

He’d met a girl.  A beautiful Hawaiian teenager with long brown legs and jet-black eyes, the kind of girl who’d greeted our airplane, the kind I dreamed of having and never would.  He wanted to stick around, and how could I argue?

Buck hesitated, not sure he wanted to continue on alone.  But he decided not to stop his journey.  He bought a plane ticket that was good for one year on any airline going anywhere.

When Knight got to Tokyo, much of the city was black because it still hadn’t been rebuilt after the bombing.

American B-29s.  Superfortresses.  Over a span of several nights in the summer of 1944, waves of them dropped 750,000 pounds of bombs, most filled with gasoline and flammable jelly.  One of the world’s oldest cities, Tokyo was made largely of wood, so the bombs set off a hurricane of fire.  Some three hundred thousand people were burned alive, instantly, four times the number who died in Hiroshima.  More than a million were gruesomely injured.  And nearly 80 percent of the buildings were vaporized.  For long, solemn stretches the cab driver and I said nothing.  There was nothing to say.

Fortunately, Buck’s father knew some people in Tokyo at United Press International.  They advised Buck to talk to two ex-GI’s who ran a monthly magazine, the Importer.

First, Knight spent long periods of time in walled gardens reading about Buddhism and Shinto.  He liked the concept of kensho, or sartori – a flash of enlightenment.

But according to Zen, reality is nonlinear.  No past, no present.  All is now.  That required Knight to change his thinking.  There is no self.  Even in competition, all is one.

Knight decided to mix it up and visited the Tokyo Stock Exchange – Tosho.  All was madness and yelling.  Is this what it’s all about?

Knight sought peace and enlightenment again.  He visited the garden of the nineteenth century emperor Meiji and his empress.  This particular place was thought to possess great spiritual power.  Buck sat beneath the ginkgo trees, beside the gorgeous torii gate, which was thought of as a portal to the sacred.

Next it was Tsukiji, the world’s largest fish market.  Tosho all over again.

Then to the lakes region in the Northern Hakone mountains.  An area that inspired many of the great Zen poets.

Knight went to see the two ex-GI’s.  They told him how they’d fallen in love with Japan during the Occupation.  So they stayed.  They had managed to keep the import magazine going for seventeen years thus far.

Knight told them he liked the Tiger shoes produced by Onitsuka Co. in Kobe, Japan.  The ex-GI’s gave him tips on negotiating with the Japanese:

‘No one ever turns you down, flat.  No one ever says, straight out, no.  But they don’t say yes, either.  They speak in circles, sentences with no clear subject or object.  Don’t be discouraged, but don’t be cocky.  You might leave a man’s office thinking you’ve blown it, when in fact he’s ready to do a deal.  You might leave thinking you’ve closed a deal, when in fact you’ve just been rejected.  You never know.’

Knight decided to visit Onitsuka right away, with the advice fresh in his mind.  He managed to get an appointment, but got lost and arrived late.

When he did arrive, several executives met him.  Ken Miyazaki showed him the factory.  Then they went to a conference room.

Knight had rehearsed this scene his head, just like he used to visualize his races.  But one thing he hadn’t prepared for was the recent history of World War II hanging over everything.  The Japanese had heroically rebuilt, putting the war behind them.  And these Japanese executives were young.  Still, Knight thought, their fathers and uncles had tried to kill his.  In brief, Knight hesitated and coughed, then finally said, “Gentlemen.”

Mr. Miyazaki interrupted, “Mr. Knight.  What company are you with?”

Knight replied, “Ah, yes.  Good question.”  Knight experienced fight or flight for a moment.  A random jumble of thoughts flickered in his mind until he visualized his wall of blue ribbons from track.  “Blue Ribbon… Gentleman, I represent Blue Ribbon Sports of Portland, Oregon.”

Knight presented his basic argument, which was that the American shoe market was huge and largely untapped.  If Onitsuka could produce good shoes and price them below Adidas, it could be highly profitable.  Knight had spent so much time on his research paper at Stanford that he could simply quote it and come across as eloquent.

The Japanese executives started talking excitedly together, then suddenly stood up and left the room.  Knight didn’t know if he had been rejected.  Perhaps he should leave.  He waited.

Then they came back into the room with sketches of different Tiger shoes.  They told him they had been thinking about the American market for some time.  They asked Knight how big he thought the market could be.  Knight tossed out, “$1 billion.”  He doesn’t know where the number came from.

They asked him if Blue Ribbon would be interested in selling Tigers in the United States.  Yes, please send samples to this address, Knight said, and I’ll send a money order for fifty dollars.

Knight considered returning home to get a jump on the new business.  But then he decided to finish his trek around the world.

Hong Kong, then the Phillipines.

I was fascinated by all the great generals, from Alexander the Great to George Patton.  I hated war, but I loved the warrior spirit.  I hated the sword, but loved the samurai.  And of all the great fighting men in history I found MacArthur the most compelling.  Those Ray-Bans, that corncob pipe – the man didn’t lack for confidence.  Brilliant tactician, master motivator, he also went on to head the U.S. Olympic Committee.  How could I not love him?

Of course, he was deeply flawed.  But he knew that…

Bangkok.  He made his way to Wat Phra Kaew, a huge 600-year-old Buddha carved from one hunk of jade.  One of the most sacred statues in Asia.

(Emerald Buddha at Wat Phra Kaew, Image by J. P. Swimmer, Wikimedia Commons)

Vietnam, where U.S. soldiers filled the streets.  Everyone knew a very ugly and different war was coming.

Calcutta.  Knight got sick immediately.  He thinks food poisoning.  He was sure, for one whole day, that he was going to die.  He rallied.  He ended up at the Ganges.  There was a funeral.  Others were bathing.  Others were drinking the same water.

“The Upanishads say, Lead me from the unreal to the real.”  So Knight went to Kathmandu and hiked up the Himalayas.

Back to India.  Bombay.

Kenya.  Giant ostriches tried to outrun the bus, records Knight.  When Masai warriors boarded the bus, a baboon or two would also try to board.

Cairo.  The Giza plateau.  Standing besides desert nomads with their silk-draped camels.  At the foot of the Great Sphinx.

…The sun hammered down on my head, the same sun that hammered down on the thousands of men who built these pyramids, and the millions of visitors who came after.  Not one of them was remembered, I thought.  All is vanity, says the Bible.  All is now, says Zen.  All is dust, says the desert.

(Great Sphinx of Giza, Photo by Johnny 201, Wikimedia Commons)

Then Jerusalem.

…the first century rabbi Eleazar ben Azariah said our work is the holiest part of us.  All are proud of their craft.  God speaks of his work;  how much more should man.

Istanbul.  Turkish coffee.  Lost on the confusing streets of the Bosphorus.  Glowing minarets.  Then the golden labyrinths of Topkapi Palace.

Rome.  Tons of pasta.  And the most beautiful women and shoes he’d ever seen, says Knight.  The Coliseum.  The Vatican.  The Sistine Chapel.

Florence.  Reading Dante.  Milan.  Da Vinci:  One of his obsessions was the human foot, which he called a masterpiece of engineering.

Venice.  Marco Polo.  The palazzo of Robert Browning:  “If you get simply beauty and naught else, you get about the best thing God invents.”

Paris.  The Pantheon.  Rousseau.  Voltaire:  “Love truth, but pardon error.”  Praying at Notre Dame.  Lost in the Louvre.

(The Louvre, Photo by Pipiten, Wikimedia Commons)

Then to where Joyce slept, and F. Scott Fitzgerald.  Walking down the Seine, and stopping where Hemingway and Dos Passos read the New Testament aloud to each other.

Next, up the Champs-Elysees, along the liberators’ path, thinking of Patton:  “Don’t tell people how to do things, tell them what to do and let them surprise you with their results.”

Munich.  Berlin.  East Berlin:

…I looked around, all directions.  Nothing.  No trees, no stores, no life.  I thought of all the poverty I’d seen in every corner of Asia.  This was a different kind of poverty, more willful, somehow, more preventable.  I saw three children playing in the street.  I walked over, took their picture.  Two boys and a girl, eight years old.  The girl – red wool hat, pink coat – smiled directly at me.  Will I ever forget her?  Or her shoes?  They were made of cardboard.

Vienna.  Stalin, Trotsky, Tito, Hitler, Jung, Freud.  All at the same location in the same time period.  A “coffee-scented crossroads.”  Where Mozart walked.  Crossing the Danube.  The spires of St. Stephen’s Church, where Beethoven realized he was deaf.

London.  Buckingham Palace, Speakers’ Corner, Harrods.

Knight asked himself what the highlight of his trip was.

Greece, I thought.  No question.  Greece.

…I meditated on that moment, looking up at those astonishing columns, experiencing that bracing shock, the kind you receive from all great beauty, but mixed with a powerful sense of – recognition?

Was it only my imagination?  After all, I was standing at the birthplace of Western civilization.  Maybe I merely wanted it to be familiar.  But I don’t think so.  I had the clearest thought:  I’ve been here before.

Then, walking up those bleached steps, another thought:  This is where it all begins.

On my left was the Parthenon, which Plato had watched the teams of architects and workmen build.  On my right was the Temple of Athena Nike.  Twenty-five centuries ago, per my guidebook, it had housed a beautiful frieze of the goddess Athena, thought to be the bringer of “nike,” or victory.

It was one of many blessings Athena bestowed.  She also rewarded the dealmakers.  In the Oresteia she says:  ‘I admire… the eyes of persuasion.’  She was, in a sense, the patron saint of negotiators.

(Temple of Athena Nike, Photo by Steve Swayne, Wikimedia Commons)

 

1963

When Buck got home, his hair was to his shoulders and his beard three inches long.  It had been four months since meeting with Onitsuka.  But they hadn’t sent the sample shoes.  Knight wrote to them to ask why.  They wrote back, “Shoes coming… In a little more days.”

Knight got a haircut and shaved.  He was back.  His father suggested he speak with his old friend, Don Frisbee, CEO of Pacific Power & Light.  Frisbee had an MBA from Harvard.  Frisbee told Buck to get his CPA while he was young, a relatively conservative way to put a floor under his earnings.  Knight liked that idea.  He had to take three more courses in accounting, first, which he promptly did at Portland State.

Then Knight worked at Lybrand, Ross Bros. & Montgomery.  It was a Big Eight national firm, but its Portland office was small.  $500 a month and some solid experience.  But pretty boring.

 

1964

Finally, twelve pairs of shoes arrived from Onitsuka.  They were beautiful, writes Knight.  He sent two pairs immediately to his old track coach at Oregon, Bill Bowerman.

Bowerman was a genius coach, a master motivator, a natural leader of young men, and there was one piece of gear he deemed crucial to their development.  Shoes.

Bowerman was obsessed with shoes.  He constantly took his runners’ shoes and experimented on them.  He especially wanted to make the shoes lighter.  One ounce over a mile is fifty pounds.

Bowerman would try anything.  Kangaroo.  Cod.  Knight says four or five runners on the team were Bowerman’s guinea pigs.  But Knight was his “pet project.”

It’s possible that everything I did in those days was motivated by some deep yearning to impress, to please, Bowerman.  Besides my father there was no man whose approval I craved more, and besides my father there was no man who gave it less often.  Frugality carried over to every part of the coach’s makeup.  He weighed and hoarded words of praise, like uncut diamonds.

After you’d won a race, if you were lucky, Bowerman might say:  ‘Nice race.’  (In fact, that’s precisely what he said to one of his milers after the young man became one of the very first to crack the mythical four-minute mark in the United States.)  More likely Bowerman would say nothing.  He’d stand before you in his tweed blazer and ratty sweater vest, his string tie blowing in the wind, his battered ball cap pulled low, and nod once.  Maybe stare.  Those ice-blue eyes, which missed nothing, gave nothing.  Everyone talked about Bowerman’s dashing good looks, his retro crew cut, his ramrod posture and planed jawline, but what always got me was that gaze of pure violet blue.

(Statue of Bill Bowerman, Photo by Diane Lee Jackson, Wikimedia Commons)

For his service in World War II, Bowerman received the Silver Star and four Bronze Stars.  Bowerman eventually became the most famous track coach in America.  But he hated being called “coach,” writes Knight.  He called himself, “Professor of Competitive Responses” because he viewed himself as preparing his athletes for the many struggles and competitions that lay ahead in life.

Knight did his best to please Bowerman.  Even so, Bowerman would often lose patience with Knight.  On one occasion, Knight told Bowerman he was coming down with the flu and wouldn’t be able to practice.  Bowerman told him to get his ass out there.  The team had a time trial that day.  Knight was close to tears.  But he kept his composure and ran one of his best times of the year.  Bowerman gave him a nod afterward.

Bowerman suggested meeting for lunch shortly after seeing the Tiger shoes from Onitsuka.  At lunch, Bowerman told Knight the shoes were pretty good and suggested they become business partners.  Knight was shocked.

Had God himself spoken from the whirlwind and asked to be my partner, I wouldn’t have been more surprised.

Knight and Bowerman signed an agreement soon thereafter.  Knight found himself thinking again about his coach’s eccentricities.

…He always went against the grain.  Always.  For example, he was the first college coach in America to emphasize rest, to place as much value on recovery as on work.  But when he worked you, brother, he worked you.  Bowerman’s strategy for running the mile was simple.  Set a fast pace for the first two laps, run the third as hard as you can, then triple your speed on the fourth.  There was a Zen-like quality to this strategy because it was impossible.  And yet it worked.  Bowerman coached more sub-four-minute milers than anybody, ever.

Knight wrote Onitsuka and ordered three hundred pairs of shoes, which would cost $1,ooo.  Buck had to ask his dad for another loan, who asked him, “Buck, how long do you think you’re going to keep jackassing around with these shoes?”  His father told him he didn’t send him to Oregon and Stanford to be a door-to-door shoe salesman.

At this point, Knight’s mother told him she wanted to purchase a pair of Tigers.  This helped convince Knight’s father to give him another loan.

In April 1964, Knight got the shipment of Tigers.  Also, Mr. Miyazaki told him he could be the distributor for Onitsuka in the West.  Knight quit his accounting job to focus on selling shoes that spring.  His dad was horrified, his mom happy, remarks Knight.

After being rejected by a couple of sporting goods stores, Knight decided to travel around to various track meets in the Pacific Northwest.  Between races, he’d talk with the coaches, the runners, the fans.  He couldn’t write the orders fast enough.  Knight wondered how this was possible, given his inability to sell encyclopedias.

…So why was selling shoes so different?  Because, I realized, it wasn’t selling.  I believed in running.  I believed that if people got out and ran a few miles every day, the world would be a better place, and I believed these shoes were better to run in.  People, sensing my belief, wanted some of that belief for themselves.

Belief, I decided.  Belief is irresistable.

(Illustration by Lkeskinen0)

Knight started the mail order business because he started getting letters from folks wanting Tigers.  To help the process along, he mailed some handouts with big type:

‘Best news in flats!  Japan challenges European track shoe domination!  Low Japanese labor costs make it possible for an exciting new firm to offer these shoes at the low, low price of $6.95.’  [Note:  This is close to $54 in 2018 dollars, due to inflation.]

Knight had sold out his first shipment by July 4, 1964.  So he ordered 900 more.  This would cost $3,000.  His dad grudgingly gave him a letter of guarantee, which Buck took to the First National Bank of Oregon.  They approved the loan.

Knight wondered how to sell in California.  He couldn’t afford airfare.  So every other weekend, he’d stuff a duffel bag with Tigers.  He’d don his army uniform and head to the local air base.  The MPs would wave him on to the next military transport to San Francisco or Los Angeles.

When in Los Angeles, he’d save more money by staying with a friend from Stanford, Chuck Cale.  At a meet at Occidental College, a handsome guy approached Knight, introducing himself as Jeff Johnson.  He was a fellow runner whom Knight had run with and against while at Stanford.  At this point, Johnson was studying anthropology and planning on becoming a social worker.  But he was selling shoes – Adidas then – on weekends.  Knight tried to recruit him to sell Tigers instead.  No, because he was getting married and needed stability, responded Johnson.

Then Knight got a letter from a high school wrestling coach in Manhasset, New York, claiming that Onitsuka had named him the exclusive distributor for Tigers in the United States.  He ordered Knight to stop selling Tigers.

Knight contacted his cousin, Doug Houser, who’d recently graduated from Stanford Law School.  Houser found out Mr. Manhasset was a bit of a celebrity, a model who was one of the original Marlboro Men.  Knight:  “Just what I need.  A pissing match with some mythic American cowboy.”

Knight went into a funk for awhile.  Then he decided to go visit Onitsuka in Japan.  Knight bought a new suit and also a book, How to Do Business with the Japanese.

Knight realized he had to remain cool.  Emotion could be fatal.

The art of competition, I’d learned from track, was the art of forgetting, and now I reminded myself of that fact.  You must forget your limits.  You must forget your doubts, your pain, your past.  You must forget that internal voice screaming, begging, ‘Not one more step!’  And when it’s not possible to forget it, you must negotiate with it.  I thought over all the races in which my mind wanted one thing, and my body wanted another, those laps in which I’d had to tell my body, ‘Yes, you raise some excellent points, but let’s keep going anyway…’

After finding a place to stay in Kobe, Knight called Onitsuka and requested a meeting.  He got a call back saying Mr. Miyazaki no longer worked there.  Mr. Morimoto had replaced him, and didn’t want Knight to visit headquarters.  Mr. Morimoto would meet him for tea.  None of this was good.

At the meeting, Knight layed out the arguments.  They had had an agreement.  He also pointed out the very robust sales Blue Ribbon had had thus far.  He dropped the name of his business partner.  Mr. Morimoto, who was about Knight’s age, said he’d get back to him.

Knight thought it was over.  But then he got a call from Morimoto saying, “Mr. Onitsuka… himself… wishes to see you.”

At this meeting, Knight first presented his arguments again to those who were initially present.  Then Mr. Onitsuka arrived.

Dressed in a dark blue Italian suit, with a head of black hair as thick as shag carpet, he filled every man in the conference room with fear.  He seemed oblivious, however.  For all his power, for all his wealth, his movements were deferential… Morimoto tried to summarize my reasons for being there.  Mr. Onitsuka raised a hand, cut him off.

Without preamble, he launched into a long, passionate monologue.  Some time ago, he’d said, he’d had a vision.  A wondrous glimpse of the future.  ‘Everyone in the world wear athletic shoes all the time,’ he said.  ‘I know this day will come.’  He paused, looking around the table at each person, to see if they also knew.  His gaze rested on me.  He smiled.  I smiled.  He blinked twice.  ‘You remind me of myself when I am young,’ he said softly.  His stared into my eyes.  One second.  Two.  Now he turned his gaze to Morimoto.  ‘This about those thirteen western states?’ he said.  ‘Yes,’ Morimoto said.  ‘Hm,’ Onitsuka said.  ‘Hmmmm.’  He narrowed his eyes, looked down.  He seemed to be meditating.  Again he looked up at me.  ‘Yes,’ he said.  ‘Alright.  You have western states.’

Knight ordered $3,400 worth of shoes [about $26,000 in 2018 dollars].

(Mount Fuji, Photo by Wipark Kulnirandorn)

To celebrate, Knight decided to climb to the top of Mount Fuji.  Buck met a girl on the wap up, Sarah, who was studying philosophy at Connecticut College for Women.  It went well for a time.  Many letters back and forth.  A couple of visits.  But she decided Knight wasn’t “sophisticated” enough.  Jeanne, one of Buck’s younger sisters, found the letters, read them, and told Buck, “You’re better off without her.”  Buck then asked his sister – given her interest in mail – if she’d like to help with the mail order business for $1.50 an hour.  Sure.  Blue Ribbon Employee Number One.

 

1965

Buck got a letter from Johnson.  He’d bought some Tigers and loved them.  Could he become a commissioned salesman for Blue Ribbon?  Sure.  $1.75 for each pair of running shoes, $2 for spikes, were the commissions.

Then the letters from Johnson kept coming:

I liked his energy, of course.  And it was hard to fault his enthusiasm.  But I began to worry he might have too much of each.  With the twentieth letter, or the twenty-fifth, I began to worry that the man might be unhinged.  I wondered why everything was so breathless.  I wondered if he was ever going to run out of things he urgently needed to tell me, or ask me…

…He wrote to say that he wanted to expand his sales territory beyond California, to include Arizona, and possibly New Mexico.  He wrote to suggest that we open a retail store in Los Angeles.  He wrote to tell me that he was considering placing ads in running magazines and what did I think?  He wrote to inform me that he’d placed those ads in running magazines and the response was good.  He wrote to ask why I hadn’t answered any of his previous letters.  He wrote to plead for encouragement.  He wrote to complain that I hadn’t responded to his previous plea for encouragement.

I’d always considered myself a conscientious correspondent… And I always meant to answer Johnson’s letters.  But before I got around to it, there was always another one, waiting.  Something about the sheer volume of his correspondence stopped me…

Eventually Johnson realized he loved shoes and running more than anthropology or social work.

(Monk meditating, Photo by Ittipon)

In his heart of hearts Johnson believed that runners are God’s chosen, that running, done right, in the correct spirit and with the proper form, is a mystical exercise, no less than meditation or prayer, and thus he felt called to help runners reach their nirvana.  I’d been around runners much of my life, but this kind of dewy romanticism was something I’d never encountered.  Not even the Yahweh of running, Bowerman, was as pious about the sport as Blue Ribbon’s Part-Time Employee Number Two.

In fact, in 1965, running wasn’t even a sport.  It wasn’t popular, it wan’t unpopular, it just was.  To go out for a three-mile run was something weirdos did, presumably to burn off manic energy.  Running for exercise, running for pleasure, running for endorphins, running to live better and longer – these things were unheard of.

People often went out of their way to mock runners.  Drivers would slow down and honk their horns.  ‘Get a horse!,’ they’d yell, throwing a beer or soda at the runner’s head.  Johnson had been drenched by many a Pepsi.  He wanted to change all this…

Above all, he wanted to make a living doing it, which was next to impossible in 1965.  In me, in Blue Ribbon, he thought he saw a way.

I did everything I could to discourage Johnson from thinking like this.  At every turn, I tried to dampen his enthusiasm for me and my company.  Besides not writing back, I never phoned, never visited, never invited him to Oregon.  I also never missed an opportunity to tell him the unvarnished truth.  I put it flatly:  ‘Though our growth has been good, I owe First National Bank of Oregon $11,000… Cash flow is negative.’

He wrote back immediately, asking if he could work for me full-time…

Knight just shook his head.  Finally in last summer of 1965, Knight accepted Johnson’s offer.  Johnson had been making $460 as a social worker, so he proposed $400 a month [over $3,000 a month in 2018 dollars].  Knight very reluctantly agreed.  It seemed like a huge sum.  Knight writes:

As ever, the accountant in me saw the risk, the entrepreneur the possibility.  So I split the difference and kept moving forward.

Knight then forgot about Johnson because he had bigger issues.  Blue Ribbon had doubled its sales in one year.  But Knight’s banker said they were growing too fast for their equity.  Knight asked how doubling sales – profitably – can be a bad thing.

In those days, however, commercial banks were quite different from investment banks.  Commercial banks never wanted you to outgrow your cash balance.  Knight tried to explain that growing sales as much as possible – profitably – was essential to convince Onitsuka to stick with Blue Ribbon.  And then there’s the monster, Adidas.  But his banker kept repeating:

‘Mr. Knight, you need to slow down.  You don’t have enough equity for this kind of growth.’

Knight kept hearing the word “equity” in his head over and over.  “Cash,” that’s what it meant.  But he was deliberately reinvesting every dollar – on a profitable basis.  What was the problem?

Every meeting with his banker, Knight managed to hold his tongue and say nothing, basically agreeing.  Then he’d keep doubling his orders from Onitsuka.

Knight’s banker, Harry White, had essentially inherited the account.  Previously, Ken Curry was Knight’s banker, but Curry bailed when Knight’s father wouldn’t guarantee the account in the case of business failure.

Furthermore, the fixation on equity didn’t come from White, but from White’s boss, Bob Wallace.  Wallace wanted to be the next president of the bank.  Credit risks were the main roadblock to that goal.

Oregon was smaller back then.  First National and U.S. Bank were the only banks, and the second one had already turned Blue Ribbon down.  So Knight didn’t have a choice.  Also, there as no such thing as venture capital in 1965.

(First National Bank of Oregon, Photo by Steve Morgan, Wikimedia Commons)

To make matters worse, Onitsuka was always late in its shipments, no matter how much Knight pleaded with them.

By this point, Knight had passed the four parts of the CPA exam.  So he decided to get a job as an accountant.  He invested a good chunk of his paycheck into Blue Ribbon.

In analyzing companies as an accountant, Knight learned how they sold things or didn’t, how they survived or didn’t.  He learned how companies got into trouble and how they got out.

It was while working for the Portland branch of Price Waterhouse that he met Delbert J. Hayes, who was the best accountant in the office.  Knight describes Hayes as a man with “great talent, great wit, great passions – and great appetites.”  Hayes was six-foot-two and three hundred pounds.  He loved food and alcohol.  And he smoked two packs a day.

Hayes looked at numbers the way a poet looks at clouds or a geologist looks at rocks, says Knight.  He could see the beauty of numbers.  Numbers were a secret code.

Every evening, Hayes would insist on taking junior accountants out for a drink.  Hayes would talk nonstop, like he drank.  But while other accountants dismissed Hayes’ stories, Knight always paid careful attention.  In every tale told by Hayes was some piece of wisdom about business.  So Knight would match Hayes, shot for shot, in order to learn as much as he could.

The following morning, Knight was always sick.  But he willed himself to do the work.  Being in the Army Reserves at the same time wasn’t easy.  Meanwhile, the conflict in Vietnam was heating up.  Knight:

I had grown to hate that war.  Not simply because I felt it was wrong.  I also felt it was stupid, wasteful.  I hated stupidity.  I hated waste.  Above all, that war, more than other wars, seemed to be run along the same principles of my bank.  Fight not to win, but to avoid losing.  A surefire losing strategy.

Hayes came to appreciate Knight.  Hayes thought it was a tough time to launch a new company with zero cash balance.  But he did acknowledge that having Bowerman as a partner was a valuable, intangible asset.

Recently, Bowerman and Mrs. Bowerman had visited Onitsuka and charmed everyone.  Mr. Onitsuka told Bowerman about founding his shoe company in the rubble after World War II.

He’d built his first lasts, for a line of basketball shoes, by pouring hot wax from Buddhist candles over his own feet.  Though the basketball shoes didn’t sell, Mr. Onitsuka didn’t give up.  He simply switched to running shoes, and the rest is shoe history.  Every Japanese runner in the 1964 Games, Bowerman told me, was wearing Tigers.

Mr. Onitsuka also told Bowerman that the inspiration for the unique soles on Tigers had come to him while eating sushi.  Looking down at his wooden platter, at the underside of an octopus’s leg, he thought a similar suction cup might work on the sole of a runner’s flat.  Bowerman filed that away.  Inspiration, he learned, can come from quotidian things.  Things you might eat.  Or find lying around the house.

Bowerman started corresponding not only with Mr. Onitsuka, but with the entire production team at the Onitsuka factory.  Bowerman realized that Americans tend to be longer and heavier than the Japanese.  He thought the Tigers could be modified to fit Americans better.  Most of Bowerman’s letters went unanswered, but like Johnson Bowerman just kept writing more.

Eventually he broke through.  Onitsuka made prototypes that conformed to Bowerman’s vision of a more American shoe.  Soft inner sole, more arch support, heel wedge to reduce stress on the Achilles tendon – they sent the prototype to Bowerman and he went wild for it.  He asked for more.

Bowerman also experimented with drinks to help his runners recover.  He invented an early version of Gatorade.  As well, he conducted experiments to make the track softer.  He invented an early version of polyurethane.

 

1966

Johnson kept inundating Knight with long letters, including a boatload of parenthetical comments and a list of PS’s.  Knight felt he didn’t have time to send the requested words of encouragement.  Also, it wasn’t his style.

I look back now and wonder if I was truly being myself, or if I was emulating Bowerman, or my father, or both.  Was I adopting their man-of-few-words demeanor?  Was I maybe modeling all the men I admired?  At the time I was reading everything I could get my hands on about generals, samurai, shoguns, along with biographies of my three main heroes – Churchill, Kennedy, and Tolstoi.  I had no love of violence, but I was fascinated by leadership, or lack thereof, under extreme conditions…

I wasn’t that unique.  Throughout history men have looked to the warrior for a model of Hemingway’s cardinal virtue, pressurized grace… One lesson I took from all my home-schooling about heroes was that they didn’t say much.  None was a blabbermouth.  None micromanaged.  “Don’t tell people how to do things, tell them what to do and let them surprise you with their results.” 

(Winston Churchill in 1944, Wikimedia Commons)

Johnson never let Knight’s lack of communication discourage him.  Johnson was full of energy, passion, and creativity.  He was going all-out, seven days a week, to sell Blue Ribbon shoes.  Johnson had an index card for each customer including their shoe sizes and preferences.  He sent all of them birthday cards and Christmas cards.  Johnson developed extensive correspondence with hundreds of customers.

Johnson began aggregating customer feedback on the shoes.

…One man, for instance, complained that Tiger flats didn’t have enough cushion.  He wanted to run the Boston Marathon but didn’t think the Tigers would last the twenty-six miles.  So Johnson hired a local cobbler to graft rubber soles from a pair of shower shoes into a pair of Tiger flats.  Voila.  Johnsn’s Frankenstein flat had space-age, full-length, midsole cushioning.  (Today it’s standard in all training shoes for runners.)  The jerry-rigged Johnson sole was so dynamic, so soft, so new, Johnson’s customer posted a personal best in the Boston.  Johnson forwarded me the results and urged me to pass them along to Tiger.  Bowerman had just asked me to do the same with his batch of notes a few weeks earlier.  Good grief, I thought, one mad genius at a time.

Johnson had customers in thirty-seven states.  Knight meant to warn him about encroaching on Malboro Man’s territory.  But he never got around to it.

Knight did write to tell Johnson that if he could sell 3,250 shoes by the end of June 1966, then he could open the retail outlet he’d been asking about.  Knight calculated that 3,250 was impossible, so he wasn’t too worried.

Somehow Johnson hit 3,250.  So Blue Ribbon opened its first retail store in Santa Monica.

He then set about turning the store into a mecca, a holy of holies for runners.  He bought the most comfortable chairs he could find, and afford (yard sales), and he created a beautiful space for runners to hang out and talk.  He built shelves and filled them with books that every runner should read, many of them first editions from his own library.  He covered the walls with photos of Tiger-shod runners, and laid in a supply of silk-screened T-shirts with Tiger across the front, which he handed out to his best customers.  He also stuck Tigers to a black lacquered wall and illuminated them with a strip of can lights – very hip.  Very mod.  In all the world, there had never been a sanctuary for runners, a place that didn’t just sell them shoes but celebrated them and their shoes.  Johnson, the aspiring cult leader of runners, finally had his church.  Services were Monday through Saturday, nine to six.

When he first wrote me about the store, I thought of the temples and shrines I’d seen in Asia, and I was anxious to see how Johnson’s compared.  But there just wasn’t time…

Knight got a heads up that the Marlboro man had just launched an advertising campaign which involved poaching customers of Blue Ribbon.  So Knight flew down to see Johnson.

(Jeff Johnson, Employee Number One)

Johnson’s apartment was one giant running shoe.  There were running shoes seemingly everywhere.  And there were many books – mostly thick volumes on philosophy, religion, sociology, anthropology, and classics in Western literature.  Knight had thought he liked to read.  This was a new level, says Knight.

Johnson told Knight he had to go visit Onitsuka again.  Johnson started typing notes, ideas, lists, which would become a manifesto for Knight to take to Onitsuka.  Knight wired Onitsuka.  They got back to him, but it wasn’t Morimoto.  It was a new guy, Kitami.

Knight told Kitami and other executives about the performance of Blue Ribbon thus far, virtually doubling sales each year and projecting more of the same.  Kitami said they wanted someone more established, with offices on the East Coast.  Knight replied that Blue Ribbon had offices on the East Coast and could handle national distribution.  “Well,” said Kitami, “this changes things.”

The next morning, Kitami awarded Blue Ribbon exclusive distribution rights for the United States.  A three-year contract.  Knight promptly placed an order for 5,000 more shoes, which would cost $20,000 – more than $150,000 in 2018 dollars – that he didn’t have.  Kitami said he would ship them to Blue Ribbon’s East Coast office.

There was only one person crazy enough to move to the East Coast on a moment’s notice….

 

1967

Knight delayed telling Johnson.  Then he hired John Bork, a high school track coach and a friend of a friend, to run the Santa Monica store.  Bork showed up at the store and told Johnson that he, Bork, was the new boss so that Johnson could go back east.

Johnson called Knight.  Knight told him he’d had to tell Onitsuka that Blue Ribbon had an east coast office.  A huge shipment was due to arrive at this office.  Johnson was the only one who could manage the east coast store.  The fate of the company was on his shoulders.  Johnson was shocked, then mad, then freaked out.  Knight flew down to visit him.

Johnson talked himself into going to the east coast.

The forgiveness Johnson showed me, the overall good nature he demonstrated, filled me with gratitude, and a new fondness for the man.  And perhaps a deeper loyalty.  I regretted my treatment of him.  All those unanswered letters.  There are team players, I thought, and then there are team players, and then there’s Johnson.

Soon thereafter, Bowerman called asking Knight to add a new employee – Geoff Hollister.  A former track guy.  Full-time Employee Number Three.

Then Bowerman called again with yet another employee – Bob Woodell.

I knew the name, of course.  Everyone in Oregon knew the name.  Woodell had been a standout on Bowerman’s 1965 team.  Not quite a star, but a gritty and inspiring competitor.  With Oregon defending its second national championship in three years, Woodell had come out of nowhere and won the long jump against vaunted UCLA.  I’d been there, I’d watched him do it, and I’d come away mighty impressed.

The very next day, during a celebration, there had been an accident.  The float twenty guys were carrying collapsed after someone lost their footing.  It landed on Woodell and crushed one of his vertebra, paralyzing his legs.

Knight called Woodell.  Knight realized it was best to keep it strictly business.  So he told Woodell that Bowerman had recommended him.  Would he like to grab lunch to discuss the possibility of working for Blue Ribbon?  Sure thing, he said.

Woodell had already mastered a special car, a Mercury Cougar with hand controls.  At lunch, they hit it off and Woodell impressed Knight.

I wasn’t certain what Blue Ribbon was, or if it would ever become a thing at all, but whatever it was or might become, I hoped it would have something of this man’s spirit.

Knight offered Woodell a job opening a second retail store, in Eugene, for a monthly salary of $400.  Woodell immediately agreed.  They shook hands.  “He still hand the strong grip of an athlete.”

(Bob Woodell 1967)

Bowerman’s latest experiment was with the Spring Up.  He noticed the outer sole melted, whereas the midsole remained solid.  He convinced Onitsuka to fuse the outer sole to the midsole.  The result looked like the ultimate distance training shoe.  Onitsuka also accepted Bowerman’s suggestion of a name for the shoe, the “Aztec,” in homage to the upcoming 1968 Olympics in Mexico City.  Unfortunately, Adidas had a similar name for one of its shoes and threatened to sue.  So Bowerman changed the name to “Cortez.”

The situation with Adidas reminded Knight of when he had been a runner in high school.  The fastest runner in the state was Jim Grelle (pronounced “Grella”) and Knight had been second-fastest.  So Knight spent many races staring at Grelle’s back.  Then they both went to Oregon, so Knight spent more years staring at Grelle’s back.

Adidas made Knight think of Grelle.  Knight felt super motivated.

Once again, in my quixotic effort to overtake a superior opponent, I had Bowerman as my coach.  Once again he was doing everything he could to put me in position to win.  I often drew on the memory of his old prerace pep talks, especially when we were up against our blood rivals, Oregon State.  I would replay Bowerman’s epic speeches… Nearly sixty years later it gives me chills to recall his words, his tone.  No one could get your blood going like Bowerman, though he never raised his voice.

Thanks to the Cortez, Blue Ribbon finished the year strong.  They had nearly doubled their sales again, to $84,000.  Knight rented an office for $50 a month.  And he transferring Woodell to the “home office.”  Woodell had shown himself to be highly skilled and energetic, and in particular, he was excellent at organizing.

The office was cold and the floor was warped.  But it was cheap.  Knight built a corkboard wall, pinning up different Tiger models and borrowing some of Johnson’s ideas from the Santa Monica store.

Knight thought perhaps he could save even more money by living at his office.  Then he reflected that living at your office was what a crazy person does.  Then he got a letter from Johnson saying he was living at his office.  Johnson had set up shop in Wellesley, a suburb of Boston.

Johnson told Knight how he had chosen the location.  He’d seen people running along country roads, many of them women.  Ali MacGraw look-alikes.  Sold.

 

1968

Knight:

I wanted to dedicate every minute of every day to Blue Ribbon… I wanted to be present, always.  I wanted to focus constantly on the one task that really mattered.  If my life was to be all work and no play, I wanted my work to be play.  I wanted to quit Price Waterhouse.  Not that I hated it;  it just wasn’t me.

I wanted what everyone wants.  To be me, full-time.

Even though Blue Ribbon was on track to double sales again, there was never enough cash, certainly not to pay Knight.  Knight found another job he thought might fit better with his desire to focus as much as possible on Blue Ribbon.  Assistant Professor of Accounting at Portland State University.

Knight, a CPA who had worked for two accounting firms, knew accounting pretty well at this point.  But he was restless and twitchy, with several nervous tics – including wrapping rubber banks around his wrist and snapping them.  One of his students was named Penelope Parks.  Knight was captivated by her.

Knight decided to use the Socratic method to teach accounting.  Miss Parks turned out to be the best student in the class.  Soon thereafter, Miss Parks asked if Knight would be her advisor.  Knight then asked her if she’d like a job for Blue Ribbon to help with bookkeeping.  “Okay.”

On Miss Parks’ first day at Blue Ribbon, Woodell gave her a list of things – typing, bookkeeping, scheduling, stocking, filing invoices – and told her to pick two.  Hours later, she’d done every thing on the list.  Within a week, Woodell and Knight couldn’t remember how they’d gotten by without her, recalls Knight.

Furthermore, Miss Parks was “all-in” with respect to the mission of Blue Ribbon.  She was good with people, too.  She had a healing effect on Woodell, who was still struggling to adjust to his legs being paralyzed.

Knight often volunteered to go get lunch for the three of them.  But his head was usually so full of business matters that he would invariably get the orders mixed up.  “Can’t wait to see what I’m eating for lunch today,” Woodell might say quietly.  Miss Parks would hide a smile.

Later on, Knight found out that Miss Parks and Woodell weren’t cashing any of their paychecks.  They truly believed in Blue Ribbon.  It was more than just a job for them.

Knight and Penny started dating.  They were good at communicating nonverbally since they were both shy people.  They were a good match and eventually decided to get married.  Knight felt like she was a partner in life.

Knight made another trip to Onitsuka.  Kitami was very friendly this time, inviting him to the company’s annual picnic.  Knight met a man named Fujimoto at the picnic.  It turned out to be another life-altering partnership.

…I was doing business with a country I’d come to love.  Gone was the initial fear.  I connected with the shyness of the Japanese people, with the simplicity of their culture and products and arts.  I liked that they tried to add beauty to every part of life, from the tea ceremony to the commode.  I liked that the radio announced each day which cherry trees, on which corner, were blossoming, and how much.

(Cherry trees in Japan, Photo by Nathapon Triratanachat)

 

1969

Knight was able to hire more ex-runners on commission.  Sales in 1968 had been $150,000 and now they were on track for $300,000 for 1969.

Knight was finally able to pay himself a salary.  But before leaving Portland State, he happened to see a starving artist in the hallway and asked if she’d do advertising art part-time.  Her name was Carolyn Davidson, and she said OK.

Bowerman and Knight were losing trust in Kitami.  Bowerman thought he didn’t know much about shoes and was full of himself.  Knight hired Fujimoto to be a spy.  Knight pondered again that when it came to business in Japan, you never knew what a competitor or a partner would do.

Knight was absentminded.  He couldn’t go to the store and return with the one thing Penny asked for.  He misplaced wallets and keys frequently.  And he was constantly bumping into trees, poles, and fenders while driving.

Knight got in the habit of calling his father in the evening.  His father would be in his recliner, while Buck would be in his.  They’d hash things over.

Woodell and Knight began looking for a new office.  They started enjoying hanging out together.  Before parting, Knight would time Woodell on how fast he could fold up his wheelchair and get it and himself into his car.

Woodell was super positive and super energetic, a constant reminder of the importance of good spirits and a great attitude.

Buck and Penny would have Woodell over for dinner.  Those were fun times.  They would take turns describing what the company was and might be, and what it must never be.  Woodell was always dressed carefully and always had on a pair of Tigers.

Knight asked Woodell to become operations manager.  He’d demonstrated already that he was exceptionally good at managing day-to-day tasks.  Woodell was delighted.

 

1970

Knight visited Onitsuka again.  He discovered that Kitami was being promoted to operations manager.  Onitsuka and Blue Ribbon signed another 3-year agreement.  Knight looked into Kitami’s eyes and noticed something very cold.  Knight never forgot that cold look.

Knight pondered the fact that the shipments from Onitsuka were always late, and sometimes had the wrong sizes or even the wrong models.  Woodell and Knight discovered that Onitsuka always filled its orders from Japanese companies first, and then sent its foreign exports.

Meanwhile, Wallace at the bank kept making things difficult.  Knight concluded that a small public offerings could create the extra cash Blue Ribbon needed.  At the time, in 1970, a few venture capital firms had been launched.  But they were in California and mostly invested in high-tech.  So Knight formed Sports-Tek, Inc., as a holding company for Blue Ribbon.  They tried a small public offering.  It didn’t work.

Friends and family chipped in.  Woodell’s parents were particularly generous.

On June 15, 1970, Knight was shocked to see a Man of Oregon on the cover of Sports Illustrated.  His name was Steve Prefontaine.  He’d already set a national record in high school at the two-mile (8:41).  In 1970, he’d run three miles in 13:12.8, the fastest time on the planet.

Knight learned from a Fortune magazine about Japan’s hyper-aggressive sosa shoga, “trading companies.”  It was hard to see what these trading companies were exactly.  Sometimes they were importers.  Sometimes they were exporters.  Sometimes they were banks.  Sometimes they were an arm of the government.

After being harangued by Wallace at First National about cash balances again, Knight walked out and saw a sign for the Bank of Tokyo.  He was escorted to a back room, where a man appeared after a couple of minutes.  Knight showed the man his financials and said he needed credit.  The man said that Japan’s sixth-largest trading company had an office at the top floor of this same building.  Nissho Iwai was a $100-billion dollar company.

Knight met a man named Cam Murakami, who offered Knight a deal on the spot.  Knight said he had to check with Onitsuka first.  Knight wired Kitami, but heard nothing back at all for weeks.

Then Knight got a call from a guy on the east coast who told him that Onitsuka had approached him about becoming its new U.S. distributor.  Knight checked with Fujimoto, his spy.  Yes, it was true.  Onitsuka was considering a clean break with Blue Ribbon.

Knight invited Kitami to visit Blue Ribbon.

 

1971

March 1971.  Kitami was on his way.  Blue Ribbon vowed to give him the time of his life.

Kitami arrived with a personal assistant, Hiraku Iwano, who was just a kid.  At one point, Kitami told Knight that Blue Ribbon’s sales were disappointing.  Knight said sales were doubling every year.  “Should be triple some people say,” Kitami replied.  “What people?”, asked Knight.  “Never mind,” answered Kitami.

Kitami took a folder from his briefcase and repeated the charge.  Knight tried to defend Blue Ribbon.  Back and forth.  Kitami had to use the restroom.  When he left the meeting room, Knight looked into Kitami’s briefcase and tried to snag the folder that he thought Kitami had been referring to.

Kitami went back to his hotel.  Knight still had the folder.  He and Woodell opened it up.  They found a list of eighteen U.S. athletic shoe distributors.  These were the “some people” who told Kitami that Blue Ribbon wasn’t performing well enough.

I was outraged, of course.  But mostly hurt.  For seven years we’d devoted ourselves to Tiger shoes.  We’d introduced them to America, we’d reinvented the line.  Bowerman and Johnson had shown Onitsuka how to make a better shoe, and their designs were now foundational, setting sales records, changing the face of the industry – and this was how we were repaid?

At the end of Kitami’s visit, as planned, there was dinner with Bowerman, Mrs. Bowerman, and his friend (and lawyer), Jaqua.  Mrs. Bowerman usually didn’t allow alcohol, but she was making an exception.  Knight and Kitami both liked mai tais, which were being served.

Unfortunately, Bowerman had a few too many mai tais.  It appeared things might get out of hand.  Knight looked at Jaqua, remembering that he’d been a fighter pilot in World World II, and that his wingman, one of his closest friends, had been shot out of the sky by a Japanese Zero.  Knight thought he sensed something starting to erupt in Jaqua.

Kitami, however, was having a great time.  Then he found a guiter.  He started playing it and singing a country Western.  Suddenly, he sang “O Sole Mio.”

A Japanese businessman, strumming a Western guitar, singing an Italian ballad, in the voice of an Irish tenor.  It was surreal, then a few miles past surreal, and it didn’t stop.  I’d never know there were so many verses to “O Sole Mio.”  I’d never known a roomful of active, restless Oregonians could sit still and quite for so long.  When he set down the guitar, we all tried not to make eye contact with each other as we gave him a big hand.  I clapped and clapped and it all made sense.  For Kitami, this trip to the United States – the visit to the bank, the meetings with me, the dinner with the Bowermans – wasn’t about Blue Ribbon.  Nor was it about Onitsuka.  Like everything else, it was all about Kitami.

At a meeting soon thereafter, however, Kitami told Knight that Onitsuka wanted to buy Blue Ribbon.  If Blue Ribbon did not accept, Onitsuka would have to work with other distributors.  Knight knew he still needed Onitsuka, at least for awhile.  So he thought of a stall.  He told Kitami he’d have to talk with Bowerman.  Kitami said OK and left.

Knight sent the budget and forecast to First National.  White informed Knight at a meeting that First National would no longer be Blue Ribbon’s bank.  White was sick about it, the bank officers were divided, but it had been Wallace’s call.  Knight strove straight to U.S. Bank.  Sorry.  No.

Blue Ribbon was finishing 1971 with $1.3 million in sales, but it was in danger of failing.  Fortunately, Bank of Cal gave Blue Ribbon a small line of credit.

Knight went back to Nissho and met Tom Sumeragi.  Sumeragi told Knight that Nissho was willing to take a second position to their banks.  Also, Nissho had sent a delegation to Onitsuka to try to work out a deal on financing.  Onitsuka had tossed them out.  Nissho was embarrased that a $25 million company had thrown out a $100 billion company.  Sumeragi told Knight that Nissho could introduce him to other shoe manufacturers in Japan.

Knight knew he had to find a new shoe factory somewhere.  He found one in Gaudalajara, Mexico.  Knight placed an order for three thousand soccer shoes.  It’s at this point that Knight asked his part-time artist, Carolyn Davidson, to try to design a logo.  “Something that evokes a sense of motion.”  She came back two weeks later and her sketches had a theme.  But Knight was wondering what the theme was, “…fat lightning bolts?  Chubby check marks?  Morbidly obese squiggles?…”

Davidson returned later.  Same theme, but better.  Woodell, Johnson, and a few others liked it, saying it looked like a wing or a whoosh of air.  Knight wasn’t thrilled about it, but went along because they were out of time and had to send it to the factory in Mexico.

(Nike logo, Timidonfire, Wikimedia Commons)

They also needed a name.  Falcon.  Dimension Six.  These were possibilities they’d come up with.  Knight liked Dimension Six mostly because he’d come up with it.  Everyone told him it was awful.  It didn’t mean anything.  Bengal.  Condor.  They debated possibilities.

It was time to decide.  Knight still didn’t know.  Then Woodell told him that Johnson had had a dream and then woke up with the name clearly in mind:  “Nike.”

Knight reminisced…  “The Greek goddess of victory.  The Acropolis.  The Parthenon.  The Temple…”

Knight had to decide.  He hated having to decide under time pressure.  He’s not sure if it was luck or spirit or something else, but he chose “Nike.”  Woodell said, “Hm.”  Knight replied, “Yeah, I know.  Maybe it’ll grow on us.”

(Nike logo, Wikimedia Commons)

Meanwhile, Nissho was infusing Blue Ribbon with cash.  But Knight wanted a more permanent solution.  He conceived of a public offering of convertible debentures.  People bought them, including Knight’s friend Cale.

The factory in Mexico didn’t produce good shoes.  Knight talked with Sumeragi, who knew a great deal about shoe factories around the world.  Sumeragi also offered to introduce Knight to Jonas Senter, “a shoe dog.”

Shoe dogs were people who devoted themselves wholly to the making, selling, buying, or designing of shoes.  Lifers used the phrase cheerfully to describe other lifers, men and women who had toiled so long and hard in the shoe trade, they thought and talked about nothing else.  It was an all-consuming mania… But I understood.  The average person takes seventy-five hundred steps a day, 274 million steps over the course of a long life, the equivalent of six times around the globe – shoe dogs, it seemed to me, simply wanted to be part of that journey.  Shoes were their way of connecting with humanity…

Senter was the “knockoff king.”  He’d been behind a recent flood of knockoff Adidas.  Senter’s protege was a guy named Sole.

Knight wasn’t sure partnering with Nissho was the best move.  Jaqua suggested Knight meet with his brother-in-law, Chuck Robinson, CEO of Marcona Mining, which had many joint ventures.  Each of the big eight Japanese trading firms was a partner in at least one of Marcona’s mines, records Knight.  Chuck to Buck:  “If the Japanese trading company understands the rules from the first day, they will be the best partners you’ll ever have.”

Knight went to Sumeragi and said:  “No equity in my company.  Ever.”  Sumeragi consulted a few folks, came back and said:  “No problem.  But here’s our deal.  We take four percent off the top, as a markup on product.  And market interest rates on top of that.”  Done.

Knight met Sole, who mentioned five factories in Japan.

A bit later, Bowerman was eating breakfast when he noticed the waffle iron’s gridded pattern.  This gave him an idea and he started experimenting.

…he took a sheet of stainless steel and punched it with holes, creating a waffle-like surface, and brought this back to the rubber company.  The mold they made from that steel sheet was pliable, workable, and Bowerman now had two foot-sized squares of hard rubber nubs, which he brought home and sewed to the sole of a pair of running shoes.  He gave these to one of his runners.  The runner laced them on and ran like a rabbit.

Bowerman phoned me, excited, and told me about his experiment.  He wanted me to send a sample of his waffle-soled shoes to one of my new factories.  Of course, I said.  I’d send it right away – to Nippon Rubber.

I look back over decades and see him toiling in his workshop, Mrs. Bowerman carefully helping, and I get goosebumps.  He was Edison in Menlo Park, Da Vinci in Florence, Tesla in Wardenclyffe.  Divinely inspired.  I wonder if he knew, if he had any clue, that he was the Daedalus of sneakers, that he was making history, remaking an industry, transforming the way athletes would run and stop and jump for generations.  I wonder if he could conceive in that moment all he’d done.  All that would follow.

 

1972

The National Sporting Goods Association Show in Chicago in 1972 was extremely important for Blue Ribbon because they were going to introduce the world to Nike shoes.  If sales reps liked Nike shoes, Blue Ribbon had a chance to flourish.  If not, Blue Ribbon wouldn’t be back in 1973.

Right before the show, Onitsuka announced its “acquisition” of Blue Ribbon.  Knight had to reassure Sumeragi that there was no acquisition.  At the same time, Knight couldn’t break from Onitsuka just yet.

As Woodell and Johnson prepared the booth – with stacks of Tigers and also with stacks of Nikes – they realized the Nikes from Nippon Rubber weren’t as high-quality as the Tigers.  The swooshes were crooked, too.

Darn it, this was no time to be introducing flawed shoes.  Worse, we had to push these flawed shoes on to people who weren’t our kind of people.  They were salesmen.  They talked like salesmen, walked like salesmen, and they dressed like salesmen – tight polyester shirts, Sansabelt slacks.  They were extroverts, we were introverts.  They didn’t get us, we didn’t get them, and yet our future depended on them.  And now we’d have to persuade them, somehow, that this Nike thing was worth their time and trust – and money.

I was on the verge of losing it, right on the verge.  Then I saw Johnson and Woodell were already losing it, and I realized that I couldn’t afford to… ‘Look fellas, this is the worst the shoes will ever be.  They’ll get better.  So if we can just sell these… we’ll be on our way.’

The salesmen were skeptical and full of questions about the Nikes.  But by the end of the day, Blue Ribbon had exceeded its highest expectations.  Nikes had been the smash hit of the show.

Johnson was so perplexed that he demanded an answer from the representative of one his biggest accounts.  The rep explained:

‘We’ve been doing business with you Blue Ribbon guys for years and we know that you guys tell the truth.  Everyone else bullshits, you guys always shoot straight.  So if you say this new shoe, this Nike, is worth a shot, we believe.’

Johnson came back to the booth and said, “Telling the truth.  Who knew?”  Woodell laughed.  Johnson laughed.  Knight laughed.

Two weeks later, Kitami showed up without warning in Knight’s office, asking about “this… NEE-kay.”  Knight had been rehearsing for this situation.  He replied simply that it was a side project just in case Onitsuka drops Blue Ribbon.  Kitami seemed placated.

Kitami asked if the Nikes were in stores.  No, said Knight.  Kitami asked when Blue Ribbon was going to sell to Onitsuka.  Knight answered that he still needed to talk with Bowerman.  Kitami then said he had business in California, but would be back.

Knight called Bork in Los Angeles and told him to hide the Nikes.  Bork hid them in the back of the store.  But Kitami, when visiting the store, told Bork he had to use the bathroom.  While in the back, Kitami found stacks of Nikes.

Bork called Knight and told him, “Jig’s up… It’s over.”  Bork ended up quitting.  Knight discovered later that Bork had a new job… working for Kitami.

Kitami demanded a meeting.  Bowerman, Jaqua, and Knight were in attendance.  Jaqua told Knight to say nothing no matter what.  Jaqua told Kitami that he hoped something could still be worked out, since a lawsuit would be damaging to both companies.

Knight called a company-wide meeting to explain that Onitsuka had cut them off.  Many people felt resigned, says Knight, in part because there was a recession in the United States.  Gas lines, political gridlock, rising unemployment, Vietnam.  Knight saw the discouragement in the faces of Blue Ribbon employees, so he told them:

‘…This is the moment we’ve been waiting for.  One moment.  No more selling someone else’s brand.  No more working for someone else.  Onitsuka has been holding us down for years.  Their late deliveries, their mixed-up orders, their refusal to hear and implement our design ideas – who among us isn’t sick of dealing with all that?  It’s time we faced facts:  If we’re going to succeed, or fail, we should do so on our own terms, with our own ideas – our own brand.  We posted two million in sales last year… none of which had anything to do with Onitsuka.  That number was a testament to our ingenuity and hard work.  Let’s not look at this as a crisis.  Let’s look at this as our liberation.  Our Independence Day.’

Johnson told Knight, “Your finest hour.”  Knight replied he was just telling the truth.

The Olympic track-and-field trials in 1972 were going to be in Eugene.  Blue Ribbon gave Nikes to anyone who would take them.  And they handed out Nike T-shirts left and right.

The main event was on the final day, a race between Steve Prefontaine – known as “Pre” – and the great Olympian George Young.  Pre was the biggest thing to hit American track and field since Jesse Owens.  Knight tried to figure out why.  It was hard to say, exactly.  Knight:

Sometimes I thought the secret to Pre’s appeal was his passion.  He didn’t care if he died crossing the finish line, so long as he crossed first.  No matter what Bowerman told him, no matter what his body told him, Pre refused to slow down, ease off.  He pushed himself to the brink and beyond.  This was often a counterproductive strategy, and sometimes it was plainly stupid, and occasionally it was suicidal.  But it was always uplifting for the crowd.  No matter the sport – no matter the human endeavor, really – total effort will win people’s hearts.

(Steve Prefontaine)

Gerry Lindgren was also in this race with Pre and Young.  Lindgren may have been the best distance runner in the world at that time.  Lindgren had beaten Pre when Lindgren was a senior and Pre a freshman.

Pre took the lead right away.  Young tucked in behind him.  In no time they pulled way ahead of the field and it became a two-man affair… Each man’s strategy was clear.  Young meant to stay with Pre until the final lap, then use his superior sprint to go by and win.  Pre, meanwhile, intended to set such a fast pace at the outset that by the time they got to that final lap, Young’s legs would be gone.

For eleven laps they ran a half stride apart.  With the crowd now roaring, frothing, shrieking, the two men entered the final lap.  It felt like a boxing match.  It felt like a joust… Pre reached down, found another level – we saw him do it.  He opened up a yard lead, then two, then five.  We saw Young grimacing and we knew that he would not, could not, catch Pre.  I told myself, Don’t forget this.  Do not forget.  I told myself there was much to be learned from such a display of passion, whether you were running a mile or a company.

Both men had broken the American record.  Pre had broken it by a little bit more.

…What followed was one of the greatest ovations I’ve ever heard, and I’ve spent my life in stadiums.

I’d never witnessed anything quite like that race.  And yet I didn’t just witness it.  I took part in it.  Days later I felt sore in the hams and quads.  This, I decided, this is what sports are, what they can do.  Like books, sports give people a sense of having lived other lives, of taking part in other people’s victories.  And defeats.  When sports are at their best, the spirit of the fan merges with the spirit of the athlete, and in that convergence, in that transference, is the oneness that mystics talk about.

 

1973

Bowerman had retired from coaching, partly because of the sadness of the terrorist attacks at the 1972 Olympics in Munich.  Bowerman had been able to help hide one Israeli athlete.  Bowerman had immediately called the U.S. consul and shouted, “Send the marines!”  Eleven Israeli athletes had been captured and later killed.  An unspeakable tragedy.  Knight thought of the deaths of the two Kennedys, and Dr. King, and the students at Kent State.

Ours was a difficult, death-drenched age, and at least once every day you were forced to ask yourself:  What’s the point?

Although Bowerman had retired from coaching, he was still coaching Pre.  Pre had finished a disappointing fourth at the Olympics.  He could have gotten silver if he’d allowed another runner to be the front runner and if he’d coasted in his wake.  But, of course, Pre couldn’t do that.

It took Pre six months to re-emerge.  He won the NCAA three-mile for a fourth straight year, with a time of 13:05.3.  He also won in the 5,000 by a good margin with a time of 13:22.4, a new American record.  And Bowerman had finally convinced Pre to wear Nikes.

At that time, Olympic athletes couldn’t receive endorsement money.  So Pre sometimes tended bar and occasionally ran in Europe in exchange for illicit cash from promoters.

Knight decided to hire Pre, partly to keep him from injuring himself by racing too much.  Pre’s title was National Director of Public Affairs.  People often asked Knight what that meant.  Knight would say, “It means he can run fast.”  Pre wore Nikes everywhere and he preached Nike as gospel, says Knight.

Around this time, Knight realized that Johnson was becoming an excellent designer.  The East Coast was running smoothly, but needed reorganization.  So Knight asked Johnson to switch places with Woodell.  Woodell excelled at operations and thus would be a great fit for the East Coast situation.

Although Johnson and Woodell irritated one another, they both denied it.  When Knight asked them to switch places, the two exchanged house keys without the slightest complaint.

In the spring of 1973, Knight held his second meeting with the debenture holders.  He had to tell them that despite $3.2 million in sales, the company had lost $57,000.  The reaction was negative.  Knight tried to explain that sales continue to explode higher.  But the investors were not happy.

Knight left the meeting thinking he would never, ever take the company public.  He didn’t want to deal with that much negativity and rejection ever again.

Onitsuka filed suit against Blue Ribbon in Japan.  So Blue Ribbon had to file against them in the United States.

Knight asked his Cousin Houser to be in charge of the case.  Houser was a fine lawyer who carried himself with confidence.

Better yet, he was a tenacious competitor.  When we were kids Cousin Houser and I used to play vicious, marathon games of badminton in his backyard.  One summer we played exactly 116 games.  Why 116?  Because Cousin Houser beat me 115 straight times.  I refused to quit until I’d won.  And he had no trouble understanding my position.

More importantly, Cousin Houser was able to talk his firm into taking the Blue Ribbon case on contingency.

Knight continued his evening conversations with this father, who believed strongly in Blue Ribbon’s cause.  Knight’s father, who had been trained as a lawyer, spent time studying law books.  He reassured Buck, “we” are going to win.  This support from his father boosted Buck’s spirits at a challenging time.

(Law library, Photo by Spiroview Inc.)

Cousin Houser told Knight one day that he was bringing on a new member of the team, a young lawyer from UC Berkeley School of Law, Rob Strasser.  Not only was Strasser brilliant.  He also believed in the rightness of Blue Ribbon’s case, viewing it as a “holy crusade.”

Strasser was a fellow Oregonian who felt looked down on by folks north and south.  Moreover, he felt like an outcast.  Knight could relate.  Strasser often downplayed his intelligence for fear of alienating people.  Knight could relate to that, too.

Intelligence like Strasser’s, however, couldn’t be hidden for long.  He was one of the greatest thinkers I ever met.  Debator, negotiator, talker, seeker – his mind was always whirring, trying to understand.

When he wasn’t preparing for the trial, Knight was exclusively focused on sales.  It was essential that they sell out every pair of shoes in each order.  The company was still growing fast and cash was always short.

Whenever there was a delay, Woodell always knew what the problem was and could quickly let Knight know.  Knight on Woodell:

He had a superb talent for underplaying the bad, and underplaying the good, for simply being in the moment… throughout the day a steady rain of pigeon poop would fall on Woodell’s hair, shoulders, desktop.  But Woodell would simply dust himself off, casually clear his desk with the side of his hand, and continue with his work.

…I tried often to emulate Woodell’s Zen monk demeanor.  Most days, however, it was beyond me…

Blue Ribbon couldn’t meet demand.  This frustrated Knight.  Supplies were arriving on time.  But in 1973, it seemed that the whole world, all at once, wanted running shoes.  And there were never enough.  This made things precarious, to say the least, for Blue Ribbon:

…We were leveraged to the hilt, and like most people who live from paycheck to paycheck, we were walking the edge of a precipice.  When a shipment of shoes was late, our pair count plummeted.  When our pair count plummeted, we weren’t able to generate enough revenue to repay Nissho and the Bank of California on time.  When we couldn’t repay Nissho and the Bank of California on time, we couldn’t borrow more.  When we couldn’t borrow more we were late placing our next order.

Sales for 1973 hit $4.8 million, up 50 percent from the previous year.  But Blue Ribbon was still on fragile ground, it seemed.  Knight then thought of asking their retailers to sign up for large and unrefundable orders, six months in advance, in exchange for hefty discounts, up to 7 percent.  Such long-term commitments from well-established retailers like Nordstrom, Kinney, Athlete’s Foot, United Sporting Goods, and others, could then be used to get more credit from Nissho and the Bank of California.

Much later, after much protesting, the retailers signed on to the long-term commitments.

 

1974

The trial.  Federal courthouse in downtown Portland.  Wayne Hilliard was the lead lawyer for the opposition.  He was fiery and eloquent.  Cousin Houser was the lead for Blue Ribbon.  He’d convinced his firm to take the Blue Ribbon case on contingency.  But instead of a few months, it was now two years later.  Houser hadn’t seen a dime and costs were huge.  Moreover, Houser told Knight that his fellow law partners sometimes put a great deal of pressure on Houser to drop the Blue Ribbon case.

(Federal courthouse in Portland, Oregon, Wikimedia Commons)

Houser stuck with the case.  He wasn’t fiery.  But he was prepared and dedicated.  Knight was initially disappointed, but later came to admire him.  “Fire or no, Cousin Houser was a true hero.”

After being questioned by both sides, Knight felt he hadn’t done well at all, a D minus.  Houser and Strasser didn’t disagree.

The judge in the case was the Honorable James Burns.  He called himself James the Just.  Johnson made the mistake of discussing the trial with a store manager after James the Just had expressly forbidden all discussion of the case outside the courtroom.  James the Just was upset.  Knight:

Johnson redeemed himself with his testimony.  Articulate, dazzlingly anal about the tiniest details, he described the Boston and the Cortez better than anyone else in the world could, including me.  Hilliard tried and tried to break him, and couldn’t.

Later on, the testimony of Iwano, the young assistant who’d been with Kitami, was heard.  Iwano testified that Kitami had a fixed plan already in place to break the contract with Blue Ribbon.  Kitami had openly discussed this plan on many occasions, said Iwano.

Bowerman’s testimony was so-so because, out of disdain, he hadn’t prepared.  Woodell, for his part, was nervous.

Mr. Onitsuka said he hadn’t known anything about the conflict between Kitami and Knight.  Kitami, in his testimony, lied again and again.  He said that he had no plan to break the contract with Blue Ribbon.  He also claimed that meeting with other distributors had just been market research.  As well, the idea of acquiring Blue Ribbon “was initiated by Phil Knight.”

James the Just was convinced that Blue Ribbon had been more truthful.  In particular, Iwano seemed truthful, while Kitami didn’t.  On the issue of trademarks, Blue Ribbon would retain all rights to the Boston and the Cortez.

A bit later, Hilliard offered $400,000.  Finally, Blue Ribbon accepted.  Knight was happy for Cousin Houser, who would get half.  It was the largest payment in the history of his firm.

Knight, with help from Hayes, convinced Strasser to come work for Blue Ribbon.  Strasser later accepted.

Japanese labor costs were rising.  The yen was fluctuating.  Knight decided Blue Ribbon needed to find factories outside of Japan.  He looked at Taiwan, but shoe factories there weren’t quite ready.  He looked next at Puerto Rico.

Then Knight went to the east coast to look for possible factories.  The first factory owner laughed in Knight’s face.

The next empty factory Knight visited – with Johnson – the owner was willing to lease the third floor to Blue Ribbon.  He suggested a local guy to manage the factory, Bill Giampietro.  Giampietro turned out to be “a true shoe dog,” said Knight.  All he’d ever done is make shoes, like his father.  Perfect.  Could he get the old Exeter factory up and running?  How much would it cost?  No problem.  About $250,000.  Deal.

Knight asked Johnson to run the new factory.  Johnson said, “…what do I know about running a factory?  I’d be in completely over my head.”

Knight couldn’t stop laughing:  “Over your head?  Over your head!  We’re all in over our heads!  Way over!”

Knight writes that, at Blue Ribbon, it wasn’t that they thought they couldn’t fail.  On the contrary, they thought they would fail.  But they believed they would fail fast, learn from it, and be better for it.

Finishing up 1974, the company was on track for $8 million in sales.  Their contact at Bank of California, Perry Holland, kept telling them to slow down.  So they sped up, as usual.

 

1975

Knight kept telling Hayes, “Pay Nissho first.”  Blue Ribbon had a line of credit at the bank for $1 million.  They had a second million from Nissho.  That was absolutely essential.

…Grow or die, that’s what I believed, no matter the situation.  Why cut your order from $3 million down to $2 million if you believed in your bones that demand out there was for $5 million?  So I was forever pushing my conservative bankers to the brink, forcing them into a game of chicken.  I’d order a number of shoes that seemed to them absurd, a number we’d need to stretch to pay for, and I’d always just barely pay for them, in the nick of time, and then just barely pay our other monthly bills, at the last minute, always doing just enough, and no more, to prevent the bankers from booting us.  And then, at the end of the month, I’d empty our accounts to pay Nissho and start from zero again.

Demand was always greater than sales, so Knight concluded his approach was reasonable.  There was a new manager at Nissho’s Portland office, Tadayuki Ito, in place of Sumeragi.  (Sumeragi still helped with the Blue Ribbon account, though.)

One day in the spring of 1975, Blue Ribbon was $75,000 short of the $1 million they owed Nissho.  Blue Ribbon would have to completely drain every other account to make up for the shortfall.  Retail stores.  Johnson’s Exeter factory.  All of them.

(Illustration by Lkeskinen0)

In Exeter, a mob of angry workers was at Johnson’s door.  Giampetro drove with Johnson to see an old friend who owned a box company that depended on Blue Ribbon.  Giampetro asked for a loan of $5,000 (more than $25,000 in 2018), which was outrageous.  The man counted out fifty crisp hundred-dollar bills, says Knight.

Then Holland called Knight and Hayes to a meeting at the Bank of California.  The bank would no longer do business with Blue Ribbon.

Knight was worried how Ito and Sumeragi, representing Nissho, would react.  Ito and Sumeragi, after hearing what happened, said they would need to look at Blue Ribbon’s books.

On the weekend, Knight called a company-wide meeting to discuss the situation.  The Exeter factory had been a secret kept from Nissho.  But everyone agreed to give Nissho all information.

During this meeting, two creditors – owed $500,000 and $100,000 – called and were livid.  They were on their way to Oregon to collect and cash out.

On Monday, Ito and Sumeragi arrived at Blue Ribbon’s office.  Without a word, they went through the lobby to the conference room, sat down with the books and got to work.  Then Ito came to information related to the Exeter factory.  He did a slow double-take and then looked up at Knight.  Knight nodded.  Ito smiled.  Knight:

I gave him a weak half smile in return, and in that brief wordless exchange countless fates and futures were decided.

It turned out that Sumeragi had been trying to help Blue Ribbon by hiding Nissho’s invoices in a drawer.  Blue Ribbon had been stressing out trying to pay Nissho on time, but they’d never paid them on time because Sumeragi thought he was helping, writes Knight.

Ito accused Sumeragi of working for Blue Ribbon.  Sumeragi swore on his life that he’d acted independently.  Ito asked why.  Sumeragi answered that he thought Blue Ribbon would be a great success, perhaps a $20 million account.  Ito eventually forgave Blue Ribbon.  “There are worse things than ambition,” he said.

Ito accompanied Knight and Hayes to a meeting with the Bank of California.  Only this time, Ito – whom Knight saw as a “mythic samurai, wielding a jeweled sword” – was on their side.

(Samurai, Photo by Esolex)

According to Knight, Ito opened the meeting and “went all in.”  After confirming that Bank of California no longer wanted to handle Blue Ribbon’s account, Ito said Nissho wanted to pay off Blue Ribbon’s outstanding debt.  He asked for the number and it was the same number he’d learned earlier.  Ito already had a check made out for the amount and slid an envelope with the check across the table.  Ito insisted the check be deposited immediately.

After the meeting, Knight and Hayes bowed to Ito.  Ito remarked:

‘Such stupidity… I do not like such stupidity.  People pay too much attention to numbers.’

***

Blue Ribbon still needed a bank.  They started calling.  “The first six hung up on us,” recalls Knight.  First State Bank of Oregon didn’t hang up.  They offered one million in credit.

Pre died in a tragic car accident at the age of twenty-four.  At the time of his death, he held every American record from 2,000 to 10,000 meters, from two miles to six miles.  People created a shrine where Pre had died.  They left flowers, letters, notes, gifts.  Knight, Johnson, and Woodell decided that Blue Ribbon would curate Pre’s rock, making it a holy site forever.

 

1976

Knight had several meetings early in 1976 with Woodell, Hayes, and Strasser about the company’s cash situation.  Nissho was lending Blue Ribbon millions, but to keep up with demand, they needed millions more.  The most logical solution was to go public.  But Knight and the others felt that it just wasn’t who they were.  No way.

They found other ways to raise money, including a million-dollar loan guaranteed by the U.S. Small Business Administration.

Meanwhile, Bowerman’s waffle trainer was getting even more popular.

(Nike 1976 waffle trainer)

With its unique outer sole, and its pillowy midsole cushion, and its below-market price ($24.95), the waffle trainer was continuing to capture the popular imagination like no previous shoe.  It didn’t just feel different, or fit different – it looked different.  Radically so.  Bright red upper, fat white swoosh – it was a revolution in aesthetics.  Its look was drawing hundreds of thousands of new customers into the Nike fold, and its performance was sealing their loyalty.  It had better traction and cushioning than anything on the market.

Watching that shoe evolve in 1976 from popular accessory to cultural artifact, I had a thought.  People might start wearing this thing to class.

And the office.

And the grocery store.

And throughout their everyday lives.

It was a rather grandiose idea… So I ordered the factories to start making the waffle trainer in blue, which would go better with jeans, and that’s when it really took off.

We couldn’t make enough.  Retailers and sales reps were on their knees, pleading for all the waffle trainers we could ship.  The soaring pair counts were transforming our company, not to mention the industry.  We were seeing numbers that redefined our long-term goals, because they gave us something we’d always lacked – an identify.  More than a brand, Nike was now becoming a household word, to such an extent that we would have to change the company name.  Blue Ribbon, we decided, had run its course.  We would have to incorporate as Nike, Inc.

They needed to ramp up production.  Knight realized the time had come to visit Taiwan.  To help with the Taiwan effort, Knight turned to Jim Gorman.  Gorman had been raised in a series of foster homes.  Nike was the family he’d never had.

…In every instance, Gorman had done a fine job and never uttered a sour word.  He seemed the perfect candidate to take on the latest mission impossible – Taiwan.  But first I needed to give him a crash course on Asia.  So I scheduled a trip, just the two of us.

Gorman was full of questions for Knight and took notes on everything.  Knight enjoyed teaching Gorman, partly because Knight himself could learn what he knew even better through the process of teaching.

Taiwan had a hundred smaller factories, whereas South Korea had a few larger ones.  That’s why Nike needed to go to Taiwan at this juncture.  Demand for Nikes was exploding, but their volume was still too low for a giant shoe factory.  However, Knight knew it would be a challenge to get a shoe factory in Taiwan to improve its quality enough to be able to produce Nikes.

During the visit to various Taiwan shoe factories, Jerry Hsieh introduced himself to Knight and Gorman.  Hsieh was a genuine shoe dog, but quite young, twenty-something.  When Knight and Gorman found their way to Hsieh’s office – a room stuffed with shoes everywhere – Hsieh started sharing his deep knowledge of shoes.  Also, Hsieh told them he knew the very best shoe factories in Taiwan and for a small fee, would be happy to introduce them.  They agreed on a commission per pair.

The 1976 Olympic trials, again in Eugene.  In the 10,000 meter race, all top three finishers wore Nikes.  Some top finishers in other qualifying races also wore Nikes.  Meanwhile, Penny created a great number of Nike T-shirts.  People would see other people wearing the Nike T-shirts and want to buy one.  The Nike employees heard people whispering.  “Nike.”  “Nike.”  “Nike.”

At the close of 1976, Nike had doubled its sales to $14 million.  The company still had no cash, though.  Its bank accounts were often at zero.

The company’s biannual retreat was taking place.  People called it Buttface.

Johnson coined the phrase, we think.  At one of our earliest retreats he muttered:  “How many multi-million dollar companies can you yell out, ‘Hey, Buttface,’ and the entire management team turns around?”  It got a laugh.  And then it stuck.  And then it became a key part of our vernacular.  Buttface referred to both the retreat and the retreaters, and it not only captured the informal mood of those retreats, where no idea was too sacred to be mocked, and no person was too important to be ridiculed, it also summed up the company spirit, mission and ethos.

Knight continues:

…The problems confronting us were grave, complex, insurmountable… And yet we were always laughing.  Sometimes, after a really cathartic guffaw, I’d look around the table and feel overcome by emotion.  Camaraderie, loyalty, gratitude.  Even love.  Surely love.  But I also remember feeling shocked that these were the men I’d assembled.  These were the founding fathers of a multi-million dollar company that sold athletic shoes?  A paralyzed guy, two morbidly obese guys, a chain-smoking guy?  It was bracing to realize that, in this group, the one with whom I had the most in common was… Johnson.  And yet, it was undeniable.  While everyone else was laughing, rioting, he’d be the sane one, sitting quietly in the middle of the table reading a book.

A bit later, Knight writes:

Undoubtedly we looked, to any casual observer, like a sorry, motley crew, hopelessly mismatched.  But in fact we were more alike than different, and that gave a coherence to our goals and our efforts.  We were mostly Oregon guys, which was important.  We had an inborn need to prove ourselves, to show the world that we weren’t hicks and hayseeds.  And we were nearly all merciless self-loathers, which kept the egos in check.  There was none of that smartest-guy-in-the-room foolishness.  Hayes, Strasser, Woodell, Johnson, each would have been the smartest guy in any room, but none believed of himself, or the next guy.  Our meetings were defined by contempt, disdain, and heaps of abuse.

(Photo by Chris Dorney)

Knight records:

…Each of us had been misunderstood, misjudged, dismissed.  Shunned by bosses, spurned by luck, rejected by society, short-changed by fate when looks and other natural graces were handed out.  We’d each been forged by early failure.  We’d each given ourselves to some quest, some attempt at validation or meaning, and fallen short.

I identified with the born loser in each Buttface, and vice versa, and I knew that together we could become winners…

Knight’s management style continued to be very hands-off, following Patton’s leadership belief:

Don’t tell people how to do things, tell them what to do and let them surprise you with their results.

Nike’s culture seemed to be working thus far.  Since Bork, no one had gotten really upset, not even what they were paid, which is unusual, notes Knight.  Knight created a culture he himself would have wanted:  let people be, let people do, let people make their own mistakes.

 

1977

M. Frank Rudy, a former aerospace engineer, and his business partner, Bob Bogert, presented to Nike the idea of putting air in the soles of shoes.  Great cushioning, great support, a wonderful ride.  Knight tried wearing a pair Rudy showed him on a six-mile run.  Unstable, but one great ride.

Strasser, who by this point had become Nike’s negotiator, offered Rudy 10 cents for every pair we sold.  Rudy asked for twenty.  They settled somewhere in the middle.  Knight sent Rudy and his partner back to Exeter, which “was becoming our de facto Research and Development Department.”

Knight calls this time “an odd moment,” saying furthermore that “a second strange shoe dog showed up on our door step.  His name was Sonny Vaccaro…”.  Vaccaro had founded the Dapper Dan Classic, a high school all-star game that had become very popular.  Though it, Vaccaro had gotten to know many coaches.  Knight hired Vaccaro and sent him, with Strasser, to sign up college basketball coaches.  Knight expected them to fail.  But they succeeded.

Knight knew he had to meet again with Chuck Robinson, who’d served with distinction as a lieutenant commander on a battle ship in World War II.  Chuck knew business better than anyone Knight had ever met.  Recently, he’d been the number two guy under Henry Kissinger, so he wasn’t available for meetings.  Now Chuck was free.

Chuck took a look at Nike’s financials and couldn’t stop laughing, saying, “Compositionally, you are a Japanese trading company – 90 percent debt!”

Chuck told Buck, “You can’t live like this.”  The solution was to go public in order to raise a large amount of cash.  Knight invited Chuck to join the board.  Chuck agreed, to Knight’s surprise.

When Knight put the question of going public to a company vote, however, the consensus was still to remain private.

Then they received a letter from the U.S. Customs Service containing a bill for $25 million.  Nike’s competitors, Converse and Keds – plus a few small factories – were behind it.  They had been lobbying in Washington, DC, trying to slow Nike by enforcing the American Selling Price, an old law dating back to protectionist days.

(Photo by Ian Wilson)

ASP – American Selling Price – said that import duties on nylon shoes should be 20 percent of the shoe’s manufacturing cost.  Unless there was a “similar shoe” made by a U.S. competitor.  Then it should be 20 percent of that shoe’s selling price.  Nike’s competitors just needed to make some shoes deemed “similar,” price them very high, and voila – high import duties for Nike.

They’d managed to pull the trick off, raising Nike’s import duties retroactively by 40 percent.

Near the end of 1977, Nike’s sales were approaching $70 million.

 

1978

Knight calls Strasser the “five-star general” in the battle with the U.S. government.  But they knew they needed “a few good men.”  Strasser suggested a friend of his, a young Portland lawyer, Richard Werschkul.  Stanford undergrad, University of Oregon law.  A sharp guy with a presence.  And an eccentric streak.  Some worried he was too serious and obsessive.  But that seemed good to Knight.  And Knight trusted Strasser.  Werschkul was dispatched to Washington, DC.

Meanwhile, sales were on track for $140 million.  Furthermore, Nike shoes were finally recognized as higher quality than Adidas shoes.  Knight thought Nike had led in quality and innovation for years.

Nike had to start selling clothes, announced Knight at Buttface in 1978.  First, Adidas sold more apparel than shoes.  Second, it would be easier to get athletes into endorsement deals.

Knight decided to hire a young accountant, Bob Nelson, and put him in charge of the new line of Nike apparel.  But Nelson had no sense of style, unfortunately.  When he presented his ideas, they didn’t look good.  Knight decided to transfer him to an accounting position, where he would excel.  Knight writes:

…Then I quietly shifted Woodell to apparel.  He did his typically flawless job, assembling a line that gained immediate attention and respect in the industry.  I asked myself why I didn’t just let Woodell do everything.

Tailwind – a new Nike shoe with air – came out in late 1978.  Then Nike had to recall it due to a design flaw.  Knight concluded they’d learned a valuable lesson.  “Don’t put twelve innovations into one shoe.”

Around this time, many seemed to be suffering from burnout, including Knight.  And back in DC, Werschkul was becoming hyper obsessive.  He’d tried to talk with everyone possible.  They all told him to put something in writing so they could study it.

Werschkul spent months writing.  It became hundreds of pages.  “Without a shred of irony Werschkul called it:  Werschkul on American Selling Price, Volume I.”  Knight:

When you thought about it, when you really thought about it, what really scared you was that Volume I.

Knight sent Strasser to calm Werschkul down.  Knight realized that he himself would have to go to DC.  “Maybe the cure for any burnout… is just to work harder.”

 

1979

Senators Mark O. Hatfield and Bob Packwood helped Nike deal with the $25 million bill from U.S. Customs.  Knight started the process of looking for a factory in China.

 

1980

Chuck Robinson suggested to Knight that Nike could go public but have two classes of stock, class A and class B.  Nike insiders would own class A shares, which would allow them to name three-quarters of the board of directors.  The Washington Post Company and a few other companies had done this.

Knight explained the idea – going public with two classes of stock – to colleagues at Nike.  All agreed that it was time to go public to raise badly needed cash.

In China, Knight – with Strasser, Hayes, and others – signed a deal with China’s Ministry of Sports.  Four years later, at the Olympics in Los Angeles, the Chinese track-and-field team entered the stadium wearing Nike shoes and warm-ups.  Before leaving China, Nike signed a deal with two Chinese factories.

Knight then muses about “business”:

It seems wrong to call it “business.”  It seems wrong to throw all those hectic days and sleepless nights, all those magnificent triumphs and desperate struggles, under that bland, generic banner:  business.  What we were doing felt like so much more.  Each new day brought fifty new problems, fifty tough decisions that needed to be made, right now, and we were always acutely aware that one rash move, one wrong decision could be the end.  The margin for error was forever getting narrower, while the stakes were forever creeping higher – and none of us wavered in the belief that “stakes” didn’t mean “money.”  For some, I realize, business is the all-out pursuit of profits, period, full stop, but for us business was no more about making money than being human is about making blood.  Yes, the human body needs blood.  It needs to manufacture red and white cells and platelets and redistribute them evenly, smoothly, to all the right places, on time, or else.  But that day-to-day mission of the human body isn’t our mission as human beings.  It’s a basic process that enables our higher aims, and life always strives to transcend the basic processes of living – and at some point in the late 1970s, I did, too.  I redefined winning, expanded it beyond my original definition of not losing, of merely staying alive.  That was no longer enough to sustain me, or my company.  We wanted, as all great businesses do, to create, to contribute, and we dared to say so aloud.  When you make something, when you improve something, when you add to some new thing or service to the lives of strangers, making them happier, or healthier, or safer, or better, and when you do it all crisply and efficiently, smartly, the way everything should be done but so seldom is – you’re participating more fully in the whole grand human drama.  More than simply alive, you’re helping others to live more fully, and if that’s business, all right, call me a businessman.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The 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.

Forecasting

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.

 

COMPOUNDING

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/

 

MEASURING UP

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.

 

THE PARTNERSHIP: AN ELEGANT STRUCTURE

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.

 

THE GENERALS

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/

Concentration

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.

 

WORKOUTS

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

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.

Buffett:

… 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 DIVING:  THE ASSET CONVERSION PLAY

Dempster was a tiny micro cap, a family-owned company in Beatrice, Nebraska, that manufactured windmills and farm equipment.

(Photo by Digikhmer)

Miller:

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.

 

CONSERVATIVE VERSUS CONVENTIONAL

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…

 

SIZE VERSUS PERFORMANCE

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.

 

GO-GO OR NO-GO

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.

 

TOWARD A HIGHER FORM

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.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.  

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.