June 12, 2022

Would you like to improve as an investor? One of the best things you can do is to study great investors like Warren Buffett.

Robert Hagstrom has written an excellent book–The Warren Buffett Way(Wiley, 2014)–explaining Buffett’s approach to investing. Hagstrom’s goal is to help investors improve.

Here is the outline for this blog post:

• A Five-Sigma Event: The World’s Greatest Investor
• The Education of Warren Buffett
• Buying a Business: The Twelve Immutable Tenets
• Common Stock Purchases: Nine Case Studies
• Portfolio Management: The Mathematics of Investing
• The Psychology of Investing
• The Value of Patience
• The World’s Greatest Investor

(Photo by USA International Trade Administration)

 

A FIVE-SIGMA EVENT: THE WORLD’S GREATEST INVESTOR

Buffett has always maintained that he won the ovarian lottery.

My wealth has come from a combination of living in America, some lucky genes, and compound interest. My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well.

Buffett keeps things in perspective by saying that he happens to work “in an economy that rewards someone who saves lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect mispricing of securities with sums reaching into the billions.”

Buffett was entrepreneurial from a young age. He would buy a six-pack of coke for 25 cents, then sell each one for 6 cents. He had two paper routes during the time he lived in Washington, D.C., when his father was a congressman from Nebraska. He and a buddy bought used pinball machines, and made a profit from them.

(Photo by Shahroozporia, via Wikimedia Commons)

But Buffett didn’t figure out the right way to invest for some time. He tried charting. He read books on technical analysis. He got hot tips from brokers. Finally, he came across a copy of The Intelligent Investor, by Benjamin Graham. Buffett then realized that the strategy of value investing explained by Graham was a reliable way to succeed at investing over time.

Buffett attendedgraduate school at Columbia University in order to study under Graham. Once in Graham’s class, everyone saw that Buffett was the brightest and most knowledgeable student. The class was like a conversation between Graham and Buffett. Buffett got an A+ in the course, the first A+ Graham had given in 22 years of teaching.

Upon graduating from Columbia, Buffett was not able to work for Graham at Graham-Newman right away. At the time, Graham was only hiring Jewish analysts because they were being discriminated against elsewhere. Buffett periodically sent Graham stock ideas until Graham finally hired him.

Two years later in 1956, after Graham retired, Buffett returned to Omaha. Buffett launched a limited investment partnership, which included some family and friends as investors. At the outset, the partnership had $105,000 under management.

Buffett’s goal was to beat the Dow Jones Industrial Average by 10 percentage points a year. Approximately thirteen years later, Buffett had beaten the Dow Jones Average by over 22 percentage points a year.

In the early 1960s there was a corporate scandal. The Allied Crude Vegetable Oil Company, led by Tino De Angelis, found that it could get loans based on its inventory of salad oil. De Angelis built a refinery in New Jersey with 139 five-story storage tanks. Because oil floats on top of water, De Angelis filled the tanks with water with just a few feet of oil on the top. The inspectors didn’t notice for some time.

American Express lost $58 million in the salad oil scandal, and its stock dropped over 50 percent. Buffett went to restaurants in Omaha, and discovered that there was no decrease in usage of the American Express Green Card. Buffett also visited banks and learned that the scandal was having no impact on the use of American Express Travelers Cheques.

(Amex Logo, by American Express via Wikimedia Commons)

The strong brand of American Express was still intact. The stock had plummeted based on a huge, but temporary problem. So Buffett invested 40 percent of the partnership in American Express. The shares nearly tripled over the next two years.

By 1965, Buffett had acquired–via the partnership–a controlling interest in Berkshire Hathaway, a struggling New England textile company. When Buffett closed his investment partnership in 1969, he himself kept his stock in Berkshire Hathaway and limited partners received some stock in Berkshire Hathaway. Buffett advised limited partners on how to invest in municipal bonds. (Buffett thought that stocks were not a very good value in 1969.) Or limited partners could invest with Bill Ruane, Buffett’s friend from Columbia University and Graham-Newman. Meanwhile, Berkshire Hathaway, despite excellent management from Ken Chace, had disappointing results for many years. Buffett only kept Berkshire Hathaway open out of concern for the workers.

The textile mills were the largest employer in the area; the workforce was an older age group that possessed relatively nontransferable skills; management had shown a high degree of enthusiasm; the unions were being reasonable; and, very importantly, Buffett believed that some profits could be realized from the textile business.

But Berkshire Hathaway continued to struggle. Buffett siphoned off cash from the business in order to invest in better businesses. (Had the cash been reinvested in Berkshire, the returns would have been below the cost of capital, thus destroying value.) Later, Buffett reluctantly closed Berkshire Hathaway because unending losses would otherwise have been the result.

(Hathaway Mills, Photo byMarcbela via Wikimedia Commons)

In 1967, with the excess cash from the textile operations, Berkshire Hathaway purchased two insurance companies headquartered in Omaha: National Indemnity Company and National Fire & Marine Insurance Company. As Hagstrom writes, this was the beginning of Berkshire Hathaway’s legendary success story.

Instead of having the float from the insurance operations invested mostly in bonds, Buffett invested much of the float in stocks. Over time, due to Buffett’s great skill in investing, investment assets grew significantly in value. Importantly, the underlying insurance operations themselves were profitable because they were disciplined in pricing their policies. The profitability of the insurance operations meant that the float had a very low cost.

Going forward, Buffett was open to investing in more insurance companies. By 1991, Berkshire owned nearly half of GEICO. GEICO was a very profitable auto insurer. GEICO had structurally lower costs than its competitors because GEICO sold direct to customers, without needing agents or branch offices.

Buffett bought other insurance companies over time, including large reinsurers. Hagstrom notes that Buffett’s best acquisition was a person–Ajit Jain. Jain has brilliantly managed the Berkshire Hathaway Reinsurance Group over the years. Buffett said of Ajit:

His operation combines capacity, speed, decisiveness, and most importantly, brains in a manager that is unique in the insurance business.

Over several decades, Buffett invested in a focused portfolio of common stocks. He also acquired a number of private businesses. He views both types of investment the same way: he looks to pay a good price for a simple business, run by able and honest management, with good economics.

Hagstrom notes Buffett’s track record:

Over the past 48 years, starting in 1965, the year Buffett took control of Berkshire Hathaway, the book value of the company has grown from $19 to $114,214 per share, a compounded gain of 19.7 percent; during that period, the Standard & Poor’s (S&P) 500 index gained 9.4 percent, dividends included.

The margin of outperformance combined with the length of the track record is simply unparalleled in the investment world. But Hagstrom argues that other investors can improve by studying Buffett’s career. Hagstrom quotes Buffett:

What we do is not beyond anyone else’s competence. I feel the same way about managing that I do about investing: it is just not necessary to do extraordinary things to get extraordinary results.

 

THE EDUCATION OF WARREN BUFFETT

Hagstrom writes that Buffett was influenced primarily by three investors: Benjamin Graham, Philip Fisher, and Charlie Munger.

At age 20, Graham graduated from Columbia University and was offered several positions at the university (in literature, mathematics, and philosophy). Graham was clearly a genius. Perhaps based partly on his experience of poverty–his father had died while Graham was young, leaving the family in a difficult financial situation–Graham decided to work on Wall Street rather than work in academia.

Graham’s first job was as a messenger–for $12 a week–for the brokerage firm of Newburger, Henderson & Loeb. Five years later, in 1919, Graham was earning $600,000 a year (almost $8 million in 2012 dollars) as a partner in the firm.

Graham launched Graham-Newman in 1926. In 1929-1932, Graham-Newman lost most of its value. Graham personally was financially ruined.

From 1929 to 1934, Graham, while teaching at Columbia University and in cooperation with another professor, David Dodd, produced Security Analysis, which continues to be the bible for value investors to this day. Graham was slowly rebuilding his fortune, and the philosophy of value investing–as expressed in Security Analysis–was the key.

(Ben Graham, by Equim43 via Wikimedia Commons)

Graham realized that many investors try to get good results over short periods of time. He saw that short-term movements in stock prices are largely random and unpredictable, but that over time, a stock price follows the earnings of a company. Graham thus distinguished between speculation and investing. Speculation meant trying to predict stock prices over the short term, whereas investing means buying below probable intrinsic value–based on net asset value or earnings power.

Intrinsic value is based on net asset value or earnings power. As long as the investor pays a price below intrinsic value, the investor has a margin of safety. The margin of safety offers protection against errors by the investor and against bad luck (or unforeseen negative events). Simultaneously, the margin of safety represents the profit the investor can earn in those cases where he or she is right and the stock price approaches intrinsic value.

Graham preferred to focus on net asset value. If you take the current assets of the company and subtract all liabilities, and if the stock price can be bought below that level, there is a strong margin of safety present. This is Graham’s net-net approach. It is meant to be applied to a basket of stocks.

The net-net approach is inherently safer than buying stocks at a discount to their earnings power. It is generally more difficult to estimate the earnings power of a company than to estimate the net-net value. (The net-net value is simply an extremely conservative measure of liquidation value.)

Thus Graham placed much more emphasis on quantitative cheapness than he did on qualitative factors like competitive position and management capability. If you keep buying stocks at a huge discount to net asset value, you are nearly certain to get good results over time. On the other hand, if you keep buying stocks at a discount to earnings power, you cannot be as certain because in many cases future earnings may turn out to be different than expected.

In brief, Graham offered two methods for investors to succeed: buying below net current asset value and buying at a low price-to-earnings ratios (P/E). In either case, the stock in question is deeply out of favor.

Every business, at any given time, is either in one of two states: it is experiencing problems or it will be experiencing problems. When a business runs into problems, the stock price typically will decline and the company will fall out of favor. The key is that most business problems are temporary and not permanent, at least when viewed over the subsequent 3 to 5 years.

When a company runs into problems, investors usually overreact and sell the stock to much lower levels than is justified by net asset value or earnings power. By systematically buying a basket of these oversold stocks, you can do well over time.

Philip Fisher

Fisher believed in a concentrated portfolio of five to eight stocks. Fisher would conduct ‘scuttlebutt’ research, which involved speaking with customers, suppliers, competitors, and industry experts. Fisher wanted to understand the quality of management and the strength of the company’s competitive position.

(Philip A. Fisher)

If you can buy stock in a company that has a strong competitive position based on continued innovation, and that is run by able and honest managers, then you’ll do well over time. Fisher also insisted that the sales force of the company in question be strong. This should be ensured by strong management. As well, Fisher made sure the company had good profits.

Good managers focus on building shareholder value. And they are honest about their mistakes and about the real difficulties being encountered by the business.

Charlie Munger

Charlie Munger was from Omaha, like Buffett. As a kid, Munger had worked for the grocery store run by Warren Buffett’s grandfather.

Munger’s grandfather was a federal judge and his father was a lawyer. Munger became a successful lawyer in Los Angeles after graduating from Harvard Law School.

One of Buffett’s early investors, Dr. Edwin Davis, had decided to invest in the Buffett Partnership because Buffett reminded him of Charlie Munger. A few years later, in 1959, Dr. David arranged a meeting between Buffett and Munger. This was the beginning of an extraordinary partnership.

(Charlie Munger at the 2010 Berkshire Hathaway shareholders meeting. Photo by Nick Webb)

Munger realized that it is better to pay a fair price for a wonderful company than a wonderful price for a fair company. Buffett had recently invested in several statistically cheap companies:

My punishment was an education in the economies of short-line farm implementation manufacturers (Dempster Mill Manufacturing), third-place department stores (Hochschild-Kohn), and New England textile manufacturers (Berkshire Hathaway).

These were three situations of paying a wonderful price for a fair company. Only the investment in Dempster worked, thanks to a turnaround specialist, Harry Bottle, whom Munger had introduced to Buffett. The Dempster investment easily could have failed. Hochschild-Kohn didn’t work. Berkshire Hathaway–the textile manufacturer–eventually went out of business.

Note: Buffett took cash out of the textile business and made a long series of highly successful investments. This was the beginning of Buffett and Munger creating today’s Berkshire Hathaway. The old textile business was closed.

In 1972, Berkshire Hathaway acquired See’s Candies at a large premium to book value. This stock was not at all statistically cheap. But it was a wonderful company at a fair price, which Munger argued made excellent sense.

Over the ensuing decades, See’s Candies produced an extraordinarily high return on invested capital (ROIC) and return on equity (ROE). Thus even though Buffett and Munger paid nearly three times book value, the investment turned out to be a grand slam. Charlie said it was ‘the first time we paid for quality.’

The success of the See’s Candies investment is what made Buffett open to making a large investment in Coca-Cola in the late 1980s. Buffett invested about one billion dollars in Coca-Cola–about a third of Berkshire’s portfolio–even though the P/E and the P/CF were high. The key was that Coca-Cola could develop and maintain a very high ROE (and ROIC).

A Blending of Influences

From Graham, Buffett learned the importance of a margin of safety. Buffett learned that it is important to estimate the intrinsic value of the business, and then pay a price well below that value. Buffett also learned from Graham that stock price fluctuations are largely random and should be ignored except when they create bargains. Thirdly, Buffett learned from Graham the importance of being an independent thinker. As Graham said:

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

From Fisher, Buffett learned to concentrate his portfolio in his best ideas: it is safer to own a few ideas with which you are thoroughly familiar than to own many ideas without knowing much about them. Buffett also learned from Fisher the value of ‘scuttlebutt’ research, which meant interviewing customers, suppliers, competitors, and industry experts. Finally, Buffett learned that a high-quality company can increase its intrinsic value over a long period of time.

Charlie Munger figured out on his own that it made sense to pay a fair price for a wonderful company. Even paying a large premium to book value, you could still have a significant margin of safety relative to a long future of compounding intrinsic value.

Thus it was primarily Munger’s influence that got Buffett to agree to purchase See’s Candies at a large premium to book value. Munger also became an expert in psychology, which impacted Buffett.

Hagstrom sums up the three influences:

Graham gave Buffett the intellectual basis for investing–the margin of safety–and helped him learn to master his emotions in order to take advantage of market fluctuations. Fisher gave Buffett an updated, workable methodology that enabled him to identify good long-term investments and manage a focused portfolio over time. Charlie helped Buffett appreciate the economic returns that come from buying and owning great businesses. [And] Charlie helped educate Buffett on the psychological missteps that often occur when individuals make financial decisions.

BUYING A BUSINESS: THE TWELVE IMMUTABLE TENETS

Buffett uses the same basic approach whether he is acquiring the business outright or buying a piece of the business via shares of stock. Owning the entire company allows Buffett to control the capital allocation of the business. On the other hand, because the stock market is so large, there are many more opportunities to find bargains among public equities than among private businesses. Hagstrom quotes Buffett:

When investing, we view ourselves as business analysts, not as market analysts, not as macroeconomic analysts, and not even as security analysts.

Thus Buffett acts primarily as a businessperson, whether he is acquiring a company or buying stock.

Hagstrom has distilled Buffett’s investment approach into twelve key tenets:

Business Tenets

• Is the business simple and understandable?
• Does the business have a consistent operating history?
• Does the business have favorable long-term prospects?

Management Tenets

• Is management rational?
• Is management candid with its shareholders?
• Does management resist the institutional imperative?

Financial Tenets

• Focus on return on equity (ROE), not earnings per share (EPS).
• Calculate ‘owner earnings.’
• Look for companies with high profit margins.
• For every dollar retained, make sure the company has created at least one dollar of market value.

Market Tenets

• What is the value of the business?
• Can the business be purchased at a significant discount to its value?

Business Tenets

• Is the business simple and understandable?
• Does the business have a consistent operating history?
• Does the business have favorable long-term prospects?

Buffett holds that most business success stories involve companies doing the same things they have been doing for decades. This often does involve ongoing innovation, but in the context of a business that already has a sustainable competitive advantage.

Investment success is not how much you know, but how well you understand the limits of what you know (and what you can know). Buffett:

Invest in your circle of competence. It’s not how big the circle is that counts; it’s how well you define the parameters.

Buffett is looking for a company with a sustainable competitive advantage demonstrated in a consistent operating history and expected to last well into the future. This doesn’t guarantee success in every case, but it does maximize the probability of success over time.

Buffett looks for great businesses or franchises:

He defines a franchise as a company providing a product or service that is (1) needed or desired, (2) has no close substitute, and (3) is not regulated. These traits allow the company to hold its prices, and occasionally raise them, without the fear of losing market share or unit volume. This pricing flexibility is one of the defining characteristics of a great business; it allows the company to earn above-average returns on capital.

(Image by Marek Uliasz)

Buffett:

The key to investing is determining the competitive advantage of any given company and, above all, the durability of the advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

Buffett again:

[The] definition of a great company is one that will be great for 25 to 30 years.

 

Management Tenets

• Is management rational?
• Is management candid with its shareholders?
• Does management resist the institutional imperative?

Buffett looks for honest and able managers whobehave like owners. Such managers understand that their mission is to build business value over time.

Allocating capital in a rational way is central to maximizing the value of the business over time. Particularly for mature companies, which Buffett often prefers based on their predictability, the allocation of excess cash can have a large impact on the value of the business.

The key is to get a return on invested capital (ROIC)–or return on equity (ROE)–that exceeds the cost of capital. (ROE is close to ROIC for companies with low or no debt, which Buffett has always preferred.) If there is no project that promises a sufficiently high return on capital, then the managers should consider buying back stock or paying dividends. Buying back stock only creates value when the stock price is below intrinsic value.

When considering projects that may have a high ROIC (or high ROE), it’s vital that managers are thinking independently.

(Photo by Marijus Auruskevicius)

Similarly, managers should never simply copy what other managers in the same industry are doing. This is a recipe for disaster. But it happens often enough. Buffett and Munger call it the institutional imperative–the lemming-like tendency of managers to imitate the behavior of others, no matter how silly or irrational. Buffett and Munger think the institutional imperative is responsible for several problems:

(1) [The organization] resists any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Jack Ringwalt was the head of National Indemnity when Berkshire acquired it in 1967. There were times when Ringwalt would simply stop selling insurance altogether if the rates on policies didn’t make sense. Buffett learned this lesson well, both for Berkshire’s many insurance operations and in general.

Management candor is essential. Good managers admit their mistakes and confront their problems rather than hiding behind GAAP (generally accepted accounting principles).

 

Financial Tenets

• Focus on return on equity (ROE), not earnings per share (EPS).
• Calculate ‘owner earnings.’
• Look for companies with high profit margins.
• For every dollar retained, make sure the company has created at least one dollar of market value.

Buffett does not take yearly results too seriously. He focuses on five-year averages. There is too much randomness in periods shorter than five years.

ROE (or ROIC) is more important than EPS. As noted earlier, a company only creates value over time to the extent that its ROIC exceeds its cost of capital. Often the cost of capital can be understood as the opportunity cost of capital, or the next best investment opportunity with a similar level of risk.

In calculating ROE–or ROIC–Buffett excludes extraordinary items. He seeks to isolate the underlying performance of the business.

The intrinsic value of any business is all future free cash flow (FCF) discounted back to the present. Buffett uses the term owner earnings in place of FCF. It equals net income plus depreciation, depletion, and amortization, and minus capital expenditures. (There may also be adjustments for changes in working capital.)

Buffett’s favorite managers minimize costs just like they breathe. They do it automatically at all times.

 

Market Tenets

• What is the value of the business?
• Can the business be purchased at a significant discount to its value?

The value of any business is all future FCF discounted back to the present. This definition was first explained by John Burr Williams in The Theory of Investment Value.

Buffett compares valuing a business to valuing a bond. You know the coupon and maturity date for the bond, so you know the future cash flows. Then you discount those future cash flows back to the present using an appropriate discount rate.

Buffett nearly always insists on a ‘coupon-like’ certainty for the future cash flows of a business in which he invests. Therefore, Buffett uses the rate of the long-term U.S. government bond as his discount rate. (If rates are very low, as today, Buffett often uses 6% as the discount rate.)

Hagstrom quotes Buffett:

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

Buffett wrote in the 1981 Berkshire Hathaway Letter to Shareholders:

[We have made mistakes as to:] (1) the management we have elected to join; (2) the future economics of the business; or (3) the price we have paid.We have made plenty of such mistakes–both in the purchase of non-controlling and controlling interests in businesses. Category (2) miscalculations are the most common.

Ben Graham taught that you only buy when there is a margin of safety between the price you pay and the intrinsic value of the business. A margin of safety simultaneously lowers the risk of the investment AND increases the potential return. The notion that lowering your risk can increase your return is directly contrary to what is taught in modern finance, where higher returns always require higher risks.

Buffett has adopted Graham’s view that investing means becoming a part owner of a business. Investing is not trading pieces of paper. Graham:

Investing is most intelligent when it is most businesslike.

Buffett says these are “the nine most important words ever written about investing.” For Buffett, becoming a part owner of a public business by buying stock is no different than becoming a part owner–or full owner–of a private business. Buffett notes:

I am a better investor because I am a businessman, and a better businessman because I am an investor.

COMMON STOCK PURCHASES: NINE CASE STUDIES

The Washington Post Company

Millionaire financier Eugene Meyer bought the Washington Post for $825,000 at an auction held to pay off creditors. Much later, Philip Graham, a brilliant Harvard-educated lawyer, took over management of the paper. Graham had married Meyer’s daughter Katharine. Graham transformed the Washington Post from a single newspaper into a media and communications company.

(Photo by Michael Fleischhacker, via Wikimedia Commons)

After Graham’s tragic suicide, control of the paper passed to Katharine Graham. She learned quickly that she had to make decisions. She made two great decisions: hiring Ben Bradlee as managing editor and then inviting Warren Buffett to become a director. Bradlee persuaded Katharine Graham to publish the Pentagon Papers and to pursue the Watergate investigation. This earned the paper a reputation for award-winning journalism. Meanwhile, Buffett taught Katharine Graham how to run a successful business. (Buffett later tutored Katharine’s son, Don Graham.)

Simple and Understandable

For Buffett, the newspaper business was simple and understandable. Buffett has said that if he were not an investor, he probably would be a journalist.

Consistent Operating History; Favorable Long-Term Prospects

The Washington Post had a consistent operating history and favorable long-term prospects. Newspapers had outstanding economics at the time. (This was in the early 1970s, well before the advent of the internet.) Even mediocre newspapers were generally quite profitable. People and businesses wanting to get a message out to the community would typically use the newspaper to do so. Moreover, newspapers had low capital needs, which meant a high ROIC and high profit margins.

Buy at Attractive Prices

In 1973, the total market value of the Washington Post Company was $80 million. Buffett held that most security analysts, media brokers, and media executives at the time would have estimated WPC’s value at $400 or $500 million. Assuming a $400 million intrinsic value, Buffett was buying at 20 percent of intrinsic value.

Return on Equity and Profit Margins

When Buffett purchased a stake in the WPC, its return on equity (ROE) was 15.7 percent. Within five years, ROE had doubled. WPC maintained a high ROE over the next ten years. At the same time, WPC had paid down most of its debt.

By 1988, pretax margin reached a high of 31.8 percent, compared to 16.9 percent for its newspaper peer group and 8.6% for S&P Industrials.

Management Rationality

Using the gobs of excess cash, between 1975 and 1991, the Washington Post Company repurchased an incredible 43 percent of its shares at relatively low prices.

GEICO Corporation

Leo Goodwin, an insurance accountant, founded the Government Employees Insurance Company (GEICO) in 1936. His idea was to insure only preferred-risk drivers and to sell this insurance directly by mail, bypassing the need for agents or branch offices. Direct selling eliminated overhead expenses equal to 10 to 25 percent of every premium dollar. Goodwin also realized that government employees had fewer accidents than the general public.

(GEICO logo by Dream out loud, via Wikimedia Commons)

Goodwin partnered with a Fort Worth, Texas, banker Cleaves Rhea. Goodwin invested $25,000 for a 25% stake in the business, while Rhea invested $75,000 for a 75% stake in the business. In 1948, the Rhea family decided to sell its interest. Ben Graham decided to buy half Rhea’s stock for $720,000. David Kreeger, a Washington, D.C., lawyer and Lorimer Davidson, a Baltimore bond salesperson, bought the other half.

Lorimer Davidson joined GEICO’s management team and became chairman in 1958. By 1970, GEICO not only had written policies that would lead to underwriting losses; but it also had inadequate reserves. Norman Gidden was tapped to run the company when Davidson retired.

GEICO attempted to grow out of its problems. By 1974, GEICO was facing a potential underwriting loss of $140 million (it turned out to be $126 million). The stock fell from $61 to $5, and was heading lower. GEICO had lost underwriting and cost control discipline.

In 1976, John J. Byrne, a 43-year-old marketing executive from Travelers Corporation, took over as president of GEICO. Meanwhile, the stock drifted down to $2.

Warren Buffett invested $4.1 million at an average price of $3.18.

Simple and Understandable

Back in 1950, Ben Graham–Buffett’s teacher at Columbia University–was a director of GEICO. One Saturday, Buffett went to visit the company in Washington, D.C., to try to learn. A janitor let him in the building, and Buffett ended up getting a 5-hour tutorial from Lorimer Davidson, who was the only executive in the office that day.

Later, when Buffett returned to Omaha and his father’s brokerage firm, he recommended GEICO to the firm’s clients. Buffett himself invested $10,000, two-thirds of his net worth. He sold a year later at a 50 percent profit. Buffett would not invest again in GEICO until 1976.

Buffett owned Kansas City Life and Massachusetts Indemnity & Life Insurance. In 1967, Buffett purchased a controlling interest in National Indemnity. Over the next decade, Buffett learned the insurance business from Jack Ringwalt, the CEO of National Indemnity.

Buffett’s expertise in insurance is what gave him the confidence to invest heavily in GEICO. Between 1976 and 1980, Berkshire invested $47 million in GEICO, 7.2 million shares at an average price of $6.67. The stake was worth $105 million by 1980, representing Buffett’s largest holding.

Consistent Operating History; Favorable Long-Term Prospects

Buffett’s large investment in GEICO seemed to violate the consistent operating history tenet, since GEICO was a turnaround. But Buffett had determined that the essential competitive advantage of the business–providing low-cost agentless insurance–was still intact. Thus, Buffett judged that the problems in 1976, though huge, would ultimately be temporary.

Management Candor and Rationality

Byrne drastically reduced costs. The number of policyholders went from 2.7 million to 1.5 million. GEICO went from being the 18^th largest insurer to 31^st a year later. But GEICO went from losing $126 million in 1976 to earning an impressive $58.6 million (on $463 million in revenues) in 1977.

Byrne continued to reduce costs. The company stumbled in 1985. But Byrne was very candid about it, and the company quickly recovered. By this point, Byrne had developed a reputation not only for great leadership, but also for candor with shareholders.

From 1983 to 1992, GEICO used excess cash to repurchase 30 million shares, reducing total shares outstanding by 30 percent. GEICO also increased the dividend.

Return on Equity and Profit Margins

In 1980, the ROE at GEICO was 30.8 percent, almost twice as high as the peer group average. Buying back stock and paying dividends helped maintain a high ROE by reducing capital.

GEICO’s combined ratio of corporate expenses and underwriting losses was significantly better than the industry average.

Capital Cities/ABC

(Wikimedia Commons)

In 1954, Lowell Thomas, the famous journalist; his business manager, Frank Smith; and a group of associates bought Hudson Valley Broadcasting Company, which included an Albany television and AM radio station. At the time, Tom Murphy was a product manager at Lever Brothers.

Frank Smith was a golfing partner of Murphy’s father. Smith hired Murphy to manage the company’s television station. In 1957, the company purchased a Raleigh-Durham television station. The company was renamed Capital Cities Broadcasting, since Albany and Raleigh were capital cities.

In 1960, Murphy hired Dan Burke to manage the Albany station. During the next several decades, Murphy and Burke ran Capital Cities. They made more than 30 acquisitions in broadcasting and publishing.

In the late 1960s, Murphy met Buffett. Murphy invited Buffett to join the board of Cap Cities. Buffett declined, but he and Murphy became good friends.

In early 1985, Murphy obtained an initial agreement for a merger between Cap Cities and ABC. Although Murphy had always done his own deals up until then, this time he brought his friend Warren Buffett. They worked out the largest media merger in history (up to that point). Berkshire Hathaway agreed to purchase three million newly issued shares of Cap Cities at $172.50 per share. Murphy asked Buffett again to join the board, and this time Buffett agreed.

Simple and Understandable

Having served on the Washington Post Company board for more than a decade, Buffett had a very good understanding of television broadcasting, and newspaper and magazine publishing.

Consistent Operating History; Favorable Long-Term Prospects

Both Cap Cities and ABC had more than 30 years of profitable histories. ABC averaged 17 percent ROE from 1975 through 1984. Cap Cities, in the decade before its purchase of ABC, averaged 19 percent ROE. (Both companies also had low debt.)

Hagstrom explains the economics:

Once a broadcasting tower is built, capital reinvestment and working capital needs are minor and inventory investment is nonexistent. Movies and programs can be bought on credit and settled later when advertising dollars roll in. Thus, as a general rule, broadcasting companies produce above-average returns on capital and generate substantial cash in excess of their operating needs.

In 1985, the basic economics were above average.

Determine the Value

Berkshire’s $517 million investment in Cap Cities was the single largest investment Buffett ever made up until then. This was not a cheap price. Buffett joked, ‘I doubt if Ben’s up there applauding me on this one.’

Much of Buffett’s investment depended on Murphy. Operating margins at Cap Cities were 28 percent, but were only 11 percent at ABC. Murphy could improve the margins at ABC.

In essence, Murphy was Buffett’s margin of safety. Murphy and Burke used a decentralized management style, hiring the best people and then leaving them alone to do their job. Managers were expected to operate their businesses as if they owned them. Moreover, Murphy excelled at minimizing costs, while Burke excelled at ongoing operations.

The Institutional Imperative and Rationality

Despite enormous free cash flow, Murphy remained very disciplined about not overpaying for acquisitions. He would sometimes wait for years until the right property at the right price became available.

Because the stock of Cap Cities/ABC was cheap for several years, Murphy repurchased a large number of shares. Murphy also reduced the company’s debt that had resulted from the ABC acquisition.

Buffett viewed Cap Cities/ABC as the best-managed public company in the United States. He assigned all voting rights for the ensuing 11 years to Murphy and Burke as long as at least one of them managed the company.

The Coca-Cola Company

(Wikimedia Commons)

Hagstrom writes:

By the spring of 1989, Berkshire Hathaway shareholders learned that Buffett had spent $1.02 billion buying Coca-Cola shares. He had bet a third of the Berkshire portfolio, and now owned 7 percent of the company. It was the single-largest Berkshire investment to date, and already Wall Street was scratching its head. Buffett had paid five times book value and over 15 times earnings, then a premium to the stock market, for a hundred-year-old company that sold soda pop. What did the Wizard of Omaha see that everyone else missed?

As a kid, Buffett would buy six Cokes for 25 cents, then resell them at 5 cents each. And in 1986, Buffett announced that Cherry Coke would be the official soft drink at Berkshire Hathaway’s annual meetings. But it wasn’t until 1988 that Buffett began buying shares.

Simple and Understandable

The company sells a concentrate to bottlers, who combine it with other ingredients and then sell the finished product to retail outlets. The company also sells soft drink syrups to restaurants and fast-food retailers.

Consistent Operating History; Favorable Long-Term Prospects

Buffett explained in an interview with Melissa Turner of the Atlanta Constitution his reasoning: If he could make one investment and then go away for ten years without access to any information about the investment, what would he buy? As far as remaining a worldwide leader and experiencing big ongoing unit growth, there was nothing (in 1989) like Coke.

Furthermore, the chairman and CEO of Coke, Roberto Goizueta, and the president Donald Keough, were doing an outstanding job erasing mistakes that had been made in the 1970s. Robert Woodruff, the company’s 91-year-old patriarch, hired Roberto Goizueta in 1980. Goizueta cut costs and demanded that any business owned by Coca-Cola maximize return on assets.

High Profit Margins and ROE

Under Goizueta and Keough, pretax margins rose from 12.9 percent to a record 19 percent by 1988. Goizueta sold any business that did not generate good ROE. By 1988, the company’s ROE reached 31 percent, up from 20 percent during the 1970s.

Management Candor and Rationality

Under Goizueta’s leadership, Coke’s mission became crystal clear: maximize shareholder value over time. This would be achieved by optimizing profit margins and ROE.

Meanwhile, Goizueta announced that the company would repurchase shares, which were trading at a discount to the company’s now-higher intrinsic value.

The Institutional Imperative

Hagstrom describes Goizueta’s leadership:

When Goizueta took over Coca-Cola, one of his first moves was to jettison the unrelated businesses that Paul Austin had developed, and return the company to its core business: selling syrup. It was a clear demonstration of Coca-Cola’s ability to resist the institutional imperative.

Reducing the company to a single-product business was undeniably a bold move…

… Because the economic returns of selling syrup far outweighed the economic returns of the other businesses, the company was now reinvesting its profits in its highest-return business.

Determine the Value

Buffett paid 5 times book value, 15 times earnings, and 12 times cash flow. This was at a time when long-term bonds were yielding 9 percent. Hagstrom:

…The company was earning 31 percent on equity while employing relatively little in capital investment. Buffett has explained that price tells you nothing about value. The value of Coca-Cola, he said, like that of any other company, is determined by the total owner earnings expected to occur over the life of the business, discounted by the appropriate interest rate.

Owner earnings is the term Buffett uses for free cash flow (FCF). We can use a two-stage discount model to calculate the present value in 1988. Assuming 15 percent growth in owner earnings for the next 10 years, and then 5 percent growth thereafter, and assuming a 9 percent discount rate, intrinsic value for Coca-Cola would be $48.377 billion. That’s compared to the 1988 market value of $14.8 billion.

At year-end 1999, the market value of Coke was $143 billion, and Berkshire’s original $1.02 billion investment was worth $11.6 billion.

General Dynamics

In 1990, General Dynamics was the country’s second-largest defense contractor behind McDonnell Douglas Corporation. General Dynamics produced missile systems in addition to air defense systems, space-launched vehicles, and fighter planes for the U.S. armed forces.

(Wikimedia Commons)

In January 1991, General Dynamics appointed William Anders as CEO. Within six months, the company had raised $1.25 billion by selling noncore businesses. With the cash, the company first paid down its debt. Then as excess cash flow continued, General Dynamics purchased 13.2 million shares at prices between $65.37 and $72.25, reducing its shares outstanding by 30 percent.

Although Buffett initially had purchased General Dynamics as an arbitrage–in anticipation of stocks buybacks–Buffett later noticed that Anders was very focused on maximizing shareholder value. So Buffett held the stake:

From July 1992 through the end of 1993, for its investment of $72 per share, Berkshire received $2.60 in common dividends, $50 in special dividends, and a share price that rose to $103. It amounted to a 116 percent return over 18 months.

Wells Fargo & Company

In October 1990, Buffett announced that Berkshire had purchased five million shares in Wells Fargo, investing $289 million at an average price of $57.88 per share. This turned into a battle between bulls like Buffett and bears like the Feshbach brothers.

(Wikimedia Commons)

Buffett knew a lot about the business of banking. In 1969, Berkshire Hathaway purchased 98 percent of the holdings of Illinois National Bank and Trust Company. Gene Abegg, the chairman of Illinois National Bank, taught Buffett about the banking business. Buffett learned that banks were profitable if they issued loans intelligently and curtailed costs.

Favorable Long-Term Prospects

When assets are 20 times equity, which is normal in banking, even a small mistake can cause the bank to go bankrupt. But if management does a good job, a bank can earn 20 percent on equity, which is above the average of most businesses. Also, Buffett believed he had the best management team in Carl Reichardt and Paul Hazen. Buffett: “In many ways, the combination of Carl and Paul reminds me of another–Tom Murphy and Dan Burke at Capital Cities/ABC.”

Munger explained: ‘It’s all a bet on management. We think they will fix the problems faster and better than other people.”

Rationality

Reichardt was legendary for relentlessly lowering costs. He never let up, always searching for ways to improve profitability.

American Express Company

(Wikimedia Commons)

Buffett: “I find that a long-term familiarity with a company and its products is often helpful in evaluating it.” Hagstrom explains:

With the exception of selling bottles of Coca-Cola for a nickel, delivering copies of the Washington Post, and recommending that his father’s clients buy shares of GEICO, Buffett has had a longer history with American Express than any other company Berkshire owns. You may recall that in the mid-1960s, the Buffett Limited Partnership invested 40 percent of its assets in American Express shortly after the company’s losses in the salad oil scandal. Thirty years later, Berkshire accumulated 10 percent of American Express shares for $1.4 billion.

Consistent Operating History

American Express was essentially the same business when Berkshire invested as it had been when the Buffett partnership invested. Travel Related Services (TRS) made up 72 percent of American Express’s sales. American Express Financial Advisors represented 22 percent of sales. American Express Bank was about 5%.

Under James Robinson, the company used excess cash to acquire related business. Although IDS (renamed American Express Financial Advisors) had proved to be a profitable purchase, Robinson’s $4 billion investment in Shearson-Lehman was a financial drain and prompted Robinson to contact Buffett. Buffett was willing to buy $300 million in preferred shares. But Buffett was not ready to invest in the common shares until he saw more management rationality.

Rationality

In 1992, Harvey Golub took over as CEO. Golub clearly recognized the brand value of the American Express Card. Over the next two years, Golub sold off American Express’s underperforming assets, and restored profitability and high ROE. By 1994, American Express management was focused on making the American Express Card the “world’s most respected service brand.”

Golub also set financial targets: to increase EPS by 12 to 15 percent annually and to achieve an 18 to 20 percent ROE. Management was also planning to repurchase 20 million shares of its common stock.

In the summer of 1994, Buffett converted Berkshire’s preferred issue into American Express common stock. And he began to acquire even more shares of common stock. Berkshire owned 27 million shares at an average price of $25 by the end of the year. When American Express finished repurchasing 20 million shares, it announced that it would repurchase an additional 40 million shares, or 8 percent of the stock outstanding. By March 1995, Buffett had added another 20 million shares, which increased Berkshire’s ownership to a bit less than 10 percent of American Express.

Determine the Value

Assuming 12 percent growth in owner earnings for 10 years, then 5 percent growth thereafter, and assuming a discount rate of 10 percent–which is conservative–the intrinsic value of American Express at the end of 1994 was about $50 billion, or $100 per share. Thus Buffett’s purchase of 27 million shares at $25 had a significant margin of safety, and therefore significant potential upside.

International Business Machines

Buffett had always avoided investing in technology companies because constant disruption and innovation make for very short company life spans. But by the end of 2011, Berkshire Hathaway had purchased 63.9 million shares of IBM, or 5.4 percent of the company. At $10.8 billion, it was the largest purchase of individual stock Buffett has ever made.

(Photo by Paul Rand, via Wikimedia Commons)

Favorable Long-Term Prospects

After 50 years of reading the financial statements of IBM, Buffett suddenly realized the competitive advantages IBM has in finding and keeping clients. IBM dominates information technology (IT) services, which includes consulting, systems integration, IT outsourcing, and business process outsourcing. IBM is number-one globally in the consulting and systems integration space, and number-one globally in IT outsourcing.

Revenues from IT services are relatively stable. Consulting, systems integration, and IT outsourcing are even thought to possess ‘moat-like’ qualities, writes Hagstrom. In consulting and systems integration, intangible assets like reputation, track record, and client relationships are sources of a moat. In IT outsourcing, switching costs and scale advantages create a moat.

J. Heinz Company

On February 14, 2013, Berkshire Hathaway and 3G Capital purchased H. J. Heinz Company for $23 billion. The purchase price was $72.50 a share, a 20 percent premium to the stock price the day before.

(Wikimedia Commons)

Favorable Long-Term Prospects; Rationality

Heinz is number one in ketchup globally and second in sauces. The company is poised to do well in rapidly growing emerging markets.

Buffett has partnered with 3G Capital in the purchase of Heinz. 3G has a track record of relentlessly lowering costs.

Holding Period: Forever

Buffett is “quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.”

PORTFOLIO MANAGEMENT: THE MATHEMATICS OF INVESTING

If you do not have the time or inclination to study companies in depth, then a low-cost index fund is best. But if you can understand some businesses, then a concentrated portfolio makes sense.

There is a mathematical formula, the Kelly criterion, that you can use to get an idea of how large a position to take on your best ideas. The formula was invented by the physicist John L. Kelly.

(John L. Kelly, Wikimedia Commons)

Buffett talked about index funds vs. focused portfolios in the 1993 Berkshire Hathaway Letter to Shareholders:

By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices–the businesses he understands best and that present the least risk, along with the greatest profit potential.

Here is Buffett in a 1998 lecture at the University of Florida:

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

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

Even in a highly focused portfolio of 5 to 10 stocks, often your best idea should be by far the largest position in your portfolio.

Recall that Buffett invested two-thirds of his net worth in GEICO before he launched the Buffett partnership. He had over a 50 percent profit after a year. Later, Buffett invested 40 percent of the Buffett partnership in American Express. The shares nearly tripled over the next two years. A couple of decades later, Buffett invested $1.02 billion–about a third of Berkshire Hathaway’s portfolio–in Coca-Cola. This turned out to be a 10-bagger for Berkshire, netting $10 billion in profit over the ensuing decade.

It can be tempting for an investor to listen to forecasters predict the stock market, the economy, or elections. But owning a few good businesses over time is a far more reliable and safer way to compound your capital–at higher rates–than speculating on the stock market or the economy.

Here are a few good quotes from Buffett on forecasting:

• I don’t invest a dime based on macro forecasts.
• Market forecasters will fill your ear but never fill your wallet.
• We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
• Charlie and I never have an opinion on the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.

Hagstrom puts it as follows:

In shorter periods, we realize that changes in interest rates, inflation, or near-term expectations for a company’s earnings can affect share prices. But as the time horizon lengthens, the trendline economics of the underlying business will increasingly dominate its share price.

… Focus investors tolerate the [short-term] bumpiness because they know that, in the long run, the underlying economics of the companies will more than compensate for any short-term price fluctuations.

Investing is Probabilistic

(Photo by Michele Lombardo)

Nearly all investments are probabilistic decisions, or decisions under uncertainty. Hagstrom quotes Buffett:

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

Hagstrom also quotes Charlie Munger:

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

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

When you find a high-probability bet with substantial upside–which will only happen rarely–then you should take a big position. How big? You have to know yourself in terms of how much portfolio volatility you can tolerate. As long as you can hold for the longer term–for at least 5 or 10 years–without reacting to shorter term volatility, then it makes sense to take large positions on the best ideas you find.

If you apply the Kelly criterion to a focused portfolio of value stocks, then you typically need to normalize positions sizes. Mohnish Pabrai has explained this: https://boolefund.com/the-dhandho-investor/

John Maynard Keynes was very successful as a focused value investor: https://boolefund.com/greatest-economist-defied-convention-got-rich/

Hagstrom has a quote from Keynes:

It is a mistake to think one limits one’s risk by spreading too much between enterprises which one knows little and has no reason for special confidence… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.

Keynes was against market timing, and in favor of a very concentrated portfolio.

Hagstrom also mentions Ruane, Cuniff & Company, started by Bill Ruane and Rick Cuniff. They would have 90 percent of the fund in 6 to 10 positions.

Lou Simpson used a very concentrated approach when he managed GEICO’s equity portfolio. Between 1980 and 2004, GEICO’s portfolio returned 20.3 percent per year compared to 13.5 percent for the market.

Active share is the percentage of a portfolio that differs from the benchmark index holdings. The only way to do better than the index is to invest differently. Yet most professional investors have portfolios not much different than the index. They are more worried about not underperforming the index than they are focused on doing better than the index. Hagstrom reports that just 25 percent of mutual funds today are considered truly active.

Moreover, many professional investors are focused on short-term results. The problem is that the performance of a portfolio of stocks is largely random for time horizons less than 5 years. That is why Buffett focuses on 5-year periods to measure Berkshire Hathaway’s performance. After 5 years–and even more after 10 years–a stock will track the performance of the underlying business.

Many professional investors fixate on quarterly or annual results because many of their clients (or potential clients) decide to invest in the fund based on these short-term results.

Many of the best long-term investors have had periods of significant underperformance over shorter periods of time. When Keynes managed the Chest Fund, it underperformed the market one-third of the time. This includes underperforming the market by 18 percentage points in the first three years Keynes managed the fund. But Keynes’ record over a couple of decades was outstanding.

The Sequoia Fund, managed by Bill Ruane, underperformed the market 37 percent of the time. In fact, Sequoia underperformed for the first 4 years of its existence. By the end of 1974, the fund was 36 percentage points behind the market. Yet three years later–seven years since inception–Sequoia was up 220 percent, versus 60 percent for the S&P 500 Index.

Over 14 years, Charlie Munger underperformed 36 percent of the time. But Munger’s overall record was far better than the market. (Lou Simpson underperformed the market 24 percent of the time, but also had a remarkable long-term record of beating the market.)

If you’re a long-term investor in businesses–whether public or private–what matters over time is the economic performance of those businesses, not the prices at which the businesses can be bought or sold. Hagstrom:

If you owned a business and there were no daily quotes to measure its performance, how would you determine your progress? Likely you would measure the growth in earnings, the increase in return on capital, or the improvement in operating margins. You simply would let the economics of the business dictate whether you were increasing or decreasing the value of your investment.

Hagstrom quotes Buffett:

While market values track business values quite well over long periods, in any given year the relationship can gyrate capriciously.

Buffett again:

The speed at which a business’s success is recognized… is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give you a chance to buy more of a good thing at a bargain price.

When you consider a new investment idea, you should always compare it to the best ideas already in your portfolio. Since good ideas are rare, this should set a high threshold and screen out 99 percent of what you consider. Hagstrom observes:

You already have at your disposal, with what you now own, an economic benchmark–a measuring stick. You can define your own personal benchmark in several different ways: look-through earnings, return on equity, or margin of safety, for example. When you buy or sell stock of a company in your portfolio, you have either raised or lowered your economic benchmark. The job of a portfolio manager who is a long-term owner of securities, and who believes future stock prices eventually will match with underlying economics, is to find ways to raise your benchmark.

If you step back and think for a moment, the Standard & Poor’s 500 index is a measuring stick. It is made up of 500 companies and each has its own economic return. To outperform the S&P 500 index over time–to raise that benchmark–we have to assemble and manage a portfolio of companies with economics that are superior to the average weighted economics of the index.

Buffett:

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

Buffett again:

Inactivity strikes us as an intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit has reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?

Buying and holding wonderful businesses has two important benefits in addition to growing capital at an above-average rate. Transaction costs are kept to an absolute minimum, and after-tax returns are maximized.

Buffett gives an example of $1 doubling every year for 20 years. First assume that you sell and pay tax at the end of each year. So after the first year, you would have a total of $1.66. By the end of 20 years, you would have a net gain of $25,200, after paying taxes of $13,000. By contrast, if you held the $1 dollar as it repeatedly doubled, and didn’t sell until the end of the 20-year period, you would have $692,000 after paying taxes of about $356,000.

To achieve high after-tax returns, turnover should be between 0 and 20 percent. 20 percent turnover implies a 5-year holding period. As long as you are very patient and can stay focused on the long term without reacting emotionally to shorter term volatility, you should be able to construct and stick with a focused portfolio of businesses that you understand. Always being rational and not reacting out of emotion is more important than IQ. Buffett:

You don’t need to be a rocket scientist. Investing is not a game where the 160 IQ guy beats the guy with the 130 IQ. The size of an investor’s brain is less important than his ability to detach the brain from the emotions.

THE PSYCHOLOGY OF INVESTING

Although it’s not widely recognized, Ben Graham was keenly aware of the importance of psychology for investors. Graham held that your worst enemy as an investor is usually yourself.

Warren Buffett, Graham’s most famous student, says there are three important principles in Graham’s approach to investing:

• Stock is a fractional ownership in a business. What matters for the investor is how the business performs over time.
• Margin of safety: Given a reasonable estimate of intrinsic value–based on net asset value or earnings power–you should only buy when the price is well below that estimate. The lower the price is compared to intrinsic value, the safer the investment and simultaneously the higher the potential reward.
• Short-term price fluctuations have no meaning for the true investor because on the whole they do not reflect changes in business value. Fluctuations do occasionally create opportunities, however, for the investor to buy if the price becomes cheap enough.

When the stock price drops, a rational investor’s reaction should be the same as a businessperson who gets a lowball offer on his or her privately owned business: Ignore it. Graham:

The true investor scarcely ever is forced to sell his shares and at all other times is free to disregard the current price quotation.

Behavioral Finance

(Daniel Kahneman, via Wikimedia Commons)

Behavioral finance is based on discoveries (in the past few decades) in psychology by Daniel Kahneman, Amos Tversky, and many others. Kahneman was awarded the Nobel Prize in economics in 2002 for discoveries that he and Tversky made from decades of experiments of people making decisions under uncertainty.

Before Kahneman and Tversky, economists always assumed–based on utility theory as described by John von Neumann and Oskar Morgenstern–that people make rational decisions under uncertainty. (Investment decisions are decisions under uncertainty.)

We now know that nearly all investors make systematic errors. Behavioral finance allows us to understand these errors.

Overconfidence, Confirmation Bias, Availability Bias

People by nature are overconfident. Typically if you ask people in a random group how good a driver they are, at least 80-90 percent will say ‘above average.’ But of course no more than 50% can be above average.

In many areas of life, overconfidence is not bad and often even is helpful. When we were hunter-gatherers, it was a net benefit for the tribe if hunters were individually overconfident. Similarly today, although many entrepreneurs fail, it is a net benefit for the economy that nearly all entrepreneurs believe they will succeed.

When you are investing, however, overconfidence will penalize your results over time. Hagstrom points out:

Investors, as a rule, are highly confident they are smarter than everyone else. They have a tendency to overestimate their skills and their knowledge. They typically rely on information that confirms what they believe, and disregard contrary information. In addition, the mind works to assess whatever information is readily available rather than to seek out information that is little known….

Overconfidence explains why so many money managers make wrong calls. They take too much confidence from the information they gather, and think they are more right than they actually are.

Confirmation bias means only seeing information that confirms what you already believe, rather than seeking and being aware of potentially disconfirming information. Availability bias means only noticing information that is readily available.

Overreaction Bias

Overreaction Bias means investors overreact to bad news and react slowly to good news. If there is bad news and the stock price drops, an investor is likely to overreact and to sell, even though the long-term, underlying economics of the business are often unchanged.

Richard Thaler researched overreaction. He constructed a portfolio of ‘Loser’ stocks–stocks that had been the worst performers over the preceding 5 years. He compared the ‘Loser’ portfolio to a portfolio of ‘Winner’ stocks–stocks that had performed best over the preceding 5 years. Thaler found that over the subsequent 5 years, the ‘Loser’ portfolio far outperformed both the market and the ‘Winner’ portfolio.

Loss Aversion

People are risk averse when considering potential gains, but risk seeking when facing the possibility of a certain loss. This is the essence ofprospect theory–invented by Kahneman and Tversky–which is captured in the following graph:

(Value function in Prospect Theory, drawing by Marc Rieger, via Wikimedia Commons)

Loss aversion means that, in general, people feel a loss 2 to 2.5 times more than an equivalent gain. (That’s why the value function in the graph is steeper for losses.) Therefore, when people are presented with a 50/50 bet, on average they will only bet if the potential gain is at least twice as large as the potential loss.

Loss aversion causes people to hold on to their losing investments for too long. By not selling an investment that hasn’t worked, the investor can postpone the feeling of a loss. Yet the sooner the investor can recognize a mistake and close the position, the sooner the investor can reinvest that capital in a potentially more profitable way.

Mistakes in investing are inevitable. Even for the best value investors, on average they tend to be right about two-thirds of the time and wrong one-third of the time. The best investors can recognize quickly when either they have made a mistake or when unforeseeable events have invalidated the investment thesis.

Long-Term Investment Time Horizon

Warren Buffett focuses on the performance of the business over a 5-year or 10-year period. He invests in a stock when it is a bargain relative to the probable long-term earnings power of the business.

Many investors are way too focused on the short term. The problem is that if you check a stock price each day, there is 50 percent chance it will be lower. And due to loss aversion, you will feel the pain of a lower price at least twice as much as the pleasure of an equivalent gain. Therefore, after carefully constructing your portfolio, it’s essential to stay focused on the performance of the businesses over rolling 5-year periods. It’s also essential to check stock prices as infrequently as you can.

Very often the individual investors who have gotten the best results over the course of 20-30 years are those investors who effectively forgot about their investments. These investors often didn’t check stock prices for years at a time. As Ben Graham said, for many investors it would be better if they couldn’t get any stock quote at all.

Warren Buffett has often said you should only invest in a business where you wouldn’t worry at all if the stock market closed for 5 or 10 years. All that matters for the long-term value investor is how the underlying business performs over time. If it’s a good business that increases earnings and maintains a high return on capital over time, then your fractional ownership of the business will track the increase in intrinsic value.

THE VALUE OF PATIENCE

Too many investors have the mistaken belief that the stock market can be predicted. But it can’t. Ben Graham:

[If] I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.

Hagstrom did some research about long-term investing, and here is what he found:

We calculated the one-year return, trailing three-year return, and trailing five-year return (price only) between 1970 and 2012. During this 43-year period, the average number of stocks in the S&P 500 index that doubled in any one year averaged 1.8 percent, or about nine stocks out of 500. Over three-year rolling periods, 15.3 percent of stocks doubled, about 77 stocks out of 500. In rolling five-year blocks, 29.9 percent doubled, about 150 out of 500.

So, back to the original question: Over the long term, do large returns from buying and holding stocks actually exist? The answer is indisputably yes. And unless you think a double over five years is trivial, this equates to a 14.9 percent average annual compounded return.

Then Hagstrom notes that the greatest number of opportunities to get high excess returns is after three years. So, as an investor, you should patiently find cheap and good stocks that you can hold for at least 3 to 5 years. There continue to be many opportunities over this time frame because many investors only look at the very short term. The average holding period is only a few months, which is hardly different from a coin flip.

Rationality

Keith Stanovich holds that rationality is not the same thing as intelligence. He says IQ tests or SAT/ACT exams do a poor job of measuring rational thought:

It is a mild predictor at best, and some rational thinking skills are totally dissociated from intelligence.

There appear to be two main reasons why even many high IQ people are not able to think rationally: a processing problem and a content problem.

To understand the processing problem, we must first note that we have essentially two different brains: System 1 and System 2.

System 1 operates automatically and quickly. It makes instinctual decisions based on heuristics.

System 2 allocates attention (which has a limited budget) to the effortful mental activities that demand it, including complex computations involving logic, math, or statistics.

Usually System 1 and System 2 work well together, but not always. Daniel Kahneman explains in his great book, Thinking, Fast and Slow:

The division of labor between System 1 and System 2 is highly efficient: it minimizes effort and optimizes performance. The arrangement works well most of the time because System 1 is generally very good at what it does: its models of familiar situations are accurate, its short-term predictions are usually accurate as well, and its initial reactions to challenges are swift and generally appropriate. System 1 has biases, however, systematic errors that it is prone to make in specified circumstances… it sometimes answers easier questions than the one it was asked, and it has little understanding of logic and statistics. One further limitation of System 1 is that it cannot be turned off.

If the situation requires a complex computation in order to arrive at a good decision, then System 1 makes predictable errors. In order to avoid these mistakes, a person must train his or her System 2 to activate and to think carefully.

So the processing problem requires training System 2. But there is a second problem the investor also must solve: the content problem. The ability to think rationally using System 2 can only lead to good decisions if System 2 has access to enough mindware. Mindware–as defined by Harvard cognitive scientist David Perkins–is all the rules, strategies, procedures, and knowledge people have at their disposal to help solve a problem.

In investing, the most important thing is reading a great deal, especially the financial statements of various companies. Over time, an investor can slowly develop useful mindware.

 

THE WORLD’S GREATEST INVESTOR

To determine how good Warren Buffett is, there are two basic variables: relative outperformance and duration. Hagstrom argues that both are needed. Over shorter periods of time, luck plays a large role. But as you extend out in time–several decades and then some–luck plays less and less of a role.

Buffett has crushed the market over a period of almost 60 years. Buffett is unmatched over this time frame.

Buffett also remains very bullish on the United States. He says the luckiest new babies in history are those being born today:

…Warren Buffett is unabashedly bullish on the United States of America. He has never been shy to express his belief that the United States offers tremendous opportunity to anyone who is willing to work hard. He is upbeat, cheerful, and optimistic about life in general. Conventional wisdom holds that it is the young who are the eternal optimists and as you get older pessimism begins to tilt the scale. But Buffett appears to be the exception. And I think part of the reason is that for almost six decades he has managed money through a long list of dramatic and traumatic events, only to see the market, the economy, and the country recover and thrive.

It is a worthwhile exercise to Google the noteworthy events of the 1950s, 1960s, 1970s, 1980s, 1990s, and the first decade of the twenty-first century. Although too numerous to list here, the front-page headlines would include nuclear war brinksmanship; presidential assassination and resignation; civil unrest and riots; regional wars; oil crisis, hyperinflation, and double-digit interest rates; and terrorist attacks–not to mention the occasional recession and periodic stock market crash.

Hagstrom proceeds to argue that Buffett has three advantages: behavioral, analytical, and organizational.

Behavioral Advantage

Those who know Buffett agree that it is rationality that sets him apart. Buffett is extremely rational. As Roger Lowenstein writes in Buffett: The Making of an American Capitalist, “Buffett’s genius [is] largely a genius of character–of patience, discipline, and rationality.” The maximization of shareholder value depends largely on the rational allocation of capital. This is a key trait Buffett looks for in good managers, and it’s a trait he himself has to a remarkable degree.

Analytical Advantage

For Buffett, both the investor and the businessperson should look at a company in terms of how much cash it can produce over time. By recognizing, furthermore, that short-term stock prices are largely random, you can learn to value a business–based on discounted FCF or net asset value–and wait patiently until its stock price is well below intrinsic value.

Don’t waste time trying to predict the stock market, the economy, or elections. No one has been able to predict these things. Instead, stay focused on understanding individual businesses. Over a long period of time–at least 5-10 years–what really matters, as long as you paid reasonable prices, is the performance of the businesses you own.

Organizational Advantage

Buffett has set up Berkshire Hathaway so that he can focus on long-term capital allocation, while the managers of the businesses Berkshire owns can focus on maximizing long-term business value.

If you’re an individual investor, you don’t have to worry about short-term performance or consensus opinions. You can find a simple business that you understand, and then wait patiently for it to go on sale. Find a few such businesses. Then buy and hold, paying attention only to how the businesses perform over the years.

I would add that, for the individual investor, most often you can find the best investment opportunities among microcap companies–companies with market caps up to $300 million. Because very few professional investors ever look at micro caps, the greatest pricing inefficiencies usually occur here.

 

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: https://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 approachesintrinsic 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: [email protected]

 

 

 

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.

https://www.gmo.com/docs/default-source/research-and-commentary/strategies/equities/global-equities/an-investment-only-a-mother-could-love-the-case-for-natural-resource-equities.pdf

June 5, 2022

Daniel Pecaut and Corey Wrenn recently published a wonderful book, University of Berkshire Hathaway.  The book is a summary of 30 years’ worth of teachings delivered by Warren Buffett and Charlie Munger at the annual meetings of Berkshire Hathaway (1986 through 2015).

Pecaut and Wrenn had the same idea that many value investors have had:  To figure out how to succeed as a value investor, it makes sense to study the best.  Warren Buffett and Charlie Munger are at the top of the list.

(Photo by USA International Trade Administration, via Wikimedia Commons)

Through 2017, after 52 years under Buffett and Munger’s management, the value of Berkshire Hathaway has grown 2,404,748% versus 15,508% for the S&P 500 Index.  Compounded annually, that’s 20.9% per year for Berkshire stock versus 9.9% per year for the S&P 500.

(Photo by Nick Webb)

Pecaut and Wrenn point out a key fact about how Buffett and Munger have achieved this stunning success:

More than two-thirds of Berkshire’s performance over the S&P was earned during down years.  This is the fruit of Buffett and Munger’s “Don’t lose” philosophy.  It’s the losing ideas avoided, as much as the money made in bull markets that has built Berkshire’s superior wealth over the long run.

Buffett himself has made the same point, including at the 2007 meeting.  His best ideas have not outperformed the best ideas of other great value investors.  However, his worst ideas have not been as bad, and have lost less over time, as compared with the worst ideas of other top value investors.

Pecaut then states:

Though Corey and I have been aware of the results for a number of years, we still marvel at Buffett and Munger’s marvelous achievement.  They have presided over one of the greatest records of wealth-building in history.  For five decades, money under Buffett’s control has grown at a phenomenal rate.

In the 1970s, the annual meeting of Berkshire Hathaway was attended by a half-dozen people or so.  In recent years, there have been roughly 40,000 attendees.  The event has been dubbed “Woodstock for Capitalists.”

(2011 Berkshire Hathaway Annual Meeting, Photo by timbu, licensed under CC BY 2.0)

Pecaut and Wrenn write that studying the teachings of Professors Buffett and Munger can be as good as an MBA if you’re a value investor.  They declare:

It is, without a shadow of a doubt, the best investment either of us has ever made.

That’s not to say there are any easy answers if you want to become a good value investor.  It takes many years to master the art.  And even after you’ve found an investment strategy that fits you personally, you must keep learning and improving forever.

There are two important points to make immediately.  First, it’s a statistical fact that most of us will do better over time by adopting a fully automated investment strategy “” whether indexed or quantitative.

Second, whether you use an automated strategy or not, if you’re investing relatively small sums, you are likely to do best by focusing on micro caps (companies with market caps under $300 million).  Most great value investors, including Buffett and Munger, started their careers investing in micro caps.  In general, you can get the best returns by investing in micro caps because they are largely neglected by investors.  Also, most microcap businesses are tiny and thus easier to understand.

Although Pecaut and Wrenn’s book is organized by year, I’ve re-arranged the teachings of Buffett and Munger based on topic.  Here’s the outline:

Value Investing

• Value Investing
• What vs. When
• Temperament and Discipline
• Modern Portfolio Theory
• Growth, Book Value
• Business Risk
• Good Managers
• Sustainable Competitive Advantage
• Know the Big Cost
• Basic “Macro Thesis”
• Macro Forecasting
• Capital-Intensive Businesses
• Cyclical Industries

Thinking for Yourself

• Logic, Not Emotion
• Intellectual Independence
• In/Out/Too Hard
• Information:  Good, Not Quick

Lifetime Learning

• Lifetime Learning and Constructive Criticism
• Invest in Yourself
• Making It In Business
• Multidisciplinary Models, Opportunity Cost
• Biographies:  Improve Your Friends

What is Berkshire Hathaway?

• Berkshire Hathaway
• Berkshire:  Good Home for Good Businesses
• No Master Plan
• Culture
• Munger’s Optimism
• Legacy

Insurance

• Buying National Indemnity
• Insurance and Hurricanes
• Building the Insurance Business
• The Unexpected

Comments on Specific Investments

• BYD
• GEICO
• 3G Capital Partners
• ISCAR

Other Topics

• The Game of Bridge
• The Ovarian Lottery
• Predicting Changes in Technology
• Inflation:  Gold vs. Wonderful Business
• Luck and an Open Mind
• The Luckiest Crop in History

 

Value Investing

VALUE INVESTING

Here’s a summary of the basic concepts of value investing.  The intrinsic value of any business is the total cash that will be generated by the business in the future, discounted back to the present.  Another way to think of intrinsic value is “what a company would bring if sold to a knowledgeable buyer.”

Typically, if a value investor thinks a business is worth X, they will try to buy it at 1/2 X.  This creates a margin of safety in case the investor has made a mistake or experiences bad luck.  If the investor is roughly correct, they can double their money or better.

(Ben Graham, the father of value investing and Warren Buffett’s teacher and mentor, Equim43 via Wikimedia Commons)

Many good value investors are right 60% of the time and wrong 40% of the time.  Mistakes and surprises (both good and bad) are inevitable for every investor.  That’s why a margin of safety is essential.

Another wrinkle is business quality.  When Buffett and Munger started their careers, they followed the teachings of Ben Graham.  In Graham’s approach, business quality doesn’t matter as long as you buy a basket of cheap stocks.  However, Buffett and Munger slowly learned from experience the following lesson:

It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

If you buy a mediocre or bad business at half price, the problem is that the intrinsic value of the business can decline.  On the other hand, if you buy a great business, it’s often hard to overpay because the value compounds over time.

A great business is one that has a high return on invested capital (ROIC) “” and high return on equity (ROE) “” that can be sustained, ideally for decades.  If you pay a fair or even high price, but hold the business for decades, then your annual return eventually will approximate the ROE of the business.

• Say a business has an ROE of 40% and can sustain it over time.  Then your annual return as investor, if you hold the stock over decades, eventually will approximate 40%.  That’s the power of investing in a high-quality business.
• But such a great business is exceedingly rare and hard to find.  Tread very carefully.  The vast majority of investors are unable to invest successfully using this method.

Also bear in mind that Buffett and Munger have never paid any attention to forecasts, whether of the economy, interest rates, the stock market, or elections.  When they’ve been able to find a good or great business at a reasonable price, they’ve always bought, regardless of forecasts and regardless of the current economic or political situation.

• Most investors who’ve paid attention to forecasts have done worse than they would have done had they simply ignored forecasts.
• Buffett and Munger focus exclusively on the future cash flow of the individual business as compared to its current price.  Typically they assume the future cash flow will occur over decades.  Thus, shorter term forecasts of the stock market or the economy are irrelevant, in addition to being fundamentally unreliable (see Macro Forecasting below).

Central to this approach is circle of competence, or a clear awareness of which businesses you can understand.  It doesn’t matter if most businesses are beyond your ability to analyze as long as you stick with those businesses than you can analyze.

• Even if you were only able to understand 100-200 simple businesses, eventually a few of them will become cheap for temporary reasons.  That’s all you need.  Getting to that point may take a few years, though, so it’s essential that you enjoy the process.  Otherwise, just stick with index funds or quantitative value funds.

For a value investor, there are no called strikes.  As Buffett has explained, you can stand at the plate all day and watch hundreds of “pitches” “” businesses at specific prices “” without taking a swing.  You wait for the “fat pitch” “” a business you can really understand that’s available at a good price.

What’s the ideal business?  One that has a high and sustainable ROIC (and ROE).  Or, as Buffett put it at the 1987 Berkshire meeting:

Something that costs a penny, sells for a dollar and is habit forming.

Moreover, a company with a sustainably high ROIC is the best hedge against inflation over time, according to Buffett and Munger.  But it’s very difficult to find businesses like this.  There just aren’t that many.  And since Buffett and Munger have to invest tens of billions of dollars a year “” unlike earlier in their careers “” they’re forced to focus mostly on larger businesses.

At the 1996 meeting, Buffett observed that they invested in high-quality businesses that were easy to understand and not likely to change much.  Specifically, they had investments in soft drinks, candy, shaving, and chewing gum.  Buffett:

There’s not a whole lot of technology going into the art of the chew.

 

TEMPERAMENT AND DISCIPLINE

Buffett and Munger have observed that having the right temperament and extraordinary discipline is far more important than IQ for long-term success in investing.  (Of course, if you’ve got the right temperament plus a great deal of discipline, high IQ certainly helps.)

High IQ alone won’t bring success in investing.  Buffett said at the 2004 meeting that Sir Isaac Newton, one of the smartest people in history, wasted much time trying to turn lead into gold and also lost a bundle in the South Sea Bubble.

 

MODERN PORTFOLIO THEORY

Buffett and Munger have been critical of modern portfolio theory for a long time.  Munger often notes that to a man with a hammer, every problem looks pretty much like a nail.  Buffett has observed that academics have been able to gather huge amounts of data on past stock prices.  When there’s so much data, it’s often easy to find patterns.  Also, those who have been trained in higher mathematics sometimes feel the need to apply that skill even to areas that are better understood in very simple terms.  Buffett:

The business schools reward difficult, complex behavior more than simple behavior, but simple behavior is more effective.

A key part of modern portfolio theory is EMH “” the Efficient Market Hypothesis.  EMH takes different forms.  But essentially it says that all available information is already reflected in stock prices.  Therefore, it’s not possible for any investor to beat the market except by luck.

Buffett and Munger have maintained that markets are usually efficient, but not always.  If an investor has enough patience and diligence, occasionally she will discover certain stock prices that are far away from intrinsic value.

Moreover, a stock is not just a price that wiggles around.  A stock represents fractional ownership in the underlying business.  Some businesses are simple enough to be understandable.  The dedicated investor can gain enough understanding of certain businesses so that she can know if the stock price is obviously too high or too low.  Modern portfolio theorists have overlooked the fact that a stock represents fractional ownership of a business.

Buffett advises thinking about buying part ownership of a business like you would think about buying a farm.  You’d want to look at how much it produces on average and how much you’d be willing to pay for that.  Only then would you look at the current price.

(Farmland at Moss Landing, California, Photo by Fastily via Wikimedia Commons)

Furthermore, if you owned a farm, you wouldn’t consider selling just because a farm nearby was sold for a lower-than-expected price.  In Chapter 12 of The General Theory of Employment, Interest, and Money, John Maynard Keynes uses a similar example:

But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments.  It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week.

 

GROWTH, BOOK VALUE

Growth only creates value if the company has a return on invested capital (ROIC) that is higher than the cost of capital.

Also, if a company has a sustainably high ROIC and ROE, then book value is not an important factor in the investment decision.  Book value, Buffett said, is what was put into the business in the past.  What matters is how much cash you can take out of the business in the future.  If the company is high quality “” with a sustainably high ROIC and ROE “” then it’s hard to pay too high a price if you’re going to hold it for decades.  (In the 1990’s, Buffett and Munger noted that the average ROE for American businesses was about 12-13%.)

However, it’s exceptionally difficult to identify a business that will maintain a high ROIC and ROE for a couple of decades or more.  Buffett and Munger have been able to do it because they are seriously smart and they are learning machines who’ve constantly evolved.  Most investors simply cannot beat the market, regardless of their method.  Most investors would be better off investing in a low-cost index fund or in a quantitative value fund.

 

BUSINESS RISK

(Photo by Alain Lacroix)

At the 1997 meeting, Buffett identified three key business risks.  First, in general, a company with high debt is at risk of bankruptcy.  A good recent example of this is Seadrill Ltd. (NYSE: SDRL).  This company was an industry leader that was started by billionaire John Fredriksen (who started out in shipping, which he continues to do).  Seadrill is an excellent company, but it’s now in serious trouble because of its high debt levels.  Fredriksen has been forced to launch a new offshore drilling company.

The second business risk Buffett mentioned is capital intensity.  The ideal business has a sustainably high ROE and low capital requirements.  That doesn’t necessarily mean that a capital-intensive business can’t be a good investment.  For instance, Berkshire recently acquired the railroad BNSF.  The ROE obviously isn’t nearly as high as that of a company like See’s Candies.  But it’s a solid investment for Berkshire.

• As Buffett and Munger have explained, if the ROE on a regulated business is 11-12%, but part of Berkshire’s capital is insurance float that costs 3% or less, that’s obviously a good situation because the return on capital exceeds the cost by at least 8-9% per year.  In some years, Berkshire’s insurance float has even had a negative cost, meaning that Berkshire has been paid to hold it.

A third business risk is being in a commodity business.  Because a true commodity business “” like an oil producer “” has no control over price, it must be a low-cost producer to be a good investment.

 

GOOD MANAGERS

Buffett and Munger have explained that they look for .400 hitters in the business world.  Buffett says when he finds one, and can buy the business at a reasonable price while keeping the manager in place, he is thrilled.  He doesn’t then try to tell the .400 hitter how to swing.  Instead, he lets the star continue to run the business as before.

Buffett has also commented that it’s quite difficult to pay a .400 hitter too much.  A great manager can make a world of difference for a business.  For instance, when Robert Goizueta took over Coca-Cola in 1981, its market value was $4 billion.  As of 1997, Buffett remarked, the market value exceeded $150 billion.

Using another analogy, Buffett has said that he loves painting his own canvas and getting applause for it.  So he looks for managers who are wired the same way.  He gives them the freedom to continue to paint their own paintings.  Also, they don’t have to talk with shareholders, lawyers, reporters, etc.

 

SUSTAINABLE COMPETITIVE ADVANTAGE

Buffett and Munger look for companies that have a sustainably high ROIC (and ROE).  To maintain a high ROIC (and ROE) requires a sustainable competitive advantage.  Buffett:

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

Buffett and Munger have also used the term moat.  In 1995, Munger said the ideal business is a terrific castle with an honest lord.  The moat is a barrier to competition and can take many forms including low costs, patents, trademarks, technology, or advantages of scale.

(Bodiam Castle in England, Photo by Allen Watkin, via Wikimedia Commons)

A sustainable competitive advantage “” a moat “” is very rare.  The essence of capitalism is that high returns get competed away.  Generally if a company is experiencing a high ROIC, competitors will enter the market and drive the ROIC down toward the cost of capital.

• ROIC (return on invested capital) is a more accurate measure of how the business is doing than ROE (return on equity).  Buffett uses return on net tangible assets, which is ROIC.
• But ROE is close to ROIC for companies with low or no debt, which are the types of companies Berkshire usually prefers.
• Also, ROE is a bit more intuitive when you’re thinking about the advantages of holding a high-quality business for decades.  In this situation, your returns as an investor will approximate the ROE over time.

When you buy a great business with a sustainably high ROIC, you typically only have to be smart once, says Buffett.  But if it’s a mediocre business, you have to stay smart.

Buffett has also observed that paying a high price for a great business is rarely a mistake.

 

KNOW THE BIG COST

A superior cost structure is often central to a company’s competitive advantage.  Buffett said in 2001 that he doesn’t care whether the business is raw-material-intensive, people-intensive, or capital-intensive.  What matters is that the business must have a sustainable competitive advantage whereby a relatively high ROIC and ROE can be maintained.

ROIC must stay above the cost of capital.  A superior cost structure is a common way to help achieve this.

 

BASIC “MACRO THESIS”

The only long-term macro thesis Buffett has is that America will continue to do well and grow over time.  Buffett often points out that in the 20th century, there were wars, a depression, epidemics, recessions, etc., but the Dow went from 66 to 11,000 and GDP per capita increased sixfold.

As long as you believe GDP per capita will continue to increase, even if a bit more slowly, then you want to buy (and hold) good businesses.  For most investors, you should simply buy (and hold) either a quantitative value fund or a low-cost broad market index fund.

Another way Buffett has put it: In 1790, there were four million people in America, 290 million in China, and 100 million in Europe.  But 215 years later “” as of 2005 “” America has 30% of the world’s GDP.  It’s an unbelievable success story.

 

MACRO FORECASTING

Looking historically, there are virtually no top investors or business people who have done well from macro forecasting “” which includes trying to predict the stock market, the economy, interest rates, or elections.  As for those investors who have done well from macro forecasting, luck played a key role in most cases.

Warren Buffett puts it best:

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

Consider efforts to forecast what the stock market will do in any given year.  There have always been pundits making such predictions, but no one has been able to do it correctly with any sort of consistency.

(Illustration by Maxim Popov)

Furthermore, if you simply focus on individual businesses, as Buffett and Munger advise and have always done, then what happens to the overall stock market doesn’t matter.  Bear markets occur periodically, but their timing is unpredictable.  Also, even in a bear market, some stocks decline less than the market and some stocks even go up.  If you’re focused on individual businesses, then the only “macro” thesis you need is that the U.S. and global economy will continue to grow over time.

Virtually every top investor and business person has done well by being heavily invested in businesses (often only a few).  As Buffett and Munger have repeatedly observed, understanding a business is achievable, while forecasting the stock market is not.

Indeed, when Buffett started his career as an investor, both Graham and his father told him the Dow was too high.  Buffett had about $10,000.  Buffett has commented since then that if he had listened to Graham and his father, he would still probably have about $10,000.

Now, every year there are “pundits” who make predictions about the stock market.  Therefore, as a matter of pure chance, there will always be people in any given year who are “right.”  But there’s zero evidence that any of those who were “right” at some point in the past have been correct with any sort of reliability.  In other words, the fact that certain pundits turned out to be right during one period tells you virtually nothing about which pundits will turn out to be right in some future period.

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

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

Consider Buffett’s recent 10-year bet on index funds versus hedge funds.

• See pages 21-25 of the 2016 Berkshire letter: http://berkshirehathaway.com/letters/2016ltr.pdf
• See pages 11-12 of the 2017 Berkshire letter: http://berkshirehathaway.com/letters/2017ltr.pdf

Buffett chose a very low-cost Vanguard 500 index fund.  Protégé Partners, Buffett’s counterparty to the bet, selected the five best “funds-of-hedge funds” that it could.  As a group, those funds-of-hedge funds invested in over 200 hedge funds.  Buffett writes in the 2017 annual letter:

Essentially, Protégé, an advisory firm that knew its way around Wall Street, selected five investment experts who, in turn, employed several hundred other investment experts, each managing his or her own hedge fund.  This assemblage was an elite crew, loaded with brains, adrenaline, and confidence.

Here are the results of the 10-year bet:

	Net return after 10 years
Fund of Funds A	21.7%
Fund of Funds B	42.3%
Fund of Funds C	87.7%
Fund of Funds D	2.8%
Fund of Funds E	27.0%
S&P 500 Index Fund	125.8%

 

	Compound Annual Return
Fund of Funds A	2.0%
Fund of Funds B	3.6%
Fund of Funds C	6.5%
Fund of Funds D	0.3%
Fund of Funds E	2.4%
S&P 500 Index Fund	8.5%

To see a more detailed table of the results, go to page 12 of the Berkshire 2017 Letter: http://berkshirehathaway.com/letters/2017ltr.pdf

Many forecasters (including many investors) have predicted, starting in 2012 or 2013 and continuing up until today (April 2018), that the S&P 500 Index was going to be far lower.  One reason the hedge funds involved in Buffett’s bet didn’t do well at all, as a group, is because many of them were hedged against a possible market decline.

• The timing of bear markets is unpredictable.  Also, the stock market has recovered from every decline and has eventually gone on to new highs.  (As long as humans keep making progress in technology and in other areas, the stock market will keep increasing over the long term.)  For these reasons, it virtually never pays to hedge against market declines.
• Most of those who successfully hedged against the bear market in 2008 missed the recovery starting in 2009.  Said differently, most of those who “successfully” (mostly by luck) hedged against the bear market in 2008 would have been at least as well off if they’d stayed fully invested without hedging.

Virtually no one predicted 2800+ on the S&P 500, which again shows that forecasting the stock market is just not doable on a repeated basis.

• Even at 2800+, the S&P 500 Index may not be significantly overvalued because interest rates are low and profit margins are structurally higher, as Professor Bruce Greenwald of Columbia University suggested in this Barron’s interview:  http://www.barrons.com/articles/bruce-greenwald-channeling-graham-and-dodd-1494649404
• The largest companies include Apple, Alphabet (Google), Microsoft, Amazon, and Facebook, most of which have far higher normalized profit margins and ROE than the vast majority of large companies in history.  Software and related technologies are becoming much more important in the world economy.
• Moreover, progress in computer science or in other technologies could accelerate.  For instance, a big breakthrough in artificial intelligence could conceivably boost GDP by 5-10% or more.  Historically, it’s never paid to bet against progress, especially technological progress.

 

WHAT vs. WHEN

In 1994, Munger commented that figuring out the future of an individual business is much more doable “” and repeatable “” than trying to make a macro forecast “” which can’t be done repeatedly.  Munger:

To think about what will happen versus when is a far more efficient way to behave.

 

CAPITAL-INTENSIVE BUSINESSES

In 2010, Buffett discussed Berkshire’s recent investment in capital-intensive businesses.  He noted that for most of its history under current management, Berkshire tried to invest in high ROIC (and ROE) businesses that don’t require much capital, with See’s Candies being the best example.  However, due to its many successful investments, Buffett has had torrents of cash coming to headquarters for many years now.

There simply are not many businesses like See’s, and besides, as Berkshire gets larger, Buffett would need to find hundreds of companies like See’s in order to move the needle.

Buffett started investing in MidAmerican Energy in 1999.  Buffett learned that a regulated, capital-intensive business like this could earn decent returns of 11-12%.  Not brilliant and nothing like See’s.  But still decent, with ROIC above the cost of capital.

Based on his experience with MidAmerican Energy, Buffett reached the decision to acquire Burlington Northern Santa Fe (BNSF) for Berkshire.  Again, a capital-intensive, regulated business, but with a strong competitive position and with decent returns on capital.

(BNSF, Photo by Winnie Chao)

Also remember that Berkshire’s insurance float continues to have low cost “” often 3% or less, and sometimes even negative.  Investing such low-cost float at 11-12% returns is quite good.

 

CYCLICAL INDUSTRIES

Most investors don’t invest in cyclical companies because they don’t like earnings that are highly variable and unpredictable.  As a result, many cyclical companies can get very cheap indeed.

Buffett and Munger focus on normalized earnings instead of current earnings.  The volatility and unpredictability of current earnings creates some wonderful opportunities for long-term value investors.

The Boole Microcap Fund had an investment in Atwood Oceanics, which was acquired by Ensco plc. (NYSE: ESV) last year.  The Boole Fund continues to hold Ensco because it’s very cheap.  The current price is $5.43, while book value per share is $26.86.

Just how cheap is Ensco?

• Low case: If oil prices languish below $60 for the next 3 to 5 years, then Ensco will be a survivor, due to its large fleet, globally diverse customer base, industry leading customer satisfaction ratings, and well-capitalized position.  Ensco is likely worth at least half of book value ($26.86 a share), which would be $13.43 a share, nearly 150% higher than today’s $5.43.
• Mid case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years ““ which is likely based on long-term supply and demand ““ then Ensco is probably worth at least book value ($26.86 a share), nearly 400% higher than today’s $5.43.
• High case: If oil prices are in a range of $65 to $85 over the next 3 to 5 years ““ and if global rig utilization normalizes ““ then Ensco could easily be worth at least 150% of book value, which is $40+ a share, over 640% higher than today’s $5.43.

Note that oil-related companies in general are often excellent long-term investments.  They outperform the broader market over time, especially when they are cheap, as they are today.  And oil-related companies offer notable diversification, inflation protection, and exposure to global growth.

See this paper by Jeremy Grantham and Lucas White (you may have to register, but it’s free): https://www.gmo.com/docs/default-source/research-and-commentary/strategies/equities/global-equities/an-investment-only-a-mother-could-love-the-case-for-natural-resource-equities.pdf

Buffett has pointed out that See’s Candies loses money eight months out of the year.  But the company has been phenomenally profitable over the decades.

(Photo by Cihcvlss, via Wikimedia Commons)

 

Thinking for Yourself

LOGIC, NOT EMOTION

(Photo by Djama86)

Buffett first learned this lesson from Ben Graham:

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

Focus on what is knowable and important.  Ignore the crowd.  The market is there to serve you, not to instruct you.  Graham:

Basically, price fluctuations have only one significant meaning for the true investor.  They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.  At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Buffett has often suggested, including in 2010, that most investors would be better off if there were no stock market quotations.  Buy a good business and then totally ignore prices.  Just follow the progress of the business over time.  If you don’t want to follow individual businesses, then simply buy a low-cost index fund or a quantitative value fund.

 

INTELLECTUAL INDEPENDENCE

Buffett and Munger have pointed out that you’re better off as an investor not knowing popular opinion.  You’re better off learning as much as you can about businesses that you can understand.  You’re better off insulating yourself from the crowd.

Along these lines, Buffett has also commented that he’s never read an analyst report.  All the information you need can be found in the company’s financial statements.  If you need more information, you can conduct scuttlebutt research by talking with employees, customers, suppliers, competitors, etc.

Munger has said that you should focus only on the intrinsic value of the business.  If it’s a business you can understand, then only after you have a rough estimate of intrinsic value do you look at the current price.  In other words, you figure out the value of the business based on what it does and its financials.  You don’t look to the current price for information (other than as a market consensus).

 

IN/OUT/TOO HARD

Buffett and Munger have remarked that they have three boxes for potential investment ideas: in, out, and too hard.

It’s a big advantage if you classify most ideas as “too hard” because that means you can focus only on those businesses that you can understand.  As Buffett said at the 2006 meeting, if you’re fast, you can run the 100 meters for the gold medal.  You don’t have to throw the shot put.

Buffett has also often observed that generally you don’t get paid for degree of difficulty in investing.  Many of the best investment ideas have been rather simple.

At the 2008 meeting, Buffett mentioned that if it’s a worthwhile investment idea, he can usually make a good decision in five minutes.  Buffett said spending five months wouldn’t improve the quality of the decision past the five minute point.  Similarly, if it’s a “no go,” Buffett typically cuts off the proposal mid-sentence.

 

INFORMATION:  GOOD, NOT QUICK

In 1994, Buffett said good information is far more important than quick information.  His primary source for information is annual reports.  Buffett said if the mail and quotes were delayed three weeks, he would still do just fine.

 

Lifetime Learning

LIFETIME LEARNING AND CONSTRUCTIVE CRITICISM

Buffett and Munger are learning machines.  Buffett always says to read everything you can get your hands on.

Munger observed in 2003 that “Berkshire has been built on criticism.”  The ability to take constructive criticism is a central part of being a rational learning machine.

(Illustration by Hafakot)

Buffett and Munger also indicated in 2003 that their biggest errors have been errors of omission rather than commission.  Buffett said that Berkshire would have made roughly $10 billion if he had finished buying Wal-Mart.  The stock went up a bit when Buffett started buying.  Buffett waited for it to come back down, but it never did.

 

INVEST IN YOURSELF

Buffett and Munger contend that the very best investment you can make is in yourself.  Become a learning machine, and never stop learning about your passions and areas of interest.  You’ve got one brain and one life, so maximize them and have fun along the way.

(Photo by Marek Uliasz)

Do what you love.  Work for people you admire.  You can become, to a large extent, the person you want to be, notes Buffett.  And if you hang around people better than you, you’ll become better.

 

MAKING IT IN BUSINESS

In 2010, Buffett said the common factor for all of Berkshire’s excellent managers is that they love what they do.  Buffett noted that there’s nothing like following your passion.

Munger again recommended being a learning machine.  If you resolve to go to bed each night wiser than when you got up, you may rise slowly, but you’re sure to rise.

Buffett and Munger also reminded investors: stay in your circle of competence.  The size of the circle isn’t important, but knowing its boundaries is crucial.

For most investors, a quantitative value fund or an index fund is the best option.  (Buffett advises his own friends of modest means to stick with index funds.)

• The Boole Microcap Fund is a quantitative value fund.

 

MULTIDISCIPLINARY MODELS, OPPORTUNITY COST

Munger has long argued that in order to be as rational a thinker and decision-maker as you can be, you need to master the primary models in the major disciplines.  Munger noted at the meeting in 2000 that these models include probability in math and break-points and back-up systems in engineering.

Here’s a discussion of big ideas in the major subject areas: https://boolefund.com/lifelong-learning/

If you’ve only mastered one area, that can create many problems.

To a man with a hammer, every problem looks pretty much like a nail.

Moreover, Munger has pointed out that when you’re making a decision “” investment or otherwise “” your best decision is automatically a function of your next-best decision, which is your “opportunity cost.”

 

BIOGRAPHIES: IMPROVE YOUR FRIENDS

In 1988, Munger recommended reading biographies and “making friends with the eminent dead.”  This is a good way to improve your experience while also improving the quality of your friends.

Biographies are often a good way to learn about a specific subject when the person written about is an expert in that subject.

 

What is Berkshire Hathaway?

People often think Berkshire Hathaway is like a mutual fund that owns many positions in equities.  But that’s not correct.  See Buffett’s 2016 letter to shareholders:  http://berkshirehathaway.com/letters/2016ltr.pdf

(I focus here on the 2016 letter because it’s the most recent letter that still contains some discussion of the major business areas.  Going forward “”including 2017 “” you have to go to the annual report to see the discussion.  Here’s the 2017 annual report: http://berkshirehathaway.com/2017ar/2017ar.pdf)

 

(Berkshire Hathaway logo via Wikimedia Commons)

First, Berkshire Hathaway is one of the largest and most successful insurance companies in the world.  Berkshire owns excellent property/casualty (P/C) insurance companies, including reinsurance and also GEICO.  Berkshire has operated at an underwriting profit for 14 consecutive years “” up to but not including 2017 “” generating a total pre-tax gain of $28 billion.

Second, Berkshire owns outright many great (and many good) individual businesses.  This includes 44 businesses in manufacturing, services, and retailing.  Buffett refers to this group as a “motley crew,” with a couple earning an unlevered return on net tangible assets in excess of 100%.  Most earn returns in the 12% to 20% range.  As well, some of these businesses have many individual business lines.  For instance, notes Buffett, Marmon has 175 separate business units.

• Many of these businesses can operate far better being owned by Berkshire than they would if they were independent.  These companies can focus entirely on building long-term intrinsic value, without worrying about shorter term results or capital.  They can make the capital investments that make sense.  If they generate excess capital, it is sent to the parent company level, where Warren Buffett can invest it in the best available opportunities.
• Viewed as a single business, says Buffett, in 2016 this entity employed $24 billion in net tangible assets and earned 24% after-tax on that capital.
• Recent additions include Duracell and Precision Castparts.

Third, Berkshire owns regulated businesses such as Berkshire Hathaway Energy “” a multi-state, multi-country utility business, including renewable energy projects and gas pipelines.  Buffett:

When it comes to wind energy, Iowa is the Saudi Arabia of America.

The other major regulated business is Burlington Northern Santa Fe.  For BNSF, it takes a single gallon of diesel fuel to move a ton of freight almost 500 miles.  This makes railroads four times as fuel-efficient as trucks, writes Buffett.

Fourth, Berkshire owns businesses Buffett classifies as finance and financial products.  This includes CORT (furniture), XTRA (semi-trailers), and Marmon (primarily tank cars but also freight cars, intermodal tank containers and cranes).  And there’s Clayton Homes.  Most of its revenue comes from the sale of manufactured homes, but most of its earnings result from a large mortgage portfolio.

• Clayton’s customers are usually lower-income families who would not otherwise be able to own a home.  Monthly payments average only $587, including the cost of insurance and property taxes.  Clayton has programs “” such as loan extensions and payment forgiveness “” to help borrowers through difficulties.  Clayton foreclosed on only 2.5% of its mortgage portfolio in 2016.

Finally, Berkshire has well over $100 billion in public equities, such as American Express, Apple, Coca-Cola, IBM, Phillips 66, U.S. Bancorp, and Wells Fargo.  Note that Todd Combs and Ted Weschler each manage more than $12 billion of Berkshire’s public equity portfolio.

Buffett and Munger have always been highly ethical leaders, seeking to follow all laws and rules, and also working to treat their partners and employees as they would wish to be treated were their positions reversed.

 

BERKSHIRE:  GOOD HOME FOR GOOD BUSINESSES

In 2013, Munger remarked that Buffett was highly successful early in his career, when he managed an investment partnership, because he had very little competition.  This occurred primarily because Buffett focused on microcap companies, where few other investors ever look.

• Even today, micro caps are overlooked and neglected by the vast majority of investors.  There’s far less competition in microcap investing, especially as compared with mid caps and large caps.  You can usually find a far greater number of undervalued stocks among micro caps.  That’s why I launched the Boole Microcap Fund, to help folks profit in a systematic way from inexpensive micro caps:  https://boolefund.com/best-performers-microcap-stocks/
• Because Buffett is one of the best investors ever, his returns today, were he starting again, would still be phenomenal.  In fact, Buffett has said on many occasions that if he were starting again today, he could get 50% annual returns by investing in micro caps.

So the key to Buffett’s early success was no real competition.

Similarly, one reason Berkshire Hathaway has become remarkably successful today is lack of competition.  Berkshire is one of the only companies that buys great or good businesses on the condition that those businesses continue to be run as before (ideally by the same manager).  Moreover, Buffett can usually decide in five minutes whether to buy the business in question.  And no seller ever worries about Berkshire’s check clearing.

Berkshire gets many calls no one else gets.  Berkshire has the money, the willingness to act immediately, and the policy that the business be run as before.  Perhaps even more importantly, Munger has noted, Berkshire uses the golden rule in its treatment of subsidiaries:  Berkshire seeks to treat subsidiaries as it would itself like to be treated were the positions reversed.

To illustrate the point, Buffett told the story of a business owner thinking about selling.  He worried that if he sold to competitors, they would fire the people who built the business.  The new owners would behave like Attila the Hun.

If the owner sold the business to a private equity firm, they would load it up with debt with the goal of reselling it.  And when they resold it, the Attila the Hun scenario would occur again.

The owner concluded that selling to Berkshire was not necessarily wonderful, but it was the only real choice.  Buffett then commented that this particular business turned out to be an outstanding acquisition for Berkshire.  The people stayed, and the previous owner is still doing what he loves.  Buffett:

Our competitive advantage is that we have no competitors.

A similar situation happened with Nebraska Furniture Mart (NFM).  Rose Blumkin, known as “Mrs. B”, borrowed $500 from her brother and launched NFM in 1937.  Mrs. B sold products at cheaper prices than her competitors in the furniture business.

(Nebraska Furniture Mart logo, via Wikimedia Commons)

In 1983, at the age of 89, Mrs. B was interested in selling.  Many were interested in buying, but Mrs. B only wanted to sell to “Mr. Buffett”.  She sold him 80% of Nebraska Furniture Mart based on a one-page deal and a handshake.  (Buffett later commented that Mrs. B was the best entrepreneur he’d ever met and could run rings around chief executives of the Fortune 500.)

Finally, Buffett mentioned that Berkshire has a different shareholder base.  Virtually everyone “” including owner/managers “” thinks like a long-term owner.

 

NO MASTER PLAN

In 2001, say Pecaut and Wrenn, Buffett observed that he and Charlie did not have any master plan.  They just were continuing to focus on allocating capital as rationally as they could.

Henry Singleton, CEO of Teledyne, who has been described by Buffett and Munger as the greatest CEO/capital allocator in American business history, also never had a plan.

Furthermore, Buffett and Munger have often remarked that, as a value investor, you only need one good idea a year to do well over time.

 

CULTURE

In 2015, Buffett talked about developing the right culture.  It takes a long time.  Culture comes from the top.  The leader must consistently set a good example and communicate well.  Good behavior must be rewarded and bad behavior punished.

The Golden Rule

Buffett asserted that always striving to treat people the way you would like to be treated has always been a core value at Berkshire.

 

MUNGER’S OPTIMISM

People love Munger for his brilliance, wit, and honesty.  He tells it like it is in as few words as possible.  Munger sometimes comes across as a curmudgeon next to Buffett, who’s typically very upbeat and optimistic.

But the truth is that Munger loves science and technology, and is extremely optimistic about the future.  He has said that most problems are technical problems that will be solved.  The future is very bright.

At the same time, Munger recommends low expectations and gratitude “” in addition to hard work and honesty “” as a recipe for personal happiness.  Be grateful for all the good things and good people in life.  Keep your expectations low, and you’ll often be pleasantly surprised.  Be stoic through the inevitable challenges.

Munger also commented at a Daily Journal meeting in 2016 that what you want to be is stressed and challenged.  Your full potential can only come out if you challenge yourself and if you embrace all the challenges that life throws at you.

 

LEGACY

In 2011, Munger joked that Warren wanted people to say at his funeral, “That’s the oldest looking corpse I ever saw.”

More seriously, write Pecaut and Wrenn, Munger wanted his own tombstone to read, “Fairly won, wisely used.”

Buffett, for his part, wanted to be remembered as “Teacher.”  Buffett loves teaching.  At every annual meeting, Buffett and Munger spend virtually six hours teaching.  In addition to that, Buffett writes the annual letter as a form of teaching.  Buffett appears in the media frequently.  And Buffett generously hosts many hundreds of business students, who come in groups every year to Omaha for hours of great teaching.

As a young man, Buffett taught at the University of Nebraska:

(via Wikimedia Commons)

Munger:

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

 

Insurance

BUYING NATIONAL INDEMNITY

In 2003, Buffett told the story of how he bought National Indemnity from Jack Ringwalt in 1967.  Buffett had noticed that Ringwalt would get worked up once a year for 15 minutes, threatening to sell the company.  Buffett asked a mutual friend, Charlie Heider, to let Buffett know the next time Ringwalt had an episode.

Heider called Buffett one day to let him know Jack was ready.  Buffett immediately called Ringwalt and was able to buy the company from him.  National Indemnity was the foundation for Berkshire Hathaway, which today is one of the largest and most successful insurance companies in the world.

 

INSURANCE AND HURRICANES

In 2006, Buffett remarked that Hurricane Katrina was a $60 billion event and Berkshire paid out $3.4 billion.  This brought up the question of whether the preceding two years, or the previous 100 years, was the best way to think about the future.  Buffett announced:

We’re in.  If the last two years hold, we’re not getting enough.  If the last 100 years hold, we’re getting paid plenty.

Buffett imagined that there could be a $250 billion event, and that Berkshire’s exposure would be 4%, or $10 billion.  Pecaut and Wrenn pose the following question.  Berkshire has had about 8-10% of the property/casualty (P/C) insurance market based on their float.  But their exposure is around 4-5%.  How?  Shrewd, it seems.

Berkshire doesn’t care at all about smoothness of earnings, especially in P/C insurance.  Berkshire always has at least $20 billion in cash.  And it’s approaching the point where more cash than that will come in every year from its wide variety of businesses.  Thus, Berkshire is easily able to cover occasional large payments in P/C.

In brief, Berkshire gets larger, though lumpier earnings because it’s designed that way, whereas Berkshire’s competitors need some smoothness in their earnings.  Buffett says this is close to a permanent advantage for Berkshire that increases every year.

 

BUILDING THE INSURANCE BUSINESS

In 2011, Buffett said that Ajit Jain built Berkshire’s reinsurance business from scratch.  Buffett pointed out that Ajit is as rational as anyone he’s met and loves what he does.  There’s not a single decision Ajit has made that Buffett thinks he could have done better.

Furthermore, before Ajit came along, Berkshire spent 15 years in reinsurance not making any money.  Ajit turned Berkshire’s reinsurance business into a real profit center.

Buffett also remarked that it’s difficult to differentiate between a long-term trend and a series of random events.  This makes it very challenging to price reinsurance of catastrophes.  Buffett’s tactic is to assume the worst and price from there.

(Photo by Wittayayut Seethong)

Munger observed that P/C is not such a good business in itself.  You must be in the top 10% to do well.  Of course, to the extent that Berkshire maintains its huge float at a very low cost, it gains additional long-term benefits by investing a portion of the float in undervalued or high-quality businesses.

In 2013, Buffett commented that it’s much better to build the reinsurance business “” rather than buy “” once you’ve got the right people and plenty of capital.

• As Pecaut and Wrenn record, Buffett has often emphasized that Berkshire is “an unusually rational place.”  Buffett has said that it’s been good that he and Charlie have not had outside influences pushing them in unwanted directions.
• Specifically in insurance, Berkshire has chosen to write no policies at all (for long stretches of time) if the prices are not right.  This has added to their long-term profitability, even though their earnings are lumpier than most.  (One time National Indemnity shrunk its business by 80% until prices recovered.)
• Most insurers are pressured by Wall Street to increase premiums every year.  But some years insurance prices don’t make sense and virtually guarantee losses.  As well, many managers do not have much vested interest in the insurer they manage.  This makes them even more likely to give in because they don’t want criticism or pressure.
• To make matters worse, if other insurers are writing policies and collecting premiums when prices don’t make sense, then there is “social proof” or a “bandwagon effect”:  it appears that many others are doing well at the moment, even if it’s long-term unprofitable.
• It’s not greed, but envy that drives much human behavior, says Buffett.  Envy is particularly stupid because there’s no upside, adds Munger.  Buffett agrees, joking: “Gluttony is a lot of fun.  Lust has its place, too, but we won’t get into that.”
• Recently some hedge funds have gotten into reinsurance.  Buffett commented that anything Wall Street can sell, it will.  Munger chimed in, saying Wall Street would “throw in a lot of big words, too.”
• Buffett concluded that if you own a gas station, and the guy across the street sells below cost, you’ve got a problem.  But insurance works differently.  It pays over time not to write policies when prices don’t make sense.
• Munger: “With our cranky methods, we probably have the best insurance operation in the world.  So why change?”

 

THE UNEXPECTED

Having spent decades in insurance, Buffett and Munger know how to think about risks and probabilities.  In 2004, Buffett said people tend to underestimate risks that haven’t happened for awhile, while overestimating risks when they’ve happened recently.

Buffett also has repeatedly stated that the person who runs Berkshire after Buffett must be able to consider scenarios that have never occurred before.

Here’s something else to keep in mind.  Assume there’s only a 2% chance of some event happening in any given year.  Assume the probability stays unchanged from year to year.  Then after 50 years, there’s a 63.6% chance the event will have occurred.  After 100 years, there’s an 86.7% chance the event will have ocurred.

(Photo by Michele Lombardo)

Berkshire is extremely rigorous in its consideration of various risks.  Buffett quipped at the 2005 meeting:

It’s Armageddon around here every day.

Buffett and Munger say they’ll never lose sleep because they are very careful and conservative in how they’ve structured Berkshire.  As Buffett asks, why have even a tiny risk of failure just to get an extra percentage point of return?  Ironically, write Pecaut and Wrenn, Buffett and Munger’s conservative approach has led to one of the highest multi-decade records of compounding anywhere.

 

Comments on Specific Investments

BYD

In 2010, Munger recounted how he had lost money in a venture capital investment when he was young.  Finally, decades later, Munger came across BYD, a Chinese maker of rechargeable batteries and electric cars, employing over 17,000 top engineers.  Berkshire made an investment in BYD that has worked well.

(BYD logo via Wikimedia Commons)

Munger suggested that BYD is an illustration of Berkshire’s commitment to keep learning.

 

GEICO

When Berkshire acquired control of GEICO in 1995, the auto insurer had 2.5% market share.  At the end of 2016, GEICO had reached 12% of industry volume.  GEICO’s low costs “” they sell direct without agents “” gives it a very sustainable competitive advantage.

(GEICO logo by Dream out loud, via Wikimedia Commons)

Buffett recognized GEICO’s advantage long ago when writing his Columbia grad school thesis on the company.  Since 1995, Berkshire, under Buffett’s direction, has spent annually more on advertising for GEICO than the rest of the auto insurance industry combined.  The net result is that GEICO continues to gobble up market share every year.

• Pecaut and Wrenn record that in 2013, two-thirds of all new auto policies went to GEICO.

Additionally, GEICO has enjoyed excellent management.  Buffett on Tony Nicely:

Tony became CEO of GEICO in 1993, and since then the company has been flying.  There is no better manager than Tony, who brings his combination of brilliance, dedication and soundness to the job.  (The latter quality is essential to sustained success. As Charlie says, it’s great to have a manager with a 160 IQ ““ unless he thinks it’s 180.)  Like Ajit, Tony has created tens of billions of value for Berkshire.

See page 10 of Buffett’s 2016 letter:  http://berkshirehathaway.com/letters/2016ltr.pdf

 

3G CAPITAL PARTNERS

Berkshire recently joined with 3G Capital Partners on some deals, including the $23 billion acquisition of Heinz in 2013.  3G’s Jorge Paulo Lemann and Warren Buffett have known each other since they were both on the board of Gillette.

At the 2015 meeting, a question was asked about 3G’s method of significantly reducing the workforce of recently acquired companies.  Buffett replied that Burger King was now outperforming its competitors by a wide margin, thanks to the cost-cutting methods of 3G.

Buffett then noted that the railroad business had 1.6 million people employed after World War II.  Now the railroad industry has under 200,000 employees, but it is much larger, more efficient, and safer.  In short, Buffett applauds 3G’s achievements.  Ongoing progress and improvement is the nature of capitalism.

 

ISCAR

In 2013, Buffett announced that Berkshire was buying the final 20% of ISCAR that it didn’t own from the Wertheimer family for roughly $2 billion.

Buffett compared ISCAR to Sandvik, a Swedish company that owns Sandvik Tooling and Seco Tools “” competitors of ISCAR.  Buffett stated that Sandvik is very good, but ISCAR “” an Israeli company “” is much better.

How did ISCAR become so good?  Buffett said the combination of brains and a huge amount of passion is what created ISCAR’s success.  ISCAR has long had talented and extremely hard-working people who constantly improve the product and work to delight customers.  Buffett praised ISCAR as one of the best companies in the world.

 

Other Topics

THE GAME OF BRIDGE

In the 1990’s, Buffett and Munger commented that their main job is capital allocation.  Buffett: “Aside from that, we play bridge.”  Bridge is a great game for value investors because you constantly have to make decisions based on probabilities.

www.bridgebase.com is a great site for learning and playing bridge.  Like most games, bridge gets increasingly fun the more you learn how to play.  (I enjoy bridge and chess, though I’m still a novice at both.)

(Image by Otm, via Wikimedia Commons)

 

THE OVARIAN LOTTERY

In order to create a fair economic and political system, Buffett suggests using a thought experiment called The Ovarian Lottery.  The idea is that you get to write the rules for society.  The catch is that it’s 24 hours before you will be born and you don’t know if you’ll be bright or retarded, female or male, able or disabled, etc.

No one chooses the advantages or disadvantages of one’s birth.  If you go through this thought experiment carefully, you’re likely to set up a fair society.  American political philosopher John Rawls used a similar thought experiment:  https://en.wikipedia.org/wiki/John_Rawls

Warren Buffett’s hero is his father, Howard Buffett.  Warren has called him the best human being he ever knew.  But Howard Buffett was a Republican.  Warren Buffett became a Democrat over time, partly through the influence of his wife, Susie, and partly due to thinking along the lines of The Ovarian Lottery.

 

PREDICTING CHANGES IN TECHNOLOGY

Buffett and Munger have generally avoided investing in technology companies because it’s extremely difficult to predict how technology will change.  As Munger commented at the 1999 meeting:

The development of the streetcar led to the rise of the department store.  Since streetcar lines are immovable, it was thought that the department store had an unbeatable position.  Offering revolving credit and a remarkable breadth of merchandise, the department store was king.  Yet in time, while the rails remained, the streetcars disappeared.  People moved to the suburbs, which led to the rise of the shopping center and ended the dominance of department stores.

Now the Internet poses a threat to both.

 

INFLATION:  GOLD vs. WONDERFUL BUSINESS

What’s a better inflation hedge, gold or owning a wonderful business?

When Buffett took over Berkshire, the stock was trading at three-quarters of an ounce of gold.  Now gold is just north of $1,280, while Berkshire is around $250,000.  Berkshire has returned 20x more than gold.  It’s no contest.

 

LUCK AND AN OPEN MIND

In 2015, Buffett remarked that he’d experienced many pieces of good luck, three in particular:  meeting Lorimer Davidson, buying National Indemnity, and hiring Ajit Jain.

• When Buffett was a young man, he stopped by a GEICO office on a Saturday.  Buffett told the guard he was a student of Ben Graham.  The guard let him in.  Buffett met Lorimer Davidson, a GEICO executive.  Davidson thought he would spend 5 minutes helping a student of Graham.  But when Davidson started talking with Buffett, he recognized how unusually smart and knowledgeable Buffett was.  So Davidson answered Buffett’s questions and educated him on the insurance business for four hours.  Buffett claims that he learned more in those four hours than he could have at any university course.
• As described earlier, Buffett bought National Indemnity from Jack Ringwalt.  Buffett had noticed that Ringwalt would want to sell for about 15 minutes each year.  Buffett was very patient, and then persuasive and decisive.
• In the mid 1980’s, Ajit Jain walked in on a Saturday offering to work for Berkshire even though he didn’t have any experience in insurance.

Buffett has marveled at his good luck.  He also observes that maintaining an open mind has been essential.

 

THE LUCKIEST CROP IN HISTORY

Buffett has frequently repeated that babies born in America today are the luckiest crop in history.  GDP per capita is higher than ever.  The standard of living is higher than ever.  The average person today lives far better than John D. Rockefeller, for instance.  Innovation and economic growth continue to move forward.

Buffett still says that, if he were given the choice of being born anywhere today, he would choose the U.S. over any other place.

 

 

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:  https://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: [email protected]

 

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.

May 29, 2022

Pine Cliff Energy (PIFYF) is a Canadian natural gas producer. Pine Cliff Energy has a low-risk, low decline, natural gas asset consolidation strategy in Western Canada with 11 acquisitions since 2012. PIFYF has one of the lowest decline rates in the oil and gas sector with a base decline rate of about 6% on base production.

Demand for natural gas is likely to continue to surprise to the upside. Power burn demand is likely to remain high. At the same time, there is a shortage of global LNG. New LNG export capacity is being added in the U.S. and Canada. High power burn plus high LNG gas exports is causing total natural gas demand to be very high.

Furthermore, natural gas storage in the U.S. is 16% below its 5-year average. And natural gas storage in Canada is at an unprecedented low level.

Natural gas production in the U.S. remains flat.

With high demand, low storage, and flat supply, natural gas prices are likely to remain high and will probably go higher. The AECO near-month price is $7.53 (CAD/GJ) while the NYMEX near-month price is $8.67 ($/mmbtu).

Here is the Pine Cliff Energy’s most recent investor presentation: https://pinecliff-pull.b-cdn.net/Corporate%20Presentation%202022%2005%2004%20-%20Final.pdf

For 2022, revenue will be about $175 million, EBITDA $146 million, cash flow $135 million, and earnings $95 million. The current market cap is $503.6 million, while enterprise value (EV) is $526.5 million.

Using these figures, we get the following multiples:

• • EV/EBITDA = 3.61
  • P/E = 5.30
  • P/B = 3.49
  • P/CF = 3.73
  • P/S = 2.88

Insider ownership is 12.9%, which is good. TL/TA (total liabilities/total assets) is 21.6%, which is very good. ROE is 828.24%, which is outstanding.

The Piotroski F_score is 9, which is excellent.

Intrinsic value scenarios:

• • Low case: Natural gas prices could fall during a global recession. The stock of PIFYF could decline 50% or more.
  • Mid case: Current EV/CF (where CF is cash flow) is 3.9. The average EV/CF for Pine Cliff Energy historically is 8.0. With EV/CF at 8.0, the stock would be worth $3.12, which is 105% higher than today’s $1.52.
  • High case: Natural gas prices could increase significantly, which means Pine Cliff Energy’s cash flow would increase significantly. The stock could be worth at least $4.50, which is close to 200% higher than today’s $1.52.

Risks

There will probably be a bear market and/or global recession during which natural gas prices fall temporarily but then quickly rebound. In this case, PIFYF stock would fall temporarily but then quickly rebound.

 

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.

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 approachesintrinsic 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: [email protected]

 

 

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.

May 1, 2022

Cardinal Energy (CRLFF) is a Canadian oil producer.

Here is the company’s most recent investor presentation: https://cardinalenergy.ca/wp-content/uploads/2022/03/April-2022-Corporate-Presentation.pdf

For 2022, revenue will be about $673 million, EBITDA $365 million, cash flow $337 million, and earnings $240 million. The current market cap is $804.7 million, while enterprise value (EV) is $924.8 million.

Book value at the end of 2022 will be about $742.7 million.

Using these figures, we get the following multiples:

• • EV/EBITDA = 2.53
  • P/E = 3.35
  • P/B = 1.08
  • P/CF = 2.39
  • P/S = 1.20

Insider ownership is 18%, which is very good. TL/TA (total liabilities/total assets) is 33.1%, which is good. ROE is 52.1%, which is excellent.

The Piotroski F_score is 8, which is very good.

Due to years of underinvestment from oil producers, oil supply is constrained. (Government policy has also discouraged oil investment.) Moreover, due to money printing by central banks plus strong fiscal stimulus, oil demand is strong and increasing.

The net result of constrained supply and strong demand is a structural bull market for oil that is likely to last years. The oil price is likely to remain high at $90-110 per barrel (WTI) and later perhaps even higher.

Intrinsic value scenarios:

• • Low case: Book value per share at the end of 2022 will be about $4.94. This is 7% lower than today’s stock price of $5.29.
  • Mid case: Free cash flow in 2022 will be about $233 million. Because this is probably the beginning of a structural bull market for oil, $233 million in free cash flow is a mid-cycle figure and the stock is worth a free cash flow multiple of at least 8. That works out to $12.39, which is 135% higher than today’s $5.29.
  • High case: Free cash flow is likely to reach $470 million in the next few years. With a free cash flow multiple of 6, the stock would be worth $18.75, over 250% higher than today’s $5.29.

Risks

There will probably be a bear market and/or recession during which oil prices fall temporarily but then quickly rebound. In this case, CRLFF stock would fall temporarily but then quickly rebound.

 

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.

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 approachesintrinsic 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: [email protected]

 

 

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.

April 24, 2022

InPlay Oil (IPOOF) is an oil producer based in Alberta, Canada.

Here is the company’s most recent investor presentation: https://www.inplayoil.com/sites/2/files/documents/inplay_march_presentation_web_0.pdf

For 2022, revenue will be about $300 million, EBITDA $160 million, cash flow $150 million, and earnings $90 million.  The current market cap is $261.7 million, while enterprise value (EV) is $307.5 million.

Using these figures, we get the following multiples:

• • EV/EBITDA = 1.92
  • P/E = 2.91
  • P/B = 0.93
  • P/CF = 1.74
  • P/S = 0.87

Insider ownership is 29.7%, which is excellent.  TL/TA (total liabilities/total assets) is 53.4%, which is decent.  ROE is 97.9%, which is outstanding.

The Piotroski F_score is 8, which is very good.

Intrinsic value scenarios:

• • Low case: Book value per share at the end of 2022 will be about $3.24.  This is 7% higher than today’s stock price of $3.03.
  • Mid case: Free cash flow in 2022 will be about $90 million.  Because this is probably the beginning of a structural bull market for oil””based on strong demand and constrained supply over the next 3 to 10 years””$90 million in free cash flow is a mid-cycle figure and the stock is worth a free cash flow multiple of at least 8.  That works out to $8.35, which is 175% higher than today’s $3.03.
  • High case: Because it’s probably a structural bull market for oil, free cash flow is likely to reach $180 million in the next few years.  With a free cash flow multiple of 6, the stock would be worth $12.53, over 310% higher than today’s $3.03.

Risks

There will probably be a bear market and/or recession during which oil prices fall temporarily but then quickly rebound.  In this case, IPOOF stock would fall temporarily but then quickly rebound.

 

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.

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: [email protected]

 

 

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.

April 17, 2022

Made in America isthe autobiography of Sam Walton, founder of Wal-Mart. It’s a terrific book. H. Ross Perot commented:

Every person who dreams of building a great businessmust read this book. Sam Walton set the standard for listening to his customers and listening to the people who do the work. In addition to being a great entrepreneur and business leader, Sam Walton was, above all, a fine, decent, kind, generous man.

Outline:

• Learning to Value a Dollar
• Starting on a Dime
• Bouncing Back
• Swimming Upstream
• Raising a Family
• Recruiting the Team
• Taking the Company Public
• Rolling Out the Formula
• Building the Partnership
• Stepping Back
• Creating a Culture
• Making the Customer Number One
• Meeting the Competition
• Expanding the Circles
• Thinking Small
• Giving Something Back
• Running a Successful Company: Ten Rules That Worked For Me

Sam Walton:

…ours is a story about the kinds of traditional principles that made America great in the first place. It is a story about entrepreneurship, and risk, and hard work, and knowing where you want to go and being willing to do what it takes to get there. It’s a story about believing in your idea even when maybe some other folks don’t, and about sticking to your guns. But I think more than anything it proves there’s absolutely no limit to what plain, ordinary working people can accomplish if they’re given the opportunity and the encouragement and the incentive to do their best. Because that’s how Wal-Mart became Wal-Mart: ordinary people joined together to accomplish extraordinary things.

(Photo by Sven, via Wikimedia Commons)

 

LEARNING TO VALUE A DOLLAR

Walton says growing up during the Great Depression impacted his views on money. Walton’s dad – who was a very hard worker – had a number of jobs, including banker, farmer, farm-loan appraiser, insurance agent, and real estate agent. When he was out of work in the Great Depression, Walton’s dad eventually went to work for his brother’s Walton Mortgage Company.

In twenty-nine, thirty, and thirty-one, he had to repossess hundreds of farms from wonderful people whose families had owned the land forever… All of this must have made an impression on me as a kid…

Walton’s mother started a little milk business. Young Walton helped his mom. Walton also started selling magazine subscriptions. And he had a paper route from the seventh grade through college.

I learned from a very early age that it was important for us kids to help provide for the home, to be contributors rather than just takers. In the process, of course, we learned how much hard work it took to get your hands on a dollar, and that when you did it was worth something. One thing my mother and dad shared completely was their approach to money: they just didn’t spend it.

(Image by Hohum, via Wikimedia Commons)

Walton remarks that he didn’t know much about business, even after earning a college degree in the subject. When he got to know his wife Helen’s family, he learned a great deal from Helen’s father L. S. Robson. Walton writes:

He influenced me a great deal. He was a great salesman, one of the most persuasive individuals I have ever met. And I am sure his success as a trader and a businessman, his knowledge of finance and the law, and his philosophy had a big effect on me. My competitive nature was such that I saw his success and admired it. I didn’t envy it. I admired it. I said to myself: maybe I will be as successful as he is someday.

Helen’s father organized the family businesses as a partnership. Walton later adopted this approach, creating what would later be called Walton Enterprises.

How does Walton view money?

Here’s the thing: Money has never meant that much to me, not even in the sense of keeping score. If we had enough groceries, and a nice place to live, plenty of room to keep and feed my bird dogs, a place to hunt, a place to play tennis, and the means to get the kids good educations – that’s rich. No question about it. And we have it. We’re not crazy. We don’t live like paupers the way some people depict us. We all love to fly, and we have nice airplanes, but I’ve owned about eighteen airplanes over the years, and I never bought one of them new.

When it comes to Wal-Mart, Walton has always been very cheap. Wal-Mart didn’t buy a jet until the company approached $40 billion in sales “and even then they had to practically tie me up and hold me down to do it.” In the early days of Wal-Mart, when they went on buying trips, they’d pack as many as eight people into one room.

Why did Wal-Mart continue to be cheap even after it had become a behemoth? Walton:

We exist to provide value to our customers, which means that in addition to quality and service, we have to save them money. Every time Wal-Mart spends one dollar foolishly, it comes right out of our customers’ pockets. Every time we save them a dollar, that puts us one more step ahead of the competition – which is where we always plan to be.

 

STARTING ON A DIME

Walton was always ambitious:

Mother must have been a pretty special motivator, because I took her seriously when she told me I should always try to be the best I could at whatever I took on. So, I have always pursued everything I was interested in with a true passion – some would say obsession – to win. I’ve always held the bar pretty high for myself: I’ve set extremely high personal goals.

(Photo by Travelling-light)

As a kid, Walton was a class officer several years. He was also a Boy Scout. And he played football, baseball, and basketball. In both high school and college (at the intramural level), he continued to play sports.

In high school, Walton was student body president and he was active in many clubs. He enjoyed basketball and was a “gym rat,” always at the gym playing hoops. When Walton was a senior, his basketball team went undefeated and won the state championship. This was one of his “biggest thrills.”

Walton continues:

My high school athletic experience was really unbelievable, because I was also the quarterback on the football team, which went undefeated too – and won the state championship as well… I guess I was just totally competitive as an athlete, and my main talent was probably the same as my best talent as a retailer – I was a good motivator.

Walton comments that his ambition and competitive spirit led him to consider as a distant goal running for President of the United States. In the meantime, he became president of the student body while at the University of Missouri. Walton:

I learned early that one of the secrets to campus leadership was the simplest thing of all: speak to people coming down the sidewalk before they speak to you. I did that in college. I did it when I carried my papers. I would always look ahead and speak to the person coming toward me. If I knew them, I would call them by name, but even if I didn’t I would still speak to them… I ran for every office that came along.

(Illustration by Madmirror)

While in college, Walton continued delivering papers. He had hired a few helpers by this point, and was making $4,000 to $5,000 a year. [That’s the equivalent of at least $60,000 to $75,000 in 2018 dollars.] Walton also waited tables and was a lifeguard. He graduated from the University of Missouri in June 1940.

Walton thought he was going to be an insurance salesman because his high school girlfriend’s father sold insurance for General American Life Insurance Company. It seemed like a lucrative career and Walton knew he could sell.

Walton wanted to attend Wharton business school, but he realized that even with his paper route and other jobs, he wouldn’t have enough money to pay for it. Walton met with two company recruiters who came to the Missouri campus. One was from J. C. Penney and the other from Sears Roebuck.

Walton says he got into retail – starting at J. C. Penney – simply because he was tired and wanted “a real job.” Although he was only making $75 a month, Walton loved retail. That’s where he stayed for the next fifty-two years.

Walton almost lost his job because he had never learned handwriting very well. Fortunately, the store manager, Duncan Majors, was a great motivator and believed in Walton. Duncan Majors was proud of having trained more Penney managers than anyone else in the country at that time. He spent time training and developing all his boys.

By early 1942, as an ROTC graduate, Walton prepared to join the war effort. But he flunked the physical due to a minor heart irregularity. Walton wandered south, toward Tulsa, thinking he might like to work in the oil business. Instead, he got a job at a big Du Pont gunpowder plant in the town of Pryor, outside Tulsa. That’s where he met his wife Helen Robson at a bowling alley. She was smart, educated, ambitious, opinionated, strong-willed, and energetic, and she was an athlete who enjoyed the outdoors.

Walton served in the military:

I wish I could recount a valiant military career – like my brother Bud, who was a Navy bomber pilot on a carrier in the Pacific – but my service stint was really fairly ordinary time spent as a lieutenant and then as a captain doing things like supervising security at aircraft plants and POW camps in California and around the country.

By 1945, Walton knew he wanted to go into a retailing and to own his own store. He read every book he could on retailing.

People today, looking back, know that Wal-Mart initially had a small-town strategy. This was just luck. Helen, Sam Walton’s wife, said she wouldn’t live in any town with more than 10,000 people.

Walton discovered that there was a Ben Franklin variety store that he could run in Newport, Arkansas – a cotton and railroad town of 7,000 people. The current owner was losing money and wanted to sell the store. Walton bought it for $25,000 – $5,000 of his own money and $20,000 from Helen’s father. Walton made a mistake, however, by not examining the lease agreement carefully.

(Photo by PenelopeIsMe, via Wikimedia Commons)

Walton set an ambitious goal:

I wanted my little Newport store to be the best, most profitable variety store in Arkansas within five years… Set that as a goal and see if you can’t achieve it. If it doesn’t work, you’ve had fun trying.

One important lesson Walton grasped early on was that you can learn from everybody. Walton would spend the rest of his career implementing this principle. He would visit as many stores as possible and speak with as many people as possible.

At the beginning, Walton’s main competition was across the street: Sterling Store, managed by John Dunham. Walton spent huge amounts of time visiting Sterling Store in order to absorb as much as he could.

Walton also learned a great deal from the Ben Franklin franchise program. It was a complete course in how to run a store. The only trouble was that franchisees weren’t given much discretion. Walton was told what merchandise to sell and how much to sell it for. Walton also had to buy the merchandise at set prices. Soon Walton started buying merchandise directly from manufacturers. He was always looking for “offbeat suppliers” from whom he could get a good deal. Walton did a lot of driving.

Walton says he learned a simple lesson that would later change the way retailers sell and customers buy:

…say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater. Simple enough. But this is really the essence of discounting… In retailer language, you can lower your markup but earn more because of the increased volume.

Walton tried many different promotional things. For instance, they put a popcorn machine and then an ice cream machine out in front of the store. Both turned out to be profitable.

No matter how well things were going, Walton was a tinkerer:

…I never could leave well enough alone, and, in fact, I think my constant fiddling and meddling with the status quo may have been one of my biggest contributions to the later success of Wal-Mart.

(Illustration by lkonstudio)

When Walton took over the Ben Franklin store, it had done $72,000 in annual sales. The first year Walton managed the store, it did $105,000 in sales. The second year was $142,000 and the third year was $175,000.

After five years, Walton ended up reaching his goal:

That Little Ben Franklin store was doing $250,000 in sales a year, and turning $30,000 to $40,000 a year in profit. It was the number-one Ben Franklin store – for sales and profit – not only in Arkansas, but in the whole six-state region.

Unfortunately, Walton was unable to keep the store because he forgot to include a clause in the lease that gave him an option to renew after the first five years. Walton notes that it was the low point of his business career. But he remained determined:

I’ve never been one to dwell on reverses, and I didn’t do so then. It’s not just a corny saying that you can make a positive out of most any negative if you work at it hard enough. I’ve always thought of problems as challenges, and this one wasn’t any different… I didn’t dwell on my disappointment. The challenge at hand was simple enough to figure out: I had to pick myself up and get on with it, do it all over again, only even better this time.

 

BOUNCING BACK

Helen’s father and Walton drove to Bentonville, Arkansas. They found an old variety store whose owners were looking to sell. But the two parties couldn’t reach an agreement. Later, on his own, Helen’s father was able to reach an agreement with the sellers.

Although the store had done only $32,000 in sales before Walton bought it, he had big plans. Walton had heard about two Ben Franklin stores that were using a new concept: self-service. All the merchandise was sitting on shelves for the customers to pick out. The check-out registers were at the front of the store.

(Illustration by Alexmillos)

Walton adopted the self-service concept for his Bentonville store. He called it Walton’s Five and Dime. The store did well right away. Part of the reason was Walton’s friendliness and his habit of yelling at people from a block away.

Walton then started looking for other stores that he could manage in other towns. He found one in Fayetteville and used the same name: Walton’s Five and Dime. It, too, was set up using self-service. Walton comments:

This was the beginning of our way of operating for a long while to come. We were innovating, experimenting, and expanding. Somehow over the years, folks have gotten the impression that Wal-Mart was something I dreamed up out of the blue as a middle-aged man, and that it was just this great idea that turned into an overnight success. It’s true that I was forty-four when we opened our first Wal-Mart in 1962, but the store was totally an outgrowth of everything we’d been doing since Newport – another case of me being unable to leave well enough alone, another experiment. And like most other overnight successes, it was twenty years in the making.

Walton made his first real hire at the manager level: Willard Walker. Walton found Willard by looking in competitors’ stores. He would continue using this approach to finding talent going forward. Also, Walton offered Willard equity in the business.

Meanwhile, Walton’s brother Bud had bought his own Ben Franklin store in Versailles, Missouri. So Walton asked his brother if he wanted to go fifty-fifty on a new Ben Franklin store that was going to be part of a shopping center in Kansas City. Bud agreed.

Based on what he saw in Kansas City, Walton got the notion of going into shopping center development. He persisted with the idea for two years. But it didn’t work.

I probably lost $25,000, and that was at a time when Helen and I were counting every dollar. It was probably the biggest mistake of my business career. I did learn a heck of a lot about the real estate business from the experience, and maybe it paid off somewhere down the line – though I would rather have learned it some cheaper way.

Wal-Mart executive David Glass:

Two things about Sam Walton distinguish him from almost everyone else I know. First, he gets up every day bound and determined to improve something. Second, he is less afraid of being wrong than anyone I’ve ever known. And once he sees he’s wrong, he just shakes it off and heads in another direction.

Walton developed a love of flying. His first plane, a two-seater, only went 100 miles an hour, but it allowed him to get places in a straight line. One time, the motor cut off for about a minute. Walton thought he was done. But he was able to circle around and land with a dead engine.

(Photo by TSRL, via Wikimedia Commons)

As Walton proceeded to open up new stores, he created business partnerships that included – along with other partners – himself, Bud, Sam’s dad, Helen’s two brothers, and even Sam and Helen’s kids, who invested their paper route money.

John Walton (one of Sam and Helen’s four kids):

This is hard to believe, but between my paper route money and the money I made in the Army – both of which I invested in those stores – that investment is worth about $40 million today.

In less than fifteen years, they had become the largest independent variety store operator. But in 1960, they were still only doing $1.4 million a year. Walton continued to look for ways to improve.

Soon he learned that if they built a huge store, they could sell as much as $2 million a year from one location. Walton traveled the country to look at the “early discounters.” For example, in California, Sol Price had started Fed-Mart. Closer to Arkansas, there was Herb Gibson, who sold cheaper than anyone else, but also sold higher volume than anyone else.

Soon Walton built his first discount store – what would become the first Wal-Mart. Because they couldn’t use Ben Franklin at all, Walton had to make arrangements with a distributor in Springfield, Missouri. Since nobody wanted to take a chance on the first Wal-Mart, Sam and Helen had to borrow even more than they already had:

We pledged houses and property, everything we had. But in those days, we were always borrowed to the hilt.

By the time they had three Wal-Marts up and running, Walton knew that it would work.

 

SWIMMING UPSTREAM

Wal-Mart’s challenges strengthened it:

Many of our best opportunities were created out of necessity. The things that we were forced to learn and do, because we started out underfinanced and undercapitalized in these remote, small communities, contributed mightily to the way we’ve grown as a company. Had we been capitalized, or had we been the offshoot of a large corporation the way I wanted to be, we might not ever have tried the Harrisons or the Rogers or the Springdales and all those other little towns we went into in the early days.

(Illustration by Miaoumiaou)

Early on, Wal-Mart didn’t have systems or computers. Walton recalls that much of what they did was poorly done. But they stayed focused on low prices:

The idea was simple: when customers thought of Wal-Mart, they should think of low prices and satisfaction guaranteed. They could be pretty sure they wouldn’t find it cheaper anywhere else, and if they didn’t like it, they could bring it back.

Wal-Mart lacked established distributors. Salesmen would randomly show up. It was difficult to get the bigger companies like Proctor & Gamble to show any interest.

The basic discounter’s strategy was to sell health products – toothpaste, mouthwash, headache remedies, soap, shampoo – at cost. This brought people into the store. The discounter would price everything else also at low prices, but with a 30 percent markup.

Gradually, Walton phased out his variety stores until all the stores were Wal-Marts.

Headquarters would give a profit and loss statement to each individual Wal-Mart store. Problems could be handled immediately. Most store managers owned a piece of their stores, so they were incentivized to maximize profit over time. Walton:

For several years the company was just me and the managers in the stores. Most of them came to us from variety stores, and they turned into the greatest bunch of discount merchants anybody ever saw. We all worked together, but each of them had lots of freedom to try all kinds of crazy things themselves.

Walton mentions Don Whitaker as being like an operations manager. Claude Harris was the first buyer.

Walton talks about the importance of merchandising:

…there hasn’t been a day in my adult life when I haven’t spent time thinking about merchandising. I suspect I have emphasized item merchandising and the importance of promoting items to a greater degree than most any other retail management person in this country. It has been an absolute passion of mine. It is what I enjoy doing as much as anything in the business. I really love to pick an item – maybe the most basic merchandise – and then call attention to it. We used to say you could sell anything if you hung it from the ceiling. So we would buy huge quantities of some thing and dramatize it. We would blow it out of there when everybody knew we would have only sold a few had we just left it in the normal store position. It is one of the things that has set our company apart from the very beginning and really made us difficult to compete with. And, man, in the early days of Wal-Mart it really got crazy sometimes.

(Illustration by Beststock Images)

For instance, one of Wal-mart’s managers, Phil Green, created the world’s largest display of Tide. It was eighteen cases high, 75 or 100 feet long, and 12 feet wide. Everyone thought Phil was crazy, but he sold all of it at deeply discounted prices.

Wal-Mart executive David Glass comments:

The philosophy it teaches, which rubs off on all the associates and the store managers and the department heads, is that your stores are full of items that can explode into big volume and big profits if you are just smart enough to identify them and take the trouble to promote them.

Glass explains that in retail, you’re either operations driven or merchandise driven. If a retailer is merchandise driven, they can always improve operations. But retailers that are operations driven often don’t learn merchandising. Early every Saturday morning, Wal-Mart managers would meet and critique their own and others’ merchandising. Walton:

We wanted everybody to know what was going on and everybody to be aware of the mistakes we made. When somebody made a bad mistake – whether it was myself or anybody else – we talked about it, admitted it, tried to figure out how to correct it, and then moved on to the next day’s work.

Wal-Mart associates also continued Walton’s practice of constantly checking out the competition in order to find ways to improve.

 

RAISING A FAMILY

On family vacations, it was a given that Walton would visit as many stores as possible.

Walton never pressured his kids at all to go into retailing. But they got involved anyway. Rob became the first company lawyer for Wal-Mart. Jim got involved with locating and buying store sites. John became the second company pilot. (John was a Green Beret medic who later created a business that builds boats.) Alice was a buyer for Wal-Mart and then developed her own investment company.

Walton worries that his grandchildren might join the “idle rich.”

Maybe it’s time for a Walton to start thinking about going into medical research and working on cures for cancer, or figuring out new ways to bring culture and education to the underprivileged…

 

RECRUITING THE TEAM

Walton notes that he has the personality of a promoter but the soul of an operator. He never stops trying to improve things. When the idea of discounting began to catch on, Walton visited every store and every headquarters he could. He gleaned something from each visit. He may have gotten the most from his study of Sol Price, an excellent operator who had started Fed-Mart in southern California in 1955. Walton:

I guess I’ve stolen – I actually prefer the word “borrowed” – as many ideas from Sol Price as from anybody else in the business.

Most discounters failed. Walton explains:

It all boils down to not taking care of their customers, not minding their stores, not having folks in their stores with good attitudes, and that was because they never even really tried to take care of their own people. If you want the people in the stores to take care of the customers, you have to make sure you’re taking care of the people in the stores. That’s the most important single ingredient of Wal-Mart’s success.

As Wal-Mart continued to expand, it had to hire more executives. Ferold Arend was the company’s first vice president of operations (and later president).

Logistics also became increasingly important. Walton got the idea of using computers long before they were very useful. But computers kept improving. Abe Marks comments on Walton:

He was really ten years away from the computer world coming. But he was preparing himself. And this is a very important point: without the computer, Sam Walton could not have done what he’s done. He could not have built a retailing empire the size of what he’s built, the way he built it. He’s done a lot of other things right, too, but he could not have done it without the computer. It would have been impossible.

A warehouse was long overdue. But Walton had already borrowed heavily and the company also had borrowed heavily. Walton:

…We were generating as much financing for growth as we could from the profits of the stores, but we were also borrowing everything we could. I was taking on a lot of personal debt to grow the company – it approached $2 million [over $14 million in 2018 dollars]… The debt was beginning to weigh on me.

(Photo by Adonis1969)

Wal-Mart needed someone to run operations. Walton hired a fellow named Ron Mayer. Walton says 1968 to 1976 – the time Ron was in charge of operations – was the most important period in Wal-Mart’s history. Walton:

We were forced to be ahead of our time in distribution and in communication because our stores were sitting out there in tiny little towns and we had to stay in touch and keep them supplied. Ron started the programs that eventually improved our in-store communications system. Building on the groundwork already laid by Ferold Arend, Ron also took over distribution and began to design and build a system that would enable us to grow as fast as we could come up with the money. He was the main force that moved us away from the old drop shipment method, in which a store ordered directly from the manufacturer and had the merchandise delivered directly to the store by common carrier. He pushed us in some new directions, such as merchandise assembly, in which we would order centrally for every store and then assemble their orders at the distribution center, and also cross-docking, in which preassembled orders for individual stores would be received on one side of our warehouse and leave out the other.

 

TAKING THE COMPANY PUBLIC

The company’s cash shortage forced it to give up five sites where they were going to build new stores. Going public could solve the cash problem. Thus far, there were a number of different partnership agreements for the various stores.

So Rob started to work on the plan, which was to consolidate all these partnerships into one company and then sell about 20 percent of it to the public. At the time, our family owned probably 75 percent of the company, Bud owned 15 percent or so, some other relatives owned a percentage…

(Photo by Designer491)

Anybody who bought stock in Wal-Mart’s first public offering in late 1970 – at a price of $16.50 per share – and who held it, did extraordinarily well. Walton:

…let’s say you bought 100 shares back in that original public offering, for $1,650. Since then, we’ve had nine two-for-one stock splits, so you would have 51,200 shares today. Within the last year, it’s traded at right under $60 a share. So your investment would have been worth right around $3 million…

An investment of $1,650 in late 1970 would have turned into $3 million over the ensuing two decades. An investment of $16,500 would have become $30 million. Since then, Wal-Mart has continued to grow, albeit more slowly.

Going public allowed Walton to pay off all his debts.

Walton never worried about market expectations, especially over the short term:

If we fail to live up to somebody’s hypothetical projection for what we should be doing, I don’t care. It may knock our stock back a little, but we’re in it for the long run. We couldn’t care less about what is forecast or what the market says we ought to do. If we listened very seriously to that sort of stuff, we never would have gone into small-town discounting in the first place.

 

ROLLING OUT THE FORMULA

Jack Shewmaker, later president and COO, made this remark about working at Wal-Mart in 1970:

It would be safe to say that in those days we all worked a minimum of sixteen hours day.

(Illustration by Roman Doroshenko)

Kmart was expanding rapidly, but wouldn’t go into towns with below 50,000 population. Gibson’s, another prominent discounter, wouldn’t go into towns much below 10,000. But Wal-Mart knew it could be profitable even in towns with under 5,000. As for big cities:

We never planned on actually going into the cities. What we did instead was build our stores in a ring around a city – pretty far out – and wait for the growth to come to us. That strategy worked practically everywhere.

The airplane became a useful tool for looking at real estate. When Walton was flying, he would get low and turn the plane on its side when he passed over real estate of interest.

Walton would visit individual stores as often as possible, and he expected his executives to do the same. But much of the day-to-day operations Walton left to folks like Ferold Arend and Ron Mayer, then later Jack Shewmaker, and after that David Glass and Don Soderquist. Walton sees his role as picking good people and then giving them maximum authority and responsibility. Many have pointed out that Walton is extremely good at picking the right people.

Every Saturday morning, Walton would go to work at 2 or 3 a.m. He would spend several hours examining data for many of the stores. This allowed him to be prepared for the Saturday morning meeting at 7:30 a.m. Walton:

But if you asked me am I an organized person, I would have to say flat no, not at all. Being organized would really slow me down. In fact, it would probably render me helpless. I try to keep track of what I’m supposed to do, and where I’m supposed to be, but it’s true I don’t keep much of a schedule.

Walton fondly recalls this initial period:

Managing that whole period of growth was the most exciting time of all for me personally. Really, there has never been anything quite like it in the history of retailing. It was the retail equivalent of a real gusher: the whole thing, as they say in Oklahoma and Texas, just sort of blowed. We were bringing great folks on board to help make it happen, but at that time, I was involved in every phase of the business: merchandising, real estate, construction, studying the competition, arranging the financing, keeping the books – everything. We were all working untold hours, and we were tremendously excited about what was going on.

(Photo byBj¸rn Hovdal)

Wal-Mart’s phenomenal growth:

Year	Stores	Sales
1970	32	$31 million
1972	51	$78 million
1974	78	$168 million
1976	125	$340 million
1978	195	$678 million
1980	276	$1.2 billion

Walton observes:

On paper, we really had no right to do what we did. We were all pounding sand, and stretching our people and our talents to the absolute maximum.

Walton would hire people who lacked experience but showed potential. He believed that a lack of knowledge and experience could be overcome with passion and a willingness to work extremely hard.

Distribution continued to be challenging:

…I don’t think our distribution system ever really got under complete control until David Glass finally relented and came on board in 1976. More than anybody else, he’s responsible for building the sophisticated and efficient system we use today.

 

BUILDING THE PARTNERSHIP

Giving associates a stake in the business, and giving them the chance to participate in decisions that would impact profitability, was an essential part of Wal-Mart’s growth and success.

(Photo by Adonis1969)

Walton realized that the more you share profits with associates, the more profitable the company can become. Walton explains:

…the way management treats the associates is exactly how the associates will then treat the customers. And if the associates treat the customers well, the customers will return again and again, andthat is where the real profit in this business lies, not in trying to drag strangers into your stores for one-time purchases based on splashy sales or expensive advertising. Satisfied, loyal, repeat customers are at the heart of Wal-Mart’s spectacular profit margins, and those customers are loyal to us because our associates treat them better than salespeople in other stores do.

Walton says this biggest regret is not including associates in the initial profit-sharing plan when the company went public in 1970. But in 1971, Walton started giving associates part ownership of the business. Many associates realized they were better off working at Wal-Mart – which is non-unionized – than they would be working somewhere that is unionized. Why? Both because associates can become part owners and because Wal-Mart executives have a policy of always listening to any associate with an issue or idea.

 

STEPPING BACK

One of Walton’s hobbies was tennis, which he preferred to golf since golf takes too long. Walton’s tennis partner George Billingsley says about Walton:

He loved the game. He never gave you a point, and he never quit. But he is a fair man. To him, the rules of tennis, the rules of business, and the rules of life are all the same, and he follows them. As competitive as he is, he was a wonderful tennis opponent – always gracious in losing and in winning. If he lost, he would say, ‘I just didn’t have it today, but you played marvelously.’

Walton also enjoyed training his dogs:

I pride myself on being able to train my own dogs, and I’ve never had a dog handler, like some of these country gentlemen friends of mine. I enjoy picking out ordinary setter or pointer pups and working with them…

Walton nearly always had his dogs with him when he drove around. He loved the outdoors and was a believer in conservation. Also, he liked to hunt birds. Some of his best friends were bird hunters.

(Photo by Cynoclub)

Walton stepped back somewhat from Wal-Mart in 1976. Unfortunately, two factions in the company developed and they began to compete fiercely. The old guard, including many store managers, were loyal to Ferol. The new guard lined up behind Ron. (Many in the new guard had been hired by Ron.) Soon everybody began taking sides. It was very unhealthy.

Walton made the problem much worse by appointing Ron CEO. Walton thought things might run OK this way. But Walton couldn’t stay out of things. He continued doing everything he was doing before.

The truth is, I failed at retirement worse than just about anything else I’ve ever tried.

Walton didn’t think the company was going in the right direction, so he decided to step back in as CEO. He asked Ron to stay as vice chairman and CFO. But Ron had wanted to run the company, so he decided to leave.

Before he left, Ron told Walton that Wal-Mart had such a strong organization that it would continue to do well. But Ron’s faith in Wal-Mart didn’t prevent roughly one third of senior managers from leaving after Ron left.

Walton believes most setbacks can be turned into opportunities. He promoted Jack Shewmaker to executive vice president of operations, personnel, and merchandise. And Walton hired David Glass as executive vice president in charge of finance and distribution.

These two guys are completely different in personality, but they are both whip smart. And with us up against it like we were, everybody had to head in the same direction. Once again, Wal-Mart proved everybody wrong, and we just blew the doors off our previous performances. David made us a stronger company almost immediately. Ron Mayer may have been the architect of our original distribution systems, but David Glass, frankly, was much better than Ron at distribution, and that was one of the big areas of expertise I had been afraid of losing. David also was much better at fine-tuning and honing our accounting systems. He, along with Jack, was a powerful advocate for much of the high technology that keeps us operating and growing today. And not only did he turn out to be a great chief financial officer, he also proved to be a fine talent with people. This new team was even more talented, more suited for the job at hand than the previous one.

 

CREATING A CULTURE

(Photo by Maurizio Distefano)

Saturday morning meetings often began with a cheer. Walton:

It’s sort of a “whistle while you work” philosophy, and we not only have a heck of a good time with it, we were better because of it. We build spirit and excitement. We capture the attention of our folks and keep them interested, simply because they never know what’s coming next. We break down barriers, which helps us communicate better with one another. And we make our people feel part of a family in which no one is too important or too puffed up to lead a cheer or be the butt of a joke…

In 1984, Walton lost a bet to David Glass and “had to pay up by wearing a grass skirt and doing the hula on Wall Street.” (Glass bet that the company would achieve a pretax profit of more than 8 percent; Walton bet against it.) While outsiders might have viewed it as a publicity stunt, Walton observes that it’s a part of Wal-Mart’s culture to make things interesting, unpredictable, and fun.

…we thrive on a lot of the traditions of small-town America, especially parades with marching bands, cheerleaders, drill teams, and floats. Most of us grew up with it, and we’ve found that it can be even more fun when you’re an adult who usually spends all your time working. We love all kinds of contests, and we hold them all the time for everything from poetry to singing to beautiful babies. We like theme days, where everyone in the store dresses up in costume.

Wal-Mart turned its annual meeting for shareholders into a fun, two-day event.

One potential problem for nearly all large companies is resistance to change. Walton writes:

So I’ve made it my own personal mission to ensure that constant change is a vital part of the Wal-Mart culture itself… In fact, I think one of the greatest strengths of Wal-Mart’s ingrained culture is its ability to drop everything and turn on a dime.

Ongoing education is also important. Associates can go to the Wal-Mart Institute at the University of Arkansas. Or they can, with the company’s help, earn college degrees.

 

MAKING THE CUSTOMER NUMBER ONE

(Photo by Feelfree777)

For my whole career in retailing, I have stuck with one guiding principle… the secret of successful retailing is to give your customers what they want. And really, if you think about it from your point of view as a customer, you want everything: a wide assortment of good quality merchandise; the lowest possible prices; guaranteed satisfaction with what you buy; friendly, knowledgeable service; convenient hours; free parking; a pleasant shopping experience.

Walton defends Wal-Mart:

Of all the notions I’ve heard about Wal-Mart, none has ever baffled me more than this idea that we are somehow the enemy of small-town America. Nothing could be further from the truth: Wal-Mart has actually kept quite a number of small towns from becoming practically extinct by offering low prices and saving literally billions of dollars for the people who live there, as well as by creating hundreds of thousands of jobs in our stores.

Beyond its direct economic impact – customers vote with their feet and have saved huge amounts of money – Wal-Mart is committed to creating a sense of community in its managers and associates. Community involvement is important.

In the early days of Wal-Mart, department stores put pressure on Wal-Mart. The department stores didn’t like the fact that many of their customers were switching to Wal-Mart simply because Wal-Mart’s prices were much lower. The department stores even tried to use “fair trade” laws to block discounters from doing business.

Furthermore, Wal-Mart’s vendors weren’t all happy about Wal-Mart’s determination to get the lowest possible prices from them. Walton spells out his company’s reasoning:

…we are the agents for our customers. And to do the best job possible, we’ve got to become the most efficient deliverer of merchandise that we can. Sometimes that can best be accomplished by purchasing goods directly form the manufacturer. And other times, direct purchase simply doesn’t work. In those cases, we need to use middlemen to deal with smaller manufacturers and make the process more efficient. What we believe in strongly is our right to make that decision – whether to buy directly or from a rep – based on what it takes to best serve our customers.

 

MEETING THE COMPETITION

Walton:

…We decided that instead of avoiding our competitors, or waiting for them to come to us, we would meet them head-on. It was one of the smartest strategic decisions we ever made… Our competitors have honed and sharpened us to an edge we wouldn’t have without them.

(Photo by Nataliia Shcherbyna)

Bud Walton:

Competition is very definitely what made Wal-Mart – from the very beginning. There’s not an individual in these whole United States who has been in more retail stores – all types of retail stores, too, not just discount stores – than Sam Walton. Make that all over the world. He’s been in stores in Australia and South America, Europe and Asia and South Africa. His mind is just so inquisitive when it comes to this business. And there may not be anything he enjoys more than going into a competitor’s store trying to learn something from it.

At a regional meeting of discounters, competitors went through Wal-Mart’s stores and offered their critiques. Wal-Mart executives were surprised at how many things they weren’t doing well. But they listened carefully and made adjustments accordingly. Those adjustments were crucial in preparing Wal-Mart to begin competing more broadly with Kmart. (Kmart had 1,000 stores while Wal-Mart only had 150 at that time.)

Many discounters were driven out of business in the mid-1970s when the economy weakened. Wal-Mart began to buy struggling retailers. In 1981, Wal-Mart had almost no stores east of the Mississippi. But Kuhn’s Big K stores – with 112 locations – was faltering. Wal-Mart had a difficult time deciding what to do, but they finally acquired Kuhn’s. After working through some problems related to the acquisition, Wal-Mart was now in a position to keep growing amazingly fast. Walton:

We exploded from that point on, almost always opening 100 new stores a year, and more than 150 in some years…

I don’t know how the folks around executive offices see me, and I know they get frustrated with the way I make everybody go back and forth on so many issues that come up. But I see myself as being a little more inclined than most of them are to take chances. On something like the Kuhn’s decision, I try to play a “what-if” game with the numbers – but it’s generally my gut that makes the final decision.

 

EXPANDING THE CIRCLES

…one of the main reasons we’ve been able to roll this company out nationally was all the pressure put on me by guys like David Glass and, earlier, Jack Shewmaker and Ron Mayer, to invest so heavily in technology. Yes, I argued and resisted, but I eventually signed the checks. And we have been able to move way out front of the industry in both communications and distribution… I would go so far as to say, in fact, that the efficiencies and economies of scale we realize from our distribution system give us one of our greatest competitive advantages.

Many people have contributed over the years, but David Glass has to get the lion’s share of the credit for where we are today in distribution. David had a vision for automated distribution centers – linked by computer both to our stores and to our suppliers – and he set about building such a system, beginning in 1978 at Searcy, Arkansas.

Wal-Mart’s warehouses reached a point where they could directly replenish nearly 85 percent of inventory compared to 50 to 65 percent for competitors. When in-store merchants place computer orders, the orders arrive at the store in about two days. Most competitors had to wait five or more days for their orders to arrive.

Wal-Mart has a private fleet of trucks. Walton would regularly meet in the drivers’ break room at 4 a.m. with a bunch of doughnuts. He would ask them all sorts of questions about the stores. Most truck drivers were very candid, which gave Walton another way to gain store-level intelligence.

(Wal-Mart distribution center, Photo by Redwood8)

Walton describes a distribution center:

Start with a building of around 1.1 million square feet, which is about as much floor space as twenty-three football fields, sitting out somewhere on some 150 acres. Fill it high to the roof with every kind of merchandise you can imagine, from toothpaste to TV’s, toilet paper to toys, bicycles to barbecue grills. Everything in it is bar-coded, and a computer tracks the location and movement of every case of merchandise, while it’s stored and when it’s shipped out. Some six hundred to eight hundred associates staff the place, which runs around the clock, twenty-four hours a day. On one side of the building is a shipping dock with loading doors for around thirty trucks at a time – usually full. On the other side is the receiving dock, which may have as many as 135 doors for unloading merchandise.

These goods move in and out of the warehouse on some 8 1/2 miles of laser-guided conveyor belts, which means that the lasers read the bar codes on the cases and then direct them to whatever truck is filling the order placed by one of the stores it’s servicing that night… When the thing is running full speed, it’s just a blur of boxes and crates flying down those belts, red lasers flashing everywhere, directing this box to that truck, or that box to this truck. Out in the parking lot, whole packs of Wal-Mart trucks rumble in and out all day.

 

THINKING SMALL

Walton on thinking small:

…the bigger Wal-Mart gets, the more essential it is that we think small. Because that’s exactly how we have become a huge corporation – by not acting like one… If we ever forget that looking a customer in the eye, and greeting him or her, and asking politely if we can be of help is just as important in every Wal-Mart today as it was in that little Ben Franklin in Newport, then we just ought to go into a different business because we’ll never survive in this one.

In a giant, centrally driven company, there’s no place for creativity, no room for the maverick merchant, no need for the entrepreneur or the promoter.

Walton shares six principles for how to think small:

• Think One Store at a Time
• Communicate, Communicate, Communicate
• Keep Your Ear to the Ground
• Push Responsibility – and Authority – Down
• Force Ideas to Bubble Up
• Stay Lean, Fight Bureaucracy

Think One Store at a Time

The focus always has to be on lowering prices, improving service, and making things better for customers who shop in the stores. Similarly, getting the right merchandising mix requires merchandisers at the store level, who deal with customers face to face, day in and day out.

When managers meet at the end of the week, the discussion of sales is at the individual store level. No other large retailer does that.

Communicate, Communicate, Communicate

Walton says:

If you had to boil down the Wal-Mart system to one single idea, it would probably be communication, because it is one of the real keys to our success.

[…]

That’s why we’ve spent hundreds of millions of dollars on computers and satellites – to spread all the little details around the company as fast as possible.

Sometimes Walton would get a message to everyone by doing a TV recording. One time, he had all the associates pledge to follow “the ten-foot rule.” If you come within 10 feet of a customer, look her in the eye, greet her, and ask her if you can help her. Walton told all the associates that, if they did this, not only would it be better for customers, but the associates themselves would become better leaders in the process.

Keep Your Ear to the Ground

Both district managers and regional managers are expected to travel around to individual stores, just as Walton himself used to do all the time. Valuable intelligence is always available using this approach.

As with any retailer, there’s always a head-to-head confrontation between operations and merchandising. At Wal-Mart, there are some enormous arguments. But they have a rule never to leave an item hanging in the weekly meeting. They always make a decision. Sometimes it’s wrong and gets corrected ASAP. But once the decision is made, everyone is on board as long as the decision stands.

Push Responsibility – and Authority – Down

As much as possible, every level of manager is given responsibility and authority – and is rewarded with equity. Many Wal-Mart managers who never went to college end up performing very well.

Force Ideas to Bubble Up

This goes with pushing responsibility down. Any associate can have a good idea about how to improve something. It’s happened countless times at Wal-Mart.

Stay Lean, Fight Bureaucracy

Bureaucracy builds up naturally unless the culture is to eliminate or limit bureaucracy as much as possible. Walton is committed to not letting egos get out of control because, in his view, much bureaucracy is the result of some empire builder’s ego.

 

RUNNING A SUCCESSFUL COMPANY: TEN RULES THAT WORKED FOR ME

• RULE 1: COMMIT to your business. Believe in it more than anybody else. I think I overcame every single one of my personal shortcomings by the sheer passion I brought to my work.
• RULE 2: SHARE your profits with all your associates, and treat them as partners. In turn, they will treat you as a partner, and together you will all perform beyond your wildest expectations.
• RULE 3: MOTIVATE your partners. Money and ownership alone aren’t enough. Constantly, day by day, think of new and more interesting ways to motivate and challenge your partners. Set high goals, encourage competition, and then keep score. If things get stale, cross-polinate; have managers switch jobs with one another to stay challenged… Don’t become too predictable.
• RULE 4: COMMUNICATE everything you possibly can to your partners. The more they know, the more they’ll understand. The more they understand, the more they’ll care.
• RULE 5: APPRECIATE everything your associates do for the business… all of us like to be told how much somebody appreciates what we do for them.
• RULE 6: CELEBRATE your successes. Find some humor in your failures. Don’t take yourself so seriously. Loosen up, and everybody around you will loosen up. Have fun. Show enthusiasm – always.
• RULE 7: LISTEN to everyone in your company. And figure out ways to get them talking. The folks on the front lines – the ones who actually talk to the customer – are the only ones who really know what’s going on out there.
• RULE 8: EXCEED your customers’ expectations. If you do, they’ll come back over and over. Give them what they want – and a little more. Let them know you appreciate them. Make good on all your mistakes, and don’t make excuses – apologize. Stand behind everything you do.
• RULE 9: CONTROL your expenses better than your competition. This is where you can always find the competitive advantage.
• RULE 10: SWIM upstream. Go the other way. Ignore the conventional wisdom. If everybody else is doing it one way, there’s a good chance you can find your niche by going in exactly the opposite direction. But be prepared for a lot of folks to wave you down and tell you you’re headed the wrong way.

 

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: https://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 approachesintrinsic 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: [email protected]

 

 

 

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.

April 10, 2022

I was an overnight success all right, but thirty years is a long, long night.

In Grinding It Out,Ray Kroc tells the story of how he created McDonald’s. Kroc launched the company in 1954 when he was 52 years old. Twenty-two years later McDonald’s topped one billion in total revenue.

(Photo by Ruslan Gilmanshin)

 

CHAPTER 1

Kroc spent seventeen years selling paper cups before he discovered a five-spindled milk-shake machine called the Multimixer. Kroc:

It wasn’t easy to give up security and a well-paying job to strike out on my own… I plunged gleefully into my campaign to sell a Multimixer to every drug store soda fountain and dairy bar in the nation. It was a rewarding struggle. I loved it. Yet I was alert to other opportunities.

(Multimixer, Photo by Visitor7, via Wikimedia Commons)

Kroc began to hear about the McDonald brothers. They had not just one Multimixer. Nor just two or three. They had eight Multimixers. This peaked Kroc’s curiosity, so he went to look at the McDonald brothers’ operation in San Bernardino, California.

At first, Kroc wasn’t impressed. But then he saw all the helpers arriving and setting up. Soon they were moving really fast. And flocks of people were in line getting hamburgers. Each hamburger was only 15 cents, and there was almost no wait between the customer placing an order and the order being filled.

Kroc spoke with several customers and learned that they just loved the food. Kroc was captivated by the system. He asked the McDonald brothers to join him for dinner, which they did:

I was fascinated by the simplicity and effectiveness of the system they described that night. Each step in producing the limited menu was stripped down to its essence and accomplished with a minimum of effort. They sold hamburgers and cheeseburgers only. The burgers were a tenth of a pound of meat, all fried the same way, for fifteen cents. You got a slice of cheese on it for four cents more. Soft drinks were ten cents, sixteen-ounce milk shakes were twenty cents, and coffee was a nickel.

The McDonald brothers showed Kroc the design of a new drive-in building. It was red and white with touches of yellow. There was a set of arches that went through the roof. There was also a tall sign out front with arches illuminated by neon tubes.

Kroc’s excitement grew:

That night in my motel room I did a lot of heavy thinking about what I’d seen during the day. Visions of McDonald’s restaurants dotting crossroads all over the country paraded through my brain. In each store, of course, were eight Multimixers whirring away and paddling a steady flow of cash into my pockets.

The next day, Kroc returned to see the operation in action again. He paid particular attention to how the french fries were made. McDonald’s french fries were outstanding and a key to the store’s success. Kroc observed carefully and thought that he had memorized the process for making terrific french fries. Kroc admits this was a mistake because he missed a few things.

Kroc met with Mac and Dick McDonald again. This time, Kroc asked them why they didn’t expand into a chain. The brothers demurred. When pressed, they pointed to their house on a hill. They said they were leading a peaceful existence and didn’t want any more problems. Eventually, Kroc said that he himself could open up the new locations.

 

CHAPTER 2

Kroc:

When I flew back to Chicago that fateful day in 1954, I had a freshly signed contract with the McDonald brothers in my briefcase. I was a battle-scared veteran of the business wars, but I was still eager to go into action. I was 52 years old. I had diabetes and incipient arthritis. I had lost my gall bladder and most of my thyroid gland in earlier campaigns. But I was convinced the best was ahead of me. I was still green and growing, and I was flying along at an altitude slightly higher than a plane.

Kroc recounts that he was born in Oak Park, just west of Chicago, in 1902. Kroc’s parents were of Czech origin – Bohemians, as Ray says. His father, Louis Kroc, had gone to work for Western Union at age twelve and had worked his way up. Ray Kroc’s mother, Rose, was “a loving soul.” She gave piano lessons to make extra money.

(Czech Republic on map with flag pin, Photo by Sjankauskas)

Ray Kroc’s brother, Bob, became a professor and medical researcher, but Ray wasn’t much interested in school. Ray wasn’t even interested in reading books:

I was never much of a reader when I was a boy. Books bored me. I liked action. But I spent a lot of time thinking about things. I’d imagine all kinds of situations and how I would handle them.

…

They called me Danny Dreamer a lot, even later when I was in high school and would come home all excited about some scheme I’d thought up. I never considered my dreams wasted energy; they were invariably linked to some form of action. When I dreamed about having a lemonade stand, for example, it wasn’t long before I set up a lemonade stand. I worked hard at it, and I sold a lot of lemonade. I worked at a grocery store one summer when I was still in grammar school. I worked at my uncle’s drug store. I worked in a tiny music store I’d started with two friends. I worked at something whenever possible. Work is the meat in the hamburger of life. There is an old saying thatall work and no play makes Jack a dull boy. I never believed it because, for me, work was play. I got as much pleasure out of it as I did from playing baseball.

Kroc went with his father to see many Chicago Cubs games. The Cubs were contenders then.

Kroc enjoyed working for his uncle Earl Edmund Sweet’s drug store soda fountain in Oak Park.

That was where I learned that you could influence people with a smile and enthusiasm and sell them a sundae when what they’d come for was a cup of coffee.

Kroc learned to play the piano well. He thought he could make money as a piano man. He ended up going into the music store business with two friends. But it didn’t really work.

Though Kroc didn’t like school–one reason being that the progress felt much too slow–there was one school activity he did like: debating.

When World War I came, Kroc got a job selling coffee beans and novelties door-to-door. He thought he wouldn’t need to go back to school. Soon Kroc felt he should be a part of the war effort. Kroc:

My parents objected strenuously, but I finally talked them into letting me join up as a Red Cross ambulance driver. I had to lie about my age, of course, but even my grandmother could accept that. In my company, which assembled in Connecticut for training, was another fellow who had lied about his age to get in. He was regarded as a strange duck, because whenever we had time off and went out on the town to chase girls, he stayed in camp drawing pictures. His name was Walt Disney.

Kroc writes that he wanted to be a salesman, and also to play the piano. For a time, he sold novelty ribbons. Kroc was doing well:

In 1919 anyone making twenty-five or thirty dollars a week was doing well, and it wasn’t long before–on good weeks with a lot of musical jobs–I was making more money than my father.

Kroc had several jobs as a piano man, including playing in a band at Paw-Paw Lake, Michigan. That’s where he met his first wife, Ethel Flemming, of Scottish background.

Kroc continues:

My next job was in Chicago’s financial district as a board marker on the New York Curb, as the market that became the American Stock Exchange used to be called. My employer was a firm named Wooster-Thomas. A substantial sound to that, I thought. My job was to read the ticker tape and translate the symbols from it into prices that I posted on the blackboard for the scrutiny of the gentlemen who frequented our office. I later learned that the impressive-sounding name fronted a bucket-shop operation that was selling watered stock all over the place.

A bit later, Kroc got a job selling Lily brand paper cups.

 

CHAPTER 3

Kroc was selling Lily paper cups from early in the morning until 5:00 or 5:30pm. He says he would have worked longer, but he had a job playing piano at radio station WGES in Oak Park. Kroc worked at WGES 6pm to 8pm, and then 10pm to 2am. Kroc:

I was driven by ambition. I hated to be idle for a minute.

(Photo of paper cups by Fedoseeva Galina)

Kroc again:

My cup sales kept growing as I learned how to plan my work and work my plan. My confidence grew at the same rate. I found that my customers appreciated a straightforward approach. They would buy if I made my pitch and asked for their order without a lot of beating around the bush. Too many salesmen, I found, would make a good presentation and convince the client, but they couldn’t recognize that critical moment when they should have stopped talking. If I ever notice my prospect starting to fidget, glancing at his watch or looking out the window or shuffling the papers on his desk, I would stop talking right then and ask for his order.

Winter of 1924 was tough for the paper cup business. Kroc notes that one reason he didn’t do well was because he put the customer first:

My philosophy was one of helping my customer, and if I couldn’t sell him by helping him improve his own sales, I felt I wasn’t doing my job.

Kroc started doing well in the paper cup business. But knowing how things slowed down in the winter, Kroc took a 5-month leave of absence. He got a job in Fort Lauderdale, Florida, selling real estate for W. F. Morang & Son. Kroc quickly became a top salesman.

The property was underwater, but there was a solid bed of coral rock beneath, and the dredging for the intercoastal raised all the lots high and dry, with permanent abutments. People who purchased those lots really got a bargain, even though the prices were astronomical for those times, because the area is now one of the most beautiful in all of Florida, and lots there are worth many times what they sold for then.

Of course, there were many lots sold at that time that didn’t turn out to be good investments at all. There was a great deal of chicanery. After a crackdown, Kroc got a job playing piano before returning to Chicago.

 

CHAPTER 4

From 1927 to 1937, Kroc focused entirely on selling paper cups. The paper container industry was undergoing several changes. But then the stock market crashed in 1929, which ushered in the Great Depression. Kroc’s father, who had been successfully speculating in real estate, was hit hard.

In 1930, Kroc saw an opportunity at the soda fountains in Walgreen’s Drug Company.

(Soda fountain, Photo by Bigapplestock)

At Walgreen’s, customers could buy sodas “to go.” Kroc tried to convince the food service man for Walgreen’s, a man named McNamarra. No go. But then Kroc got McNamarra to try it for one month using free cups.

Finally he agreed. I brought him the cups, and we set the thing up at one end of the soda fountain. It was a big success from the first day. It wasn’t long before McNamarra was more excited about the idea of takeouts than I was. We went in to see Fred Stoll, the Walgreen purchasing agent, and set up what was to be a highly satisfactory arrangement for both of us. The best part of it for me personally was that every time I saw a new Walgreen’s store going up it meant new business. This sort of multiplication was clearly the way to go. I spent less and less time chasing pushcart vendors around the West Side and more time cultivating large accounts where big turnover would automatically winch in sales in the thousands and hundreds of thousands. I went after Beatrice Creamery, Swift, Armour, and big plants with in-factory food service systems such as U.S. Steel.

Soon Kroc had roughly fifteen salesmen working for him.

I loved to see one of these young fellows catch hold and grow in his job. It was the most rewarding thing I’d ever experienced.

Kroc counselled his salesmen to sell themselves first, which would make it easier to sell paper cups.

Kroc mentions one of his customers, Ralph Sullivan in Battle Creek, Michican, who invented a new way to make milk shakes:

Ralph had come up with the idea of reducing butterfat content in a milk shake by making it with frozen milk. The traditional method of making a shake was to put eight ounces of milk into a metal container, drop in two small scoops of ice cream, add flavoring, and put the concoction onto a spindle mixer. Ralph’s formula was to take regular milk, add a stabilizer, sugar, corn starch, and a bit of vanilla flavoring and freeze it. The result was ice milk. He would put four ounces of milk into a metal container, drop in four scoops of this ice milk, and finish it off in the traditional way. The result was a much colder, much more viscous drink, and people loved it. The lines around his store in the summertime were nothing less than amazing. This ice milk shake had a lot of advantages over regular milk shakes. Instead of being a thin, semicool drink, it was thick and very cold.

The Multimixer was a piece of equipment that could make five milk shakes at once. It was a game changer. Kroc ended up leaving the paper cup business in order to sell Multimixers. Kroc formed a partnership with the inventor of the Multimixer, Earl Prince.

 

CHAPTER 5

Kroc encountered a great deal of adversity in his life, especially when he was trying to sell Multimixers.

For me, this was the first phase of grinding it out– building my personal monument to capitalism. I paid tribute… for many years before I was able to rise with McDonald’s on the foundation I had laid. Perhaps without that adversity I might not have been able to persevere later on when my financial burdens were redoubled.

(Illustration by Chris Dorney)

Kroc successfully marketed Multimixers at restaurant and dairy association conventions. Soon Kroc was so busy that he had to hire a bookkeeper. Partly by luck, he found Mrs. June Martino. She was warm and compassionate, but also focused and able. June studied electronics at Northwestern University. Because higher mathematics was difficult for her, she had a tutor. She was determined and “no challenge was too big for her,” notes Kroc.

 

CHAPTER 6

In Southern California in the early 1930s, the drive-in restaurant came into existence. Mac and Dick McDonald were New Englanders who moved to Southern California to work on movies. At one point, they ran their own movie theatre. Sometimes they only ate on meal a day in order to save money. They would have a hot dog from a nearby stand.

Dick McDonald later recalled that he and his brother noticed that the hot dog stand was the only business doing well then. That probably gave the brothers the idea of launching a drive-in restaurant.

The McDonald brothers’ first restaurant in San Bernardino was doing a great deal of business, but it still wasn’t very profitable. Kroc:

So they did a courageous thing. They closed that successful restaurant in 1948 and reopened it a short time later with a radically different kind of operation. It was a restaurant stripped down to the minimum in service and menu, the prototype for legions of fast-food units that later would spread across the land. Hamburgers, fries, and beverages were prepared on an assembly line basis, and, to the amazement of everyone, Mac and Dick included, the thing worked! Of course, the simplicity of the procedure allowed the McDonalds to concentrate on quality in every step, and that was the trick.

(Original McDonald’s fast food restaurant, Photo by Cogart Strangehill, via Wikimedia Commons)

Kroc reached an agreement with the McDonald brothers. Kroc would be able to franchise copies of McDonald’s everywhere in the United States. He admits he made a mistake in the contract with the McDonalds: any changes to Kroc’s units would have to be put in writing, signed by both brothers, and sent by registered mail. The McDonalds had an affable openness and Kroc trusted them. But there would be problems later.

The agreement stipulated that Kroc would receive 1.9 percent of gross sales from franchisees. Of that, 0.5 percent would go to the McDonald brothers. Kroc also could charge an initial franchise fee of $950 for each license.

Making great french fries was essential:

…I had explained to Ed MacLuckie with great pride the McDonald’s secret for making french fries. I showed him how to peel the potatoes, leaving just a bit of the skin to add flavor. Then I cut them into shoestring strips and dumped them into a sink of cold water. The ritual captivated me. I rolled my sleeves to the elbows and, after scrubbing down in proper hospital fashion, I immersed my arms and gently stirred the potatoes until the water went white with starch. Then I rinsed them thoroughly and put them into a basket for deep frying in fresh oil.

The only trouble was that, after following this process, the french fries tasted like mush. Something had gone wrong or there was a missing step. Eventually Kroc learned that potatoes taste better if they’re allowed to dry out. (Without knowing it, the McDonald brothers had been letting their potatoes dry in the desert breeze.) It took Kroc and associates three months before they perfected the process of making french fries.

Kroc’s first store was in a mediocre location, but it did well. Many of Kroc’s golfing friends from Rolling Green became successful McDonald’s operators.

Kroc frequently helped prepare a McDonald’s for opening. He didn’t mind mopping or cleaning the restrooms, even if he was in his suit.

 

CHAPTER 7

Harry Sonneborn resigned as vice-president of Tastee-Freeze and sold all his stock because he wanted to work in Ray Kroc’s organization. Sonneborn had noticed how exceptionally well a McDonald’s restaurant nearby was doing. Kroc told him that McDonald’s couldn’t afford to hire him. However, the company needed the help and Harry was persistent. McDonald’s ended up hiring him.

Kroc envisioned Sonneborn dealing with finance, June Martino running the office, and he himself managing operations and new development. Kroc, Sonneborn, and Martino worked extremely hard, but it was also fun:

We were breaking new ground, and we had to make a lot of fundamental decisions that we live with for years to come. This is the most joyous kind of executive experience. It’s thrilling to see your creation grow.

(Old style McDonald’s, Photo by Wahkeenah, via Wikimedia Commons)

Kroc writes that one fundamental decision he made was that the corporation would not be a supplier for its operators. Kroc explains:

My belief was that I had to help the individual operator succeed in every way I could. His success would ensure my success. But I couldn’t do that and, at the same time, treat him as a customer. There is a basic conflict in trying to treat a man as a partner on the one hand while selling him something at a profit on the other. Once you get into the supply business, you become more concerned about what you are making on sales to your franchisee than with how his sales are doing… Our method enabled us to build a sophisticated system of purchasing that allows the operator to get his supplies at rock-bottom prices.

Opening new locations was slow and painful work. Kroc describes what they were trying to build:

We wanted to build a restaurant system that would be known for food of consistently high quality and uniform methods of preparation.

(Photo by Ben Garney, via Wikimedia Commons)

Kroc and associates also realized that McDonald’s should go into the restaurant development business. The idea came from Harry Sonneborn. They started Franchise Realty Corporation with $1,000 paid-in capital. Harry turned that into $170 million worth of real estate. The idea was to get a property owner to lease his land on a subordinated basis. Kroc observes:

This was the beginning of real income for McDonald’s. Harry devised a formula for the monthly payments being made by our operators that paid our own mortgage and other expenses plus a profit. We received this monthly minimum or a percentage of the volume the operator did, whichever was greater.

Harry succeeded in getting life insurance companies to invest, which gave McDonald’s the capital they needed to keep growing rapidly.

Kroc notes the gratitude he felt toward Harry Sonneborn and June Martino:

…June later told me that all the while her two boys were growing up, she never made it to one of their birthday parties or graduation ceremonies, and there were several times that she had to be in the office on Christmas. I knew what she and Harry were doing, because I was in the same boat… I couldn’t give them raises to compensate them for their past efforts, but I could make sure that they would be rewarded when McDonald’s became one of the country’s major companies, which I never doubted it would. I gave them stock – ten percent to June and twenty percent to Harry – and ultimately it would make them rich.

 

CHAPTER 8

Fred Turner was a terrific worker and natural leader, says Kroc. At first, Turner was going to be a franchisee. To get experience, he started out as a worker in an already established McDonald’s. But Kroc realized that Turner should be in charge of corporate operations. Turner started at headquarters in January 1957. The company opened twenty-five new locations that year, and Turner was involved in every one.

Also involved in each opening in 1957 was Jim Schindler, a stainless-steel supplier from Leitner Equipment Company. At June’s suggestion, Kroc hired Schindler. Kroc had to pay him $12,000 a year, more than Harry, June, or Ray himself was getting. Kroc remarks that Schindler might not have come on board for that salary had he not had a Bohemian background like Kroc.

Kroc comments on a difference between Sonneborn and himself:

Harry was the scholarly type. He analyzed situations on the basis of management theory and economic principles. I proceeded on the strength of my salesman’s instinct and my subjective assessment of people.

(Illustration by Airdone)

Although he wasn’t perfect, Kroc excelled at picking the right people, which was central to McDonald’s success. But Kroc couldn’t explain exactly how he did it.

Sonneborn and Kroc complemented each other in many ways. And Fred Turner added another dimension. For instance, the hamburger bun was an object of close attention for McDonald’s. Fred Turner had some ideas:

We were buying our buns in the midwest from Louis Kuchuris’ Mary Ann Bakery. At first they were cluster buns, meaning that the buns were attached to each other in clusters of four to six, and they were only partially sliced. Fred pointed out that it would be much easier and faster for a griddle man if we had individual buns instead of clusters and if they were sliced all the way through. The baker could afford to do it our way because of the large quantities of buns we were ordering. Fred also worked with a cardboard box manufacturer on the design of a sturdy, reusable box for our buns. Handling these boxes instead of the customary packages of twelve reduced the baker’s packaging cost, so he was able to give us a better price on the buns. It also reduced our shipping costs and streamlined our operations. With the old packages, it didn’t take long for a busy griddle man to find himself buried in paper. Then there was the time spent opening packages, pulling buns from the cluster, and halving them. These fractions of seconds added up to wasted minutes. A well-run restaurant is like a winning baseball team, it makes the most of every crew member’s talents and takes advantage of every split-second opportunity to speed up service.

Many suppliers were getting the chance of a lifetime to grow with McDonald’s. For example, Mary Ann Bakery went from being a small company to having a plant with a quarter-mile long conveyor belt.

Keep in mind that headquarters set the standards for quality, and also made recommendations for packaging. But each franchisee did the purchasing for itself. Headquarters also helped suppliers figure out ways to lower their costs. These cost savings were passed to the franchisees.

Kroc describes the close attention paid to the hamburger patty:

We decided that our patties would be ten to the pound, and that soon became the standard for the industry. Fred did a lot of experimenting in the packaging of patties, too. There was a kind of paper that was exactly right, he felt, and he tested and tested until he found out what it was. It had to have enough wax on it so that the patty would pop off without sticking when you slapped it onto the griddle. But it couldn’t be too stiff or the patties would slide and refuse to stack up. There also was a science in stacking patties. If you made the stack too high, the ones on the bottom would be misshapen and dried out. So we arrived at the optimum stack, and that determined the height of our meat suppliers’ packages. The purpose of all these refinements, and we never lost sight of it, was to make our griddle man’s job easier to do quickly and well. All the other considerations of cost cutting, inventory control, and so forth were important to be sure, but they were secondary to the critical detail of what happened there at that smoking griddle. This was the vital passage in our assembly line, and the product had to flow through it smoothly or the whole plant would falter.

 

CHAPTER 9

In 1960, three life insurance companies agreed to lend the company $1.5 million in exchange for 22.5 percent of the stock. The insurance companies did well when they sold their stock a few years later for $7 to $10 million. Had they held their stock until 1973, however, they would have gotten over $500 million dollars. In any case, the loan was vital to the company’s rapid expansion in the 1960s.

McDonald’s hired people and paid them as little as possible, but also gave them stock. Those who stayed did very well. Bob Papp became vice-president in charge of construction. John Haran helped Harry with real estate. Dick Boylan helped Harry with finances.

One study showed that Ray Kroc had made more millionaires than any other person in history. Kroc comments:

I don’t know about that… I’d rather say I gave a lot of men the opportunity to become millionaires. They did it themselves. I merely provided the means. But I certainly do know a powerful number of success stories.

(Photo byBj¸rn Hovdal)

McDonald’s doesn’t confer success on anyone. It takes guts and staying power to make it with one of our restaurants. At the same time, it doesn’t require any unusual aptitude or intellect. Any man with common sense, dedication to principles, and a love of hard work can do it. And I have stood flatfooted before big crowds of our operators and asserted that any man who gets a McDonald’s store today and works at it relentlessly will become a success, and many will become millionaires – no question.

Some people go out of their way to give the competition a bad name. Some even suggest planting spies. Kroc has a different view, although he readily admits going through the garbage cans of competitors.

My way of fighting the competition is the positive approach. Stress your own strengths, emphasize quality, service, cleanliness, and value…

QSC and V are core values for McDonald’s:

• Quality
• Service
• Cleaniness
• Value

 

CHAPTER 10

The McDonald brothers offered to sell McDonald’s– all the rights, the name, and the San Bernardino store–to Kroc and associates for $2.7 million, which would give each brother a million dollars after taxes. Harry designed a brilliant way to finance the purchase.

Kroc on the formation of Hamburger University:

The idea of holding classes for new operators and managers had occurred to me when I first brought Fred Turner into headquarters. He was enthusiastic about it, too, and it was one of those goals that keep coming up in meetings but are put aside to make room for more pressing things. Fred refused to let the idea get buried, though. He collaborated with Art Bender and one of our field consultants named Nick Karos to compile a training manual for operators…

(Public domain photo)

Kroc notes the growing public attention on McDonald’s:

Ours was the kind of story the American public was longing to hear. They’d had enough of doom and gloom and cold war politics.

Dick Boylan hired a young accountant named Gerry Newman, who was brilliant. At the time, the company had huge revenue but no cash flow. Newman helped the situation by changing the pay period from weekly to bimonthly.

Kroc on integrity:

…I’ve worked out many a satisfactory deal on the strength of a handshake. On the other hand, I’ve been taken to the cleaners often enough to make me a certified cynic. But I’m just too naturally cheerful to play that role for long…

 

CHAPTER 11

Kroc had a hard time getting Harold Freund to come out of retirement and build a bakery to serve McDonald’s operators. But finally Freund agreed.

Kroc was also looking for a meat supplier. He wanted Bill Moore of Golden State Foods to do it. But Moore’s plant and equipment were outdated, and needed an infusion of capital. When Moore told Kroc about the problem, Kroc told him to hang in there because McDonald’s was going to keep growing rapidly. Moore hung in there. A few years later, Moore had enough money to build a large manufacturing and warehouse complex in City of Industry, California. Kroc:

His meat plant there now processes 300 million hamburger patties a year for McDonald’s restaurants, and in addition, he makes syrup for soft drinks and manufactures milk-shake mix. He also has gone into distribution for McDonald’s units. He perfected the one-stop service idea, in which a truck pulls up to one of our stores and fills all its needs, like an old-fashioned grocery store delivery truck, with a single call. This results in great savings for both parties….

I could tell the same story about most of the suppliers who started with us in the early days and grew right along with us.

 

CHAPTER 12

In 1963, the company built 110 stores. Revenue was $129.6 million [over $1 billion in 2018 dollars] and net income was $2.1 million [over $17 million in 2018 dollars]. Kroc believed in decentralized management:

We had 637 stores now, and it was unwieldy to supervise them all from Chicago. It has always been my belief that authority should be placed at the lowest possible level. I wanted the man closest to the stores to be able to make decisions without seeking directives from headquarters.

(Illustration by ibreakstock)

Kroc writes:

…for its size [1977], McDonald’s today is the most unstructured corporation I know, and I don’t think you could find a happier, more secure, harder working group of executives anywhere.

Back to 1966:

This was in July 1966, a year in which we broke through the top of our charts again with $200 million in sales, and the scoreboards on the golden arches in front of all our stores flipped to “OVER 2 BILLION SOLD.” Cooper and Golin sent out a blitz of press releases interpreting the magnitude of this event for a space-conscious public. “If laid end-to-end,” they enthused, “two billion hamburgers would circle the earth 5.4 times!” Great fun. Even Harry Sonneborn got caught up in the spirit of promoting McDonald’s, and he pulled off a stunt that made me proud of him. He wanted to have us represented in the big Macy’s Thanksgiving Day parade in New York, and he approved the concept of McDonald’s All-American High School Band, made up of the two best musicians from each state and the District of Columbia. Then he hired the world’s biggest drum and had it shipped by flatcar from a university in Texas… It was a huge success. So was the introduction of our clown, Ronald McDonald, who made his national television debut in the parade.

 

CHAPTER 13

Harry Sonneborn listened to forecasters telling him in 1967 that the country was headed into recession. If true, it perhaps made sense to conserve cash and not expand much (or at all). But such forecasts are notoriously unreliable, especially as a guide to business. No one knows when bears markets or recessions will come.

Warren Buffett puts it best:

• We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.
• Market forecasters will fill your ear but never fill your wallet.
• Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.
• [On economic forecasts:]Why spend time talking about something you don’t know anything about? People do it all the time, but why do it?

(Illustration by Maxim Popov)

To quote Peter Lynch:

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

Also, different individual businesses have different reactions to bear markets and recessions. Perhaps McDonald’s could do well enough during a recession, given its cheap prices.

In any case, Harry put a moratorium on all new store development because he thought business activity was going to slow down. But there were many dozens of new locations in the works. Why not proceed? Kroc thought McDonald’s should continue opening new locations. Kroc argued with Harry and forced the issue, with the result that Harry resigned.

McDonald’s Canada did even better than McDonald’s in the United States. There was less competition in Canada. McDonald’s Canada achieved an average of a million dollars in sales for all their locations. This put them ahead of the U.S. locations.

 

CHAPTER 14

Additions to McDonald’s menu over the years usually came from ideas that operators had. Filet-O-Fish, Big Mac, Hot Apple Pie, and Egg McMuffin, for example. Kroc:

I keep a number of experimental menu additions in the works all the time. Some of them now being tested in selected stores may find their way into general use. Others, for a variety of reasons, will never make it. We have a complete test kitchen and experimental lab on my ranch, where all of our products are tested; this is in addition to the creative facility in Oak Brook.

(Illustration by lkonstudio)

Kroc loves looking for new locations for McDonald’s stores:

Finding locations for McDonald’s is the most creatively fulfilling thing I can imagine. I go out and check out a piece of property. It’s nothing but bare ground, not producing a damned thing for anybody. I put a building on it, and the operator gets into business there employing fifty or a hundred people, and there is new business for the garbage man, the landscape man, and the people who sell the meat and buns and potatoes and other things. So out of that bare piece of ground comes a store that does, say, a million dollars a year in business. Let me tell you, it’s great satisfaction to see that happen.

 

CHAPTER 15

Kroc bought the San Diego Padres baseball team:

I was greeted like a hero in San Diego. Old men and little boys stopped me in the street to thank me for saving baseball for the city. The mayor presented me with an award in the opening ceremonies of our first home game. The sportswriters also gave me an award…

During the first home game, Kroc grabbed the microphone in the public address booth. He apologized to the crowd for the poor performance of the team. He said he was “disgusted.” This led to a new rule that no one but the official announcer can use the public address system during a game. Kroc explains that it’s no crime to lose unless you fail to do your best.

 

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: https://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 approachesintrinsic 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: [email protected]

 

 

 

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.

April 3, 2022

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

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

(Illustration by Rapeepon Boonsongsuwan)

Outline:

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

 

THE GROWTH IMPERATIVE

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

(Image by Bearsky23)

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

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

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

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

…

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

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

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

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

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

To know for certain what circumstances they are in, managers also must know what circumstances they arenot in. When collectively exhaustive and mutually exclusive categories of circumstances are defined, things get predictable: We can state what will cause what and why, and can predict how that statement of causality might vary by circumstance.

 

HOW CAN WE BEAT OUR MOST POWERFUL COMPETITORS?

(Illustration by T. L. Furrer)

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

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

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

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

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

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

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

(Image by Megapixie, via Wikimedia Commons)

Christensen and Raynor add:

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

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

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

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

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

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

Examples of new-market disruptions:

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

The authors then explain low-end disruptions:

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

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

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

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

The second set of questions concerns low-end disruptions:

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

A final question is a litmus test:

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

 

WHAT PRODUCTS WILL CUSTOMERS WANT TO BUY?

Christensen and Raynor:

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

(Photo by Kirill Ivanov)

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

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

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

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

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

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

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

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

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

(Photo by Creativefire)

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

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

Regarding the structure of channels:

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

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

Brands should be based on jobs to be done.

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

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

 

WHO ARE THE BEST CUSTOMERS FOR OUR PRODUCTS?

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

(Illustration by Alexmillos)

The authors continue:

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

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

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

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

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

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

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

 

GETTING THE SCOPE OF THE BUSINESS RIGHT

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

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

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

(Photo by Marek Uliasz)

Christensen and Raynor explain product architecture and interfaces:

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

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

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

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

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

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

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

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

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

 

HOW TO AVOID COMMODITIZATION

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

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

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

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

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

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

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

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

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

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

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

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

 

IS YOUR ORGANIZATION CAPABLE OF DISRUPTIVE GROWTH?

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

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

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

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

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

(Photo by Yuryz)

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

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

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

Values:

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

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

This brings up a crucial point:

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

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

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

(Photo by Golloween)

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

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

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

 

MANAGING THE STRATEGY DEVELOPMENT PROCESS

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

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

(Photo by Alain Lacroix)

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

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

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

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

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

(Illustration by Amir Zukanovic)

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

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

Intel needed both emergent and deliberate strategies:

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

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

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

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

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

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

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

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

 

THERE IS GOOD MONEY AND THERE IS BAD MONEY

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

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

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

(Image by Vpublic)

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

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

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

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

 

THE ROLE OF SENIOR EXECUTIVES IN LEADING NEW GROWTH

Christensen and Raynor:

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

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

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

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

 

 

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: https://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 approachesintrinsic 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: [email protected]

 

 

 

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.

March 27, 2022

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

Christensen:

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

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

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

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

Christensen offers more examples:

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

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

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

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

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

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

Here’s the lesson:

There are times at which it is rightnot to listen to customers, right to invest in developing lower-performance products that promiselower margins, and right to aggressively pursue small, rather than substantial, markets.

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

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

 

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: https://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 approachesintrinsic 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: [email protected]

 

 

 

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.

March 20, 2022

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

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

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

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

(Photo byPavel Å evela, Wikimedia Commons)

 

INTRODUCTION

The iPhone is the bestselling product of all time:

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

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

(Photo by Olena Golubova)

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

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

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

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

Merchant again:

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

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

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

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

 

EXPLORING NEW RICH INTERACTIONS (ENRI)

(Photo by Peshkova)

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

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

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

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

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

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

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

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

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

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

(Image by Willtron, Wikimedia Commons)

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

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

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

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

 

A SMARTER PHONE

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

(Photo by Bcos47, Wikimedia Commons)

Merchant quotes history of technology scholar Carolyn Marvin:

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

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

Merchant sums it up:

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

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

 

MINEPHONES

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

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

(Photo of Cerro Rico by Mhwater, Wikimedia Commons)

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

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

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

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

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

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

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

Silicon makes up 6 percent of the phone.

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

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

 

SCRATCHPROOF

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

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

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

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

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

(Illustration by Artsiom Kusmartseu)

 

MULTITOUCHED

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

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

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

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

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

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

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

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

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

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

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

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

Merchant comments:

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

(Illustration by Onyxprj)

 

PROTOTYPING

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

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

(Image by BP22Heber, Wikimedia Commons)

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

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

 

LION BATTERIES

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

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

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

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

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

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

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

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

 

IMAGE STABILIZATION

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

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

Merchant explains:

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

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

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

 

SENSING MOTION

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

(Coriolis effect, Wikimedia Commons)

Merchant:

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

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

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

(Photos of proximity sensor by Hyderabaduser, Wikimedia Commons)

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

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

 

STRONG-ARMed

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

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

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

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

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

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

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

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

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

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

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

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

Merchant describes the evolution of apps for the iPhone:

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

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

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

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

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

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

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

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

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

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

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

 

ENTER THE iPHONE

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

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

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

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

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

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

(Photo by Sergey Gavrilichev)

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

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

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

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

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

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

(Photo by Mohamed Soliman)

 

HEY, SIRI

Merchant:

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

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

(Photo by Christian Lagereek)

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

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

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

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

 

DESIGNED IN CALIFORNIA, MADE IN CHINA

Merchant writes about his visit to China:

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

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

(Wikimedia Commons)

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

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

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

Merchant continues:

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

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

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

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

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

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

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

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

 

SELLPHONE

Merchant writes:

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

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

(2010 Photo by Matthew Yohe)

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

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

 

THE BLACK MARKET

Merchant:

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

(Huaqiangbei electronics market, Photo by Lzf)

Merchant, a bit later:

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

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

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

Obvious counterfeits don’t last long:

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

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

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

 

THE ONE DEVICE

Merchant:

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

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

(Photo by Rafal Olechowski)

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

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

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

Then there was hardware. Merchant spoke with Tony Fadell:

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

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

(Apollo program insignia, by NASA, Wikimedia Commons)

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

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

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

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

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

 

BOOLE MICROCAP FUND

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

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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 approachesintrinsic 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: [email protected]

 

 

 

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.