Buffett’s Best: Microcap Cigar Butts

August 31, 2025

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

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

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

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

A close up of warren buffett wearing glasses

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

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

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

 

NET NETS

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

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

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

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

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

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

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

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

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

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

A cigarette butt laying on the ground.

(Photo by Sky Sirasitwattana)

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

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

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

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

 

DEMPSTER: THE ASSET CONVERSION PLAY

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

A windmill is in the water near some trees.

(Photo by Digikhmer)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Buffett “pulled all the levers” at Dempster…

 

LIQUIDATION VALUE OR EARNINGS POWER?

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

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

A person is working on some papers at the computer

(Illustration by Maxim Popov)

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

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

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

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

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

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

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

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

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

 

MEAN REVERSION FOR CIGAR BUTTS

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

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

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

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

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

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

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

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

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

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

Consider this observation by Charlie Munger:

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

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

Three horses are racing in a race.

(Illustration by Nadoelopisat)

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

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

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

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

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

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

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

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

Here’s Ben Graham explaining mean reversion:

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

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

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

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

A black and white drawing of a man riding an animal on top of a wheel.

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

 

FOCUSED vs. STATISTICAL

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

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

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

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

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

Regarding individual net nets, Graham admitted a danger:

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

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

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

A burning match with the dollar sign on it.

(Image by Preecha Israphiwat)

Value investor Seth Klarman warns:

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

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

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

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

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

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

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

 

THE REWARDS OF PSYCHOLOGICAL DISCOMFORT

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

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

A person sitting on top of a rock with their head up.

(Illustration by Sangoiri)

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

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

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

Mihaljevic explains:

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

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

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

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

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

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

 

CONCLUSION

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

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

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

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

The Art of Execution

August 24, 2025

Investor Lee Freeman-Shor hired 45 of the world’s top investors and gave each between $20 million and $150 million to invest. He instructed each one to invest only in their ten best ideas. Freeman-Shor then examined the 1,866 investments made by this elite group over the course of June 2006 to October 2013. The result is the book,The Art of Execution: How the world’s best investors get it wrong and still make millions (2015).

Freeman-Shor explains that the best ideas of the best investors could reasonably be expected to generate excellent long-term results. Freeman-Shor:

These were ideas that they had significant confidence in, and were often the result of hundreds of hours of research by some of the smartest people on the planet.

Given all this, I was sure that I would make a lot of money.

It might surprise you, then, to be told that most of their investmentslost money.

Out of 1,866 investments, a total of 920–about 49% of the total–made money.

However, almost all of these investors made money. How was this possible? Freeman-Shor studied every single trade in order to analyze what had happened.

Freeman-Shor quotes Leo Melamed, a successful futures trader:

I could be wrong 60% of the time and come out a big winner. The key is money management.

Paul Tudor Jones:

The reason for all the Wall Street success stories he knew was down to: money management, money management, money management.

George Soros:

It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

Here’s the outline for the book:

PART I. I’M LOSING (WHAT SHOULD I DO?)

    • The Rabbits: Caught in the Capital Impairment
    • The Assassins: The Art of Killing Losses
    • The Hunters: Pursuing Losing Shares

PART II. I’M WINNING (WHAT SHOULD I DO?)

    • The Raiders: Snatching at Treasure
    • The Connoisseurs: Enjoying Every Last Drop

CONCLUSION: THE HABITS OF SUCCESS

THE WINNER’S CHECKLIST

    1. Best ideas only
    2. Position size matters
    3. Be greedy when winning
    4. Materially adapt when you are losing
    5. Only invest in liquid stocks

THE LOSER’S CHECKLIST

    1. Invest in lots of ideas
    2. Invest a small amount in each idea
    3. Take small profits
    4. Stay in an investment idea and refuse to adapt when losing
    5. Do not consider liquidity

 

PART I. I’M LOSING–WHAT SHOULD I DO?

The Rabbits: Caught in the Capital Impairment

Freeman-Shor remarks that the Rabbits ended up being the least successful investors working for him, despite the fact that these were all prestigious investors.

Freeman-Shor gives a case study: Vyke Communications, a UK-based company that specialized in software that allowed users to make phone calls and send text messages. The investor bought shares on October 31, 2007 at £2.10. When the price fell, the investor bought more. This was the right move if the investor still believed in the idea. However, the stock kept falling and the investor decided to stay invested. Two and a half years later on July 2, 2010, the investor sold the entire position at £0.02, for a 99% loss.

Another case study: Vostok Nafta, an investment company listed on the Swedish stock exchange that invests in assets in the Commonwealth of Independent States, a loose associtaion of some of the countries that used to make up the USSR. This investor bought shares April 11, 2008, at £9.14. Five months later, he sold at £3.95, for a loss of 57%. Freeman-Shor notes that the only reason the investor sold was because Free-Shor was pressuring him to either buy more or sell.

Yet another case study: Raymarine, a company that specializes in marine electronics. An investor bought shares on May 31, 2007, at £4.27. 23 months later the price had collapsed, but the investor still believed in the idea. Eventually, partly due to pressure, the investor sold his entire position on April 15, 2009, at £0.17. This was a loss of 96%.

Where did the Rabbits go wrong? Freeman-Shor states ten reasons for why the Rabbits failed:

(1) The narrative fallacy framing bias

Framing bias, discovered by Amos Tversky and Daniel Kahneman, means that people tend to reach a conclusion based on the way a problem is presented. In the case of the Rabbits, they allowed their favorite types of investment to influence how they viewed the stock in question. The Rabbits still believed in the investment thesis for a stock that had fallen a great deal and so they still believed they would make money going forward. Freeman-Shor:

The Rabbits are a great example of how professional investors often react to a black-swan event–an event they did not anticipate and which has negatively impacted their investment story. They tend to dismiss it.

(2) Primacy error

Primacy error means that first impressions have a lasting and disproportional effect on a person. Because the Rabbits had a very positive first impression, they failed to update their investment thesis to incorporate new information.

(3) Anchoring

Related to primacy error is anchoring. Rabbits tended to anchor to initial information, being very slow to change their minds. Freeman-Shor:

It took one Rabbit two and a half years to change his mind on Vyke, and another Rabbit almost two years to react to Raymarine’s decline. The other never changed his mind on Vostok. Similar stubbornness occurred on many other investments.

(4) Endowment bias

As humans, we tend to overvalue our own possessions, which includes the investments we’ve made.

When there are large losses that happen quickly, they are almost impossible to accept. It’s easier to hold on to a losing position. Rabbits did not want to admit the loss by selling because they were too fixated on what they had paid for the stock.

(5) The pull of the crowd

There were many other investors who got burned on the same investments that the Rabbits got burned on. This could have contributed further to the Rabbits being unable to admit their error and sell. Freeman-Shor quotes John Maynard Keynes:

It is the long-term investor… who will in practice come in for most criticism… if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

(6) Ego

Freeman-Shor says that the Rabbits were more interested in being right than in making money. Many professional investors are this way.

The Rabbits simply could not admit that they were wrong. Freeman-Shor observes:

The fact is, the greatest minds on the planet can be wrong. My findings suggest you should expect to be wrong at least half of the time. The very best investment minds are!

(7) Self-attribution bias

Self-attribution bias means that we blame others or external factors for our misfortunes but take full credit when things go well. This is why we tend not to learn from past mistakes, but to keep repeating them.

The Rabbits, writes Freeman-Shor, tended to blame Mr. Market (“The market is being stupid”) or Mr. Unlucky (“It wasn’t muy fault, I was unlucky because of XYZ that no one could have foreseen”).

(8) The wrong information

Freeman-Shor:

Because many of the Rabbits had been professionally investing for a couple of decades, controlling a significant amount of assets, they had Rolodexes to die for. When they found the ‘story’ behind an investment being challenged, they liked nothing better than picking up the phone and dialling the CEO on his or her personal number to get to the bottom of things. Despite being reassured by the CEO that the setback was merely a bump in the road and the media was making a mountain out of a mole hill, the Rabbits would do nothing. They neither bought more shares nor sold their holdings.

A hugely appealing temptation for more information comes from the need to abrogate responsibility in times of crisis. It is very common when a difficult decision has to be made to see the decision-maker involving more people. The more people involved, the more they can relax because if it goes wrong it was not their fault.

(9) Too big to fail

Like many investors, Rabbits found it far more difficult to walk away from a large losing investment than a small losing investment.

(10) The gambler’s fallacy

The gambler’s fallacy is the mistaken belief that after a period of poor performance, a given stock was due to perform well.

Each coin toss in a series has a 50/50 chance of coming up heads and each toss is independent of prior tosses. The gambler’s fallacy ignores this and instead involves the belief that, after a series of tails, the next toss was likely to be heads. But there’s only a 50/50 chance of this because each toss is independent.

What could the Rabbits have done differently?

Freeman-Shor writes:

The bad news is, everyone can be a Rabbit. The good news is, no one needs to be. There are a few simple things they could have done to overcome their problems.

(1) Always have a plan.

Freeman-Shor:

Investing is all about probabilities. Whether you invest should depend on the odds and the edge you think you have. Given the odds and your edge you should know exactly what you are going to do if the stock you are investing in falls or rises by 20%, 50% and so on.

When faced with a painful loss-making position, most people do nothing. They turn into a Rabbit and procrastinate, letting all their biases play havoc with their decision-making, hoping time will resolve their issues so they don’t have to.

It’s essential to have a plan.

(2) Sell or buy more

Freeman-Shor:

The only solution to a losing situation is to sell out or significantly increase your stake.

Freeman-Shor says the investor needs to ask himself or herself a key question:

If I had a blank piece of paper and were looking to invest today, would I buy into that stock given what I now know?

If the answer is “no,” then the investor must sell. If the answer is “yes,” then the investor should significantly add to the position.

Freeman-Shor notes that legendary investor Peter Lynch would (i) sell if the fundamentals were worse but the price had increased or (ii) buy if the fundamentals were better but the price had decreased. This is logical.

The real mistake the Rabbits made was doing nothing when their investment had declined in price. The logical thing is either to admit a mistake and sell, or buy more at the lower price. Freeman-Shor:

I have learnt that I cannot trust great investors to do the right thing when they are losing–like top athletes, they require coaching and management.

(3) Don’t go all in

As an investor, you should always be able to add to an investment if the price falls, assuming you have taken a fresh look at the investment and decided it’s a good one at the new price. This means you don’t want one position to become too large. Freeman-Shor quotes Mohnish Pabrai:

In my own portfolios at Pabrai Funds, I adjust for this [getting the odds wrong] by simply placing bets at 10% of assets for each bet. It is suboptimal, but it takes care of the Bet 6 being superior to Bet 2 problem. Many times the bottom three to four bets outperform the ones I felt the best about.

(4) Don’t be hasty to jump in, do be hasty to jump out

Cutting your losses early makes excellent sense, although it is difficult. Freeman-Shor writes the following, ending with a quote from Ned Davis:

Not least because selling out of a stock helps clear your head and enables you to assess a situation more objectively. It’s like taking a decongestion pill when suffering from a cold.

And buying slowly over time (known as dollar or pound-cost averaging), with a reduced position size at the outset, ensures you have plenty of ammunition left to load up when a share finally capitulates (assuming it does).

“[W]hat separates the winners from the losers? The answer is simple–the winners makes small mistakes while the losers make big mistakes.”

(5) Remember there is a difference between ‘being right’ and ‘making money’

Freeman-Shor:

In investing, a lot of success can be attributed to being in the right place at the right time–otherwise known as luck.

(6) Seek out opposition

When people lose money they don’t want to be told they are wrong…

What you should really do is to speak to someone with an opposing view.

Ideally you should also sell out of the stock while you do that, so that you have removed the emotional attachment of a vested interest. This mitigates endowment bias and you can always buy the stock back later.

If you would not put money to work in a particular share today, knowing what you now know, then you have to concede that the investment is dead–and if you haven’t already sold, you absolutely should now.

(7) Be humble

Freeman-Shor notes that the Rabbits, on the whole, were incredibly smart and never said, “I don’t know.”

But this is a very dangerous mindset to have. First, it assumes the market is made up of buyers and sellers that are not equally expert, when in fact many will be. Second, ‘knowing more’ often leads to a person not seeing the wood for the trees.

Throughout history there have been many examples that demonstrate this. My favourites are Harry Warner, of Warner Bros., who in 1927 said, “Who the hell wants to hear actors talk?”, and Thomas Watson, chairman of IBM, who in 1943 said, “I think there is a world market for maybe five computers.”

Experts are surprisingly bad at forecasting. Falling for your own hype can also often lead to mistakes that the least intelligent person in the world would not be capable of. Warren Buffett, when talking about the collapse of Long-Term Capital Management, marvelled at “10 or 15 guys with an average IQ of maybe 170 getting themselves into a position where they can lose all their money.”

And crowds are often surprisingly wise–the market can be right even when everyone who makes it up is individually wrong.

Freeman-Shor mentions the jelly beans in a jar experiment. If you take a jar full of jelly beans and ask everyone in a room of 50 or 60 to guess at how many jelly beans are in the jar, typically the average guess is very close to the truth. Moreover, the best individual guess is often not even as good as the average guess, and of course there are many individual guesses that are wildly wrong. This experiment is analogous to the stock market.

Again, only 49% of the best ideas from some of the best investors–those Freeman-Shor hired–ended up being right.

(8) Keep quiet and carry on

Some investors make the mistake of talking publicly about their investments and their anticipated returns. This makes it much more difficult to change their minds if new facts warrant it.

(9) Don’t underestimate the downside–adapt to it

Many Rabbits like stocks that could shoot for the moon. However, often such stocks can get wiped out if they don’t work. Freeman-Shor suggests treating such stocks as options: Size the position as if it were an option–almost like a venture capital investment–so that, if it works, you can do well, whereas if it doesn’t work, the loss will be contained.

(10) Be open to different kinds of story

Deep value investing can produce the highest long-term returns. Freeman-Shor:

Many studies have shown that stocks with the worst stories tend to produce the highest returns.

Stated differently, value investing–investing in cheap stocks that no one likes because they have terrible stories that led to their stock price falling–produce the highest returns over time.

(11) Get sick of sick notes

Freeman-Shor suggests getting familiar with the typical excuses investors like to offer:

    • The ‘If only’ defence.
    • The ‘I would have been right but for’ defence.
    • The ‘It just hasn’t happened yet” defence.
    • The ‘Who could have foreseen at the time I invested that XYZ would happen…’ defence.
    • If it’s gone down this much already, it can’t go much lower.
    • You can always tell when a stock hits rock bottom.
    • Eventually they always come back.
    • When it rebounds slightly, I’ll sell.

(12) Be suspicious of status.

Freeman-Shor writes:

Lastly, whether you work in the investment industry or are thinking about trusting your money to someone who does, there is a bonus moral in the story of the Rabbits: it is dangerous to assume that just because an investment professional is highly educated and has years of experience, he or she will be good at making money and getting the big calls right.

IT’S ALL ABOUT CAPITAL IMPAIRMENT

Freeman-Shor says:

One of the reasons that the Rabbits held on to losing investments was fear of the unnkown: if they sold out, the shares might rally, and they would miss out. It was better to stick with a current loss than worry about that double-whammy.

This is known asambiguity aversion, and describes why people prefer to stick with intolerable situations merely because a hypothetical alternative might be worse. Better the devil you know.

Freeman-Shor again:

I believe that even the best investors often overlook the fact that a stock’s price would need a practically supernatural rise of 900% to break even if they have foolishly ridden it down 90% and done nothing.

THE LESSONS OF POKER

Freeman-Shor observes:

Stories are the biggest factor in determining what decisions we make. For the Rabbits, the stories in their heads led them to invest many millions in companies that ultimatley lost them and me vast amounts of money. Their actions post-investment were clouded by the story that led them to invest on day one.

The moral here is to try to avoid being blinded by your story. Above all, have aplan of action as to what you will do if you find yourself in a losing position, even if you still think you are right.

The key difference between the Rabbits and successful investors in this book is that when the Rabbits were losing they did nothing. As we will see with the Assassins and Hunters, they acted decisively to bail themselves out of the holes they found themselves in.

Freeman-Shor quotes Darwin:

It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.

Freeman-Shor then writes:

If only the Rabbits had played poker. Any poker player knows that it is not how many hands you win that matters, it’s how much you win when you win, and how much you lose when you lose.

Each hand in poker represents a story and the goal for a poker player is to try to make money with whatever story they have been given–good or bad. If the story is poor then you don’t stick with it and throw money at the problem; the odds are stacked against you. You fold your hand, cut your losses and live to fight another day.

Likewise, if you are dealt a good hand but then see the flop and realise the hand is now nowhere near as strong as you thought, you fold.

 

The Assassins: The Art of Killing Losses

Freeman-Shor quotes the legendary investor Warren Buffett’s rules for investing success:

Rule No. 1–Never lose money.

Rule No. 2–Never forget rule No.1.

Freeman-Shor then explains:

The Assassins are the investors who really lived and breathed this principle while working for me. When it came to selling losing positions so as to preserve their capital they were ruthless, like cold-hearted hitmen, pulling the trigger without emotion. Then they carried on with their lives like nothing had happened.

Hedge fund titan Stanley Druckenmiller had this to say about fellow hedge fund titan George Soros.

[He is] the best loss taker I have seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position.

Freeman-Shor explains that successful investing is all about asymmetric returns:

…winning is about ensuring the upside return potential is significantly greater than the downside potential loss.

Despite that you might imagine, in reality we can all be as cold and ruthless as the Assassins.

Freeman-Shor adds:

What I liked about the Assassins was that they lived by a pair of sacred rules.

The rules were derived from their own experience and beliefs, and the key to their success was that when they were losing they would always let the rules, not their emotions or feelings, drive their decision.

They knew that when faced with the uncertainty that naturally follows when the market has turned against them, they could not rely on themselves to do the right thing.

They therefore committed to becoming slaves to the rules. When a loss occurred they would follow their commandments to the letter.

Importantly, these two rules had been well thought through when the Assassins were in an emotionally ‘cold state’. They planned well in advance; before they invested, they knew what they would do afterwards. They did this because they knew that when push came to shove they were likely to make poor decisions in a ‘hot’ (or emotionally charged) state of mind.

THE CODE OF THE ASSASSINS

(1) Kill all losers at 20-33%.

The Assassins know that it’s very tempting, when it comes time to kill a losing trade, to wait. That’s why they used a device: the stop-loss.Freeman-Shor:

The Assassins’ rules required them to put a stop-loss in place at the same time they they bought any share. If the stop-loss was triggered by a share price going down a certain amount, it automatically sold their entire stake.

Freeman-Shor comments that some investors use a “review” instead of a stop-loss, but that a stop-loss is often better. Freeman-Shor continues:

Legendary investor and art collector Roy Neuberger, whose investment firm Neuberger Berman bears his name, credits the 10% rule as part of the reason for his success. He always cuts his losses when they hit 10%–no matter what.Recognise your mistakes early and take immediate action was his mantra.

The Assassins’ rule was the same, but they despatched their losers at slightly different predetermined points depending on their own experience and preferences: almost always somewhere between 20% and 33% (it depended on the Assassin). Despite Neuberger’s rule, my findings support the Assassins’ approach. This range of stop-loss levels avoids you getting whipsawed while giving a realistic chance of being able to recover from the loss incurred.

Freeman-Shor offers a case study: Genmab, a Danish biotechnology company that specializes in creating human antibody treatments for people suffering from cancer. Two weeks after investing, the Assassin was down 30%. His stop-loss activated at -32% and he sold on Nvember 16, 2009, with the shares trading at £12.43, having originally bought the company on October 29, 2009, at £18.34. This was a good decision because the shares then fell another 49%. While it was tough to take a 30% loss so quickly, that was much better than a 65% loss.

Freeman-Shor gives another case study: Dods, a media company that provides information, organizes events, and does publishing. Dods had become the most trusted source for political data. An Assassin bought shares on December 29, 2006, at £0.51. Ten months later, his stop-loss at 39% sold out on October 31, 2007 at £0.31. After that, the stock fell another 63%. So the Assassin was clearly right to sell when his stop-loss had been triggered.

Freeman-Shor comments:

In the world of investments there is no such thing as a safe bet. If you invest in a company and think that it is bulletproof, I urge you to have an action plan to decide what to do when things go wrong–things often do.

The next case study: Royal Bank of Scotland. It is one of three banks in the UK that is permitted to issue UK banknotes. An Assassin bought shares on May 30, 2008, at £22.29. When the credit crisis started, this Assassin actually moved faster than his stop-loss, selling out at £18.62. This was a loss of 16%. The stock then lost a further 82%. Good decision by this assassin.

(2) Kill losers after a fixed amount of time.

Freeman-Shor explains the logic of this rule: Time is money.

Being in a losing position too long–even if the size of that loss hasn’t hit 20% or more–can have a devastating effect on your wealth. This was something the Assassins were acutely aware of.

DON’T SELL TOO SOON

While having a strict discipline for dealing with losing stocks is important, you don’t want to be overly strict or too quick.

Freeman-Shor gives the example of Compass Group, the world’s largest food service company. It serves billions of meals a year. One of the investors that Freeman-Shor manages bought on November 20, 2007 at £3.19. He then stold the entire stake twelve months later at £3.04, for a loss of only 5%. At the time Freeman-Shor was writing the book, the stock had already increased 143% since it was sold, which was more than the overall market increased.

Freeman-Shor offers the example of BMW. One of his investors bought BMW on April 11, 2008 at £34.95. He sold two months later on June 23, 2008, at a price of £32.35 for a loss of 7%. The stock then went up 95%.

Another example: Perelli, the Italian tyre manufacturer. One of Freeman-Shor’s investors bought on January 22, 2010 at £4.61. He sold one month later at £4.26, a loss of 8%. Perilli subsequently increased 103% as of the time Freeman-Shor was writing the book.

And: Rightmove, where people in the UK look for a property to rent or buy. One of Freeman-Shor’s investors bought shares at £5.51 on November 13, 2009. A month later, on December 30, 2009, he sold at a price of £4.91, a loss of 11%. The shares then shot up 202%.

BE CAREFUL ON YOUR NEXT INVESTMENT

When a person sells a losing investment, they often become risk-seeking, which is calledthe break-even effect. This is not a good idea.

AN ELUSIVE CADRE

Freeman-Shor writes:

The Assassins were some of the most disciplined investors I have met, and a significant factor in their ability to make money was that they cut their losses consistently. A study by Professor Frazzini supports the Assassins’ approach too: it shows that the highest investment returns were achieved by those investors that had the highest rate of selling out of losing positions. Those that realised the least amount of losing positions experienced the lowest returns.

The losing trait of riding losing positions while taking profits on winning positions has been called thedisposition effect by Frazzini.

 

The Hunters: Pursuing Losing Shares

Instead of using a stop-loss like the Assassins, the Hunters instead would–in certain situations–buy more of a stock that had decreased. Quite often, the Hunters would end up making a profit.

It’s important to note that the Hunters committed to buying more at lower prices–if they became available–before they even bought their initial stake. Freeman-Shor explains:

The key reason for the Hunters’ approach lay in their invariably contrarian style. They were value investors. They generally found themselves buying when everyone else was seling, and this was an extension of that philosophy, another way of exploiting Mr. Market when he was acting irrationally.

SUCCESS STARTS FROM FAILURE

Many successful Hunters had at least one terrible year near the beginning of their career. The Hunters learned how to be contrarian but also to be right more often than not. (Otherwise, there’s no benefit from being a contrarian.) Just as important, the Hunters learned to admit when they had made a mistake. Freeman-Shor:

They also grew unafraid to sell if it became clear they really had made a mistake. Poor value investors I have come across refuse to adapt when they are losing and tend to support their lack of action by saying, “I got it wrong but the stock is simply too cheap to sell now.” A bad contrarian investor can make for a very committed Rabbit.

But if a stock still passed the vital ‘Would I buy this knowing what I know now?’ test, the Hunters followed their plan, and started to put their money on the side to work as the share price dropped.

SNATCHING VICTORY

Many Hunters enjoyed the game of trying to pick a bottom in a given stock. It’s often not possible to do this, but sometimes it is possible to come close. As Freeman-Shor explains, successfully investing near the bottom can often create a nice profit. The Hunters enjoyed snatching victory from the jaws of defeat.

Freeman-Shor:

Be under no illusions: being a Hunter requires patience and discipline. You have to expect a share price to go against you in the near term and not panic when it does. You have to be prepared to make money from stocks that may never recapture the original price you paid for your first lost of shares. If you know your personality is one which demands instant gratification, this approach is not for you.

Freeman-Shor quote Peter Lynch:

I’m accustomed to hanging around with a stock when the price is going nowhere. Most of the money I make is in the third or fourth year that I’ve owned something.

Freeman-Shor offers some case studies.

Aker Solutions is a Norwegian oil services company. It provides products and services related to the construction, maintenance, and operation of oil and gas fields. One of Freeman-Shor’s Hunters bought the stock on April 14, 2008, at £15.84 per share. A year and a half later, the stock was much lower. The Hunter bought significantly more on September 28, 2009, so that his average cost was only £7.61. He sold at £9.58 because he realized his original thesis was no longer true. Had he not done anything, he would have had a loss of 40%. Instead, he made a 24% profit.

Experian is an Irish company that operates globally. The company collects information on individuals and produces credit scores used by lenders. A Hunter bought the stock on June 13, 2006, at an initial price of £9.02. After the price declined, the Hunter bought more, reducing his average cost to £5.66. When he sold at £7.06, he realized a profit of 19%. Had he done nothing, he would have lost 22%. Freeman-Shor notes that the Hunter, by his actions, had turned a losing position into a winning position.

Technip is a French company that does engineering and construction for the oil and gas industry. It’s a leader in areas such as subsea drilling, laying specially built pipelines, producing floating offshore platforms, and planning the development of oil and gas fields. A Hunter bought the stock on April 11, 2008, at a price of £55.42. When the stock declined, the Hunter bought much more, reducing his average cost to £42.24. He later sold at £52.13. He realized a gain of 22%. Once again, a Hunter had turned a loss into a gain by buying more shares on the decline.

Thomson Reuters is a global media company based on New York. It provides the latest content and data to the finance industry. It also produces material to help lawyers and accountants ensure they are up-to-date on the professional education. Moreover, the company produces research for the pharmaceutical industry. A Hunter bought stock on June 13, 2006, at £22.25. The stock dropped and the Hunter bought materially more, reducing his average cost to £15.82. He sold on September 10, 2009, at £18.92. Instead of a loss of 15%, the Hunter made a profit of 17%.

HUNTING FOR THE COMPOUNDING EFFECT

Freeman-Shor mentions the Kelly criterion. Freeman-Shor doesn’t mention the details, but they’re important, so here they are:

The Kelly criterion can be written as follows:

    • F = p – [q/o]

where

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

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

Both Warren Buffett and Charlie Munger are proponents of the essential logic of the Kelly criterion. Here’s Charlie Munger:

The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.

As for Buffett, he famously invested 40% of his hedge fund into American Express in the late 1960s. Buffett realized a large profit. Later, Buffett invested 25% of Berkshire Hathaway’s portfolio in Coca-Cola. Buffett again enjoyed a large profit of more than 10x (and counting).

Freeman-Shor notes the following:

If a stock you are invested in has fallen materially in price, but nothing else has changed–the investment thesis is still intact–your odds will have improved significantly and you should materially increase your stake in that company.

Freeman-Shor adds:

If you are a Hunter… you choose not to control risk by diversification but by thoroughly understanding the risk and returns of a particular stock or handful or stocks. Your goal is to find companies that have an unbelievably attractive, asymmetric payoff profile.

The fact that you are only investing in a few companies means that you have the opportunity to invest big on day one, and then follow up with large top-up investments should the share price fall.

Warren Buffett wrote in his 1993 letter to the shareholders of Berkshire Hathaway:

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 make no sense for you. It is apt to simply 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.

Freeman-Shor concludes by pointing out that coaches would be quite helpful for investors:

I find it bizarre that top athletes and sportsmen and women have coaches but the majority of investment professionals do not.

How can they expect to improve their game if they do not have constructive feedback?

 

PART II. I’M WINNING–WHAT SHOULD I DO?

The Raiders: Snatching at Treasure

Freeman-Shor writes:

Raiders occupy a thin line between success and disaster. These are investors who like nothing better than taking a profit as soon as practical. They are the stock market equivalent of gold-age adventurers: having penetrated through the dense jungle, found the lost temple or buried treasure, they fill their pockts with all the ancient coins and gems they can–then turn tail and run.

Unlike gold-age adventurers, they are rarely chased by angry locals or rivals. The only boulders rolling after them are in their imaginations. They are terrified of getting caught and losing everything, and to ensure they at least come away with something end up leaving countless chests and swagbags of treasure behind completely unnecessarily.

Freeman-Shor continues:

I discovered the Raiders when I noticed the rather distressing fact that one of my investors had an incredible success rate–almost 70% of his ideas were correct, which is truly phenomenal–but he hadn’t made me any money.

I broke down the data for his investments and discovered that whenever he made a small gain, say 10%, he would immediately sell the stock and take the profit.

Interestingly, he was a hedge fund manager and in his own trading was an expert at shorting shares–and staying short. But when it came to long-only investments, he and the other Raiders lacked a key habit that the successful investors I worked with possessed. He did not embrace the right tail of the distribution curve. In ordinary terms, the Raiders did not run their winners.

Freeman-Shor then gives some examples.

Chicago Bridge & Iron is a multinational company that does energy industry infrastructure projects. One of the Raiders bought the stock on September 3, 2009, at £10.66. A month later, on October 5, 2009, he sold at £12.29. A few years later, the stock was at £30.38. The stock had increased 147% since the Raider had so prematurely sold it.

British American Tobacco manufactures and sells tobacco products, including the brands Lucky Strike, Pall Mall, Vogue, John Player, Benson & Hedges, and Kent. One of Freeman-Shor’s Raiders bought on July 3, 2009, at £19.96. Two and a half months later, on September 21, 2009, he sold at £21.75, a profit of 9%. A few years later, the stock was at £37.93, 74% higher than where the Raider had sold it.

Swedish Match is a world leader in chewable tobacco. The Raider bought on October 10, 2008, when the shares were at €10.56. This investor sold after two months on December 16, 2008, at €10.18, a 4% loss. He decided to buy back in on June 24, 2009, at €11.23, before selling on April 22, 2010, at €17.54, for a profit of 56%. A couple of years later, the stock was at €25.88, a further increase of 49%.

Novo Nordisk is a Danish pharmaceutical company and a world leader in diabetes medication (insulin) and care equipment (injection devices and needles). The company is also a leader in hemophilia care and hormone-replacement therapy. One of Freeman-Shor’s investors bought on April 22, 2009, at €35.71. He later sold on December 4, 2009, at €45.32, a profit of 27%. A couple of years later, the stock was at €124.92, a further increase of 175%. This Raider had made a huge error, assuming the intrinsic value of the stock was near €124.92 or higher.

Freeman-Shor summarizes by saying that Raiders are right most of the time, but still lose money because their losses are bigger than their gains. If they could learn to stick with winning ideas, they would be winning investors. Freeman-Shor comments:

…the most successful investors I worked with, those that made the most money, all had one thing in common: the presence of a couple of big winners in their portfolios. Any approach that does not embrace the possibility of winning big is doomed.

WHY DO INVESTORS SELL TOO SOON?

(1) It feels so good. Selling for a profit feels nice. We get a hit from testosterone and dopamine.

(2) I’m bored. As Peter Lynch observed:

[I]t’s normally harder to stick with a winning stock… than it is to believe in it after the price goes down.

(3) Frustration. It’s very difficult to patiently wait for years. One factor ishyperbolic discounting, which makes people prefer $1 today versus $2 tomorrow.

(4) Fear. Because ofloss aversion, we tend to feel the pain of a loss at least twice as much as the pleasure of an equivalent gain. When a Raider’s investment starts doing well, he often fears what might happen if he doesn’t sell.

(5) Short-termism. There isrecency bias. Freeman-Shor:

My own fund–the Old Mutual European Best Ideas fund–is a good example of this. If you took a three-year view from 2009 to 2011 you would have said I was a superstar. If you viewed my performance during August 2011, or for the year 2011 alone, you would have said quite the reverse.

The flows my fund experienced showed just this. Shortly after delivering those three-year performance figures I had over $200 million invested into my fund. But during August 2011, clients withdrew tens of millions of dollars.

Since 2011 the performance of the fund has been strong and, surprise surprise, we have attacted inflows again.

Imposing different time frames on an investment can produce very different results–and Raiders invariably impose short-term ones. This can be deadly for winning trades.

(6) Risk aversion. People are risk-averse when winning–and tend to take profits–and they are risk-seeking when losing. When winning, selling is appealing because the certainty of a small victory is better than the uncertainty of a loss or greater victory. When losing, risk is appealing because anything is better than a certain loss.

WHY YOU SHOULDN’T SELL EARLY

(1) Rarity value. Freeman-Shor:

All the successful investors I have managed made money because they won big in a few names, while ensuring the bad ideas did not materially hurt them.

… Stock market returns over time showkurtosis, which means fat tails are larger than would be expected from a normal distribution curve. This means that a few big winners and losers distort the overall market return–and an investor’s return. If you are not invested in those big winners your returns are drastically reduced.

(2) Beat your rivals. Honing your ability to let winners run can give you a very significant advantage as an investor.

(3) You cannot trust your next investment. The odds of picking a winning trade–based on the results of some of the best investors in the world working for Freeman-Shor–are roughly 49%. This means the odds of picking five winning investments in a row are roughly 2.8%. So if you have a winning investment, stick with it as long as possible.

(4) Winners can keep winning. The research says that a momentum strategy can be a winning strategy. A stock that has gone up over 6 months or a year often continues to go up. Of course, no stock goes up forever, so even though you should let a winner run–as long as the investment thesis is intact and the intrinsic value is higher than the current stock price–you should eventually sell unless it’s a company with a sustainably high return on equity (ROE).

(5) You can never predict big winners when you first invest. Freeman-Shor:

Many legendary investors did not predict their biggest winners–and have admitted it. Some all-time greats even built their investment style around not knowing how big a winner might be: Jesse Livermore became of of the wealthiest men in America in the 20th century by adopting a simple trend-following approach.

In effect he bought stocks that were being bid up and rode them up, never knowing if it would turn out to be a big winner when he initiated the position.

TOO PROFESSIONAL

Some reasons why professional investors tend to sell too soon.

(1) Bonuses. Many fund managers are paid an annual bonus. (It would make much more sense to pay a bonus–and allow the bonus to be large–every five or ten years.)

(2) Expectations. Some fund managers feel the outperformance cannot continue. The error being made is that essentially no investor can predict their biggest winners ahead of time. So it’s best to stick with a winner as long as the investment thesis is intact and the estimated intrinsic value is high enough (or the company has a sustainably high ROE).

(3) Forecasting. Often when fund managers look one or two years ahead and use conservative assumptions, the estimated intrinsic value is not much higher than the current stock price. This makes it difficult to stick with the big winners.

(4) Relativity. Unfortunately, many fund managers are evaluated on a shorter-term basis. This makes them obsess over shorter-term results. However, the biggest winners often increase the most in year 3 or year 4 or later. A fund manager worried about 6-month or 1-year performance will tend to miss the biggest winners.

Freeman-Shor writes:

So being assessed on a relative basis leads fund managers to pay alot of attention to how they are performing relative to both the benchmark index and their peer group. Worse still, some do this on a daily basis. They know the value of their holdings almost to the hour.

And it leads to a lot of unnecessary early selling. It helps professional investors think that stocks are riskier than they actually are. By monitoring a stock they are invested in several times a day, they notice the share price moves up and down quite a bit. The price seems volatile.

But what if you just reviewed an investment every ten years? You would probably find that the stock has made you quite a lot of money. Moreover, because you did not check the stock price during that ten-year period, you did not notice the price moving up and down every day. You never experienced the pain of a 20% fall in one day–perhaps 50% in a year. You were completely unaware of the volatility of the ride you were on. You therefore come to the conclusion that investing in the stock market is not risky at all.

My note: Fidelity did a study of its accounts and it found that the best-performing accounts belonged to people who either forgot they had an account or to people who had died.

 

The Connoisseurs: Enjoying Every Last Drop

Freeman-Shor writes:

The Connoisseurs are the last and most successful investment tribe I discovered among the top investors who worked for me. These are the investors whose performance lived up to the billing–or exceeded it. They did not get paralysed by unexpected losses or carried away with victories. They treated every investment like a vintage of wine: if it was off, they got rid of it immediately, but if it was good they knew it would only get better with age. They usually drank the odd bottle now and then, to tide them over–but otherwise they sat back and waited.

It takes a long of nerve to do nothing or merely trim a position when winning. Everything points to us being hard-wired to sell out of an investment when we have made a reasonable profit.

Taking small profits along the journey like a Connoisseur allows us to get instant gratification without ruining our long-term wealth aspirations. This ‘trick’ is one that I have seen in action and which allowed my best investors to stay in absolutely phenomenal winners.

HOW TO RIDE WINNERS

Freeman-Shor:

In terms of hit rate, as a group [Connoissers] actually had a worse record than the average for my investors. Six out of ten ideas the Connoisseurs invested in lost money. The trick was that when they won, they won big. They rode their winners far beyond most people’s comfort zone.

How to be like a Connoisseur:

(1) Find unsurprising companies.

The Connoisseurs’ approach was to identify companies with a view to holding them for ten or more years. They would buy businesses that they viewed as low ‘negative surprise’ companies. In other words, it was hard to envisage anything that could cause these companies to fail in generating profits over the years ahead.

Even if in the future they had terrible management at the helm, that management would have to be extraordinarily incompetent to destroy the profit-making ability of the enterprise. The companies were effectively money-printing machines.

The future growth of earnings was seen as very predictable, and because the Connoisseurs believed earnings growth drove stock prices, the stock price should therefore drift higher over time.

The main risk of buying these stocks was if they were rated highly at the outset (i.e. with high price/earnings ratio). This could mean that the company fundamentally performs as expected but the share price doesn’t follow earnings upwards due to it getting derated.

(2) Look for big upside potential. Where many investors go wrong is in investing in a lot of ideas with limited upside potential. Since your win rate may be between 40% and 49%, it’s essential to focus only on stocks with the biggest upside potential–or stocks trading at the greatest discount to intrinsic value.

(3) Invest big–and focused. Connoisseurs could end up with 50% of their portfolio in just two stocks. Freeman-Shor:

Having massive belief in a couple of names meant they were prepared to ride the stocks with big positions even when they were up 200% or more. Their success was testament to Stanley Druckenmiller’s comment that “position size can be more important than entry price.”

This is one of the reasons that I allow each of my current investors to invest up to 25% of the money I give them in a single idea.

Freeman-Shor quotes New Market Wizards:

When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

Freeman-Shor comments:

It is no use having a small investment in a big winner; you have to have a large position size to generate big returns.

(4) Don’t be scared. One key to sticking with a big winner and not being attracted by another great investment is to take small profits as the potential big winner is going up. But the bulk of the potential big winner should be maintained and not sold.

(5) Make sure you have a pillow. Freeman-Shor writes about having a high boredom threshold:

Meeting some of my Connoisseurs could be very, very boring because nothing ever changed. They would talk about the same stocks they had been invested in for the past five years or longer…

The fact is, most of us will find it difficult to emulate the Connoisseurs because we feel the need to do something when we get to the office (or home trading desk) every day. We look at stock price charts, listen to the latest market news on Bloomberg TV, and fool ourselves into believing we could add value from making a few small trades here and there. It is very hard to do nothing but focus on the same handful of companies every year, only researching new ideas on the side.

Many of us, seeing we have made a profit of 40% in one of our stocks, start actively looking for another company to invest the money into–instead of leaving it invested. This is precisely why lots of investors never become very successful.

Freeman-Shor next gives some real-life examples.

Shoprite Holdings is the largest food retailer in Africa. It also operates furniture outlets, fast food outlets, and pharmacies. It is the Wal-Mart of Africa. One of the Connoisseurs invested in Shoprite on May 20, 2009, at £3.96 per share. He sold the position three years later on August 9, 2012, at £13.10 per share. This was a return of 231% in only three years. This investor trimmed along the way and realized an overall profit of 104%.

Spirax-Sarco Engineering is a UK company that builds and maintains steam and industrial fluid plants. The company’s products–which include boilder and pipeline control valves and clean steam generators–are being used more and more. One of the Connoisseurs had known about this company for decades. He bought a position on November 30, 2007, at £9.63. He sold five years later on October 22, 2012, at £19.70. The Connoisseur trimmed along the way and so realized a profit of 70% by selling at an average price of £16.40.

Rotork is a UK-based business and the world’s leading manufacturer of valve actuators, whether electric, pneumatic, or hydraulic. The Connoisseur had known about the company for a long time. He bought a position on November 30, 2007, at £9.84. He sold five years later at £25.18. Because the investor took profits along the way, he realized an average selling price of £17.26, banking a profit of 74%.

President Chain Stores is a Taiwanese company. The company is an international food conglomerate operating in Taiwan and China. It’s similar to Wal-Mart. One of the Connoisseurs established a position on June 15, 2006, at £1.37 per share. He sold five years later on August 23, 2011, with the shares at £3.73. Because he trimmed along the way, the investor realized an average selling price of £3.17. This was a profit of 132%.

Kasikornbank is a commercial bank in Thailand. Through its wholly-owned subsidiaries, it does everything from investment banking to securities brokerage, fund management, hire purchase, and machinery/equipment leasing. A Connoiser initiated a position on June 20, 2008, at £1.09. He sold two years later on November 1, 2010, when the shares were at £2.65. Because the investor sold along the way, his average selling price was £1.88. Thus, he realized a profit of 79%.

Freeman-Shor writes an important point:

Remember, despite their successful approach, only one-in-three of the Connoisseurs’ ideas made money. In other words, every Connoisseur was also an Assassin or a Hunter when it came to losses.

CLUES FROM THEFORBES RICH LIST

Most people on the Forbes rich list not only have created a wonderful business, but also have never sold out. Many of these folks received buyout offers along the way, but they decided not to sell. Freeman-Shor:

Over the past decade or so, I would imagine Bezos has been approached by hundreds, possibly thousands of other companies wanting to buy Amazon from him. Could you have resisted if someone offered you $10m or $100m for your company? Resisting temptation and staying invested in a great idea is critical. Had Jeff sold out earlier when he was building Amazon, we may never have heard about him today.

Freeman-Shor adds:

When you are winning, dedication and discipline is what you require. The Pareto principle, otherwise known as the 80/20 rule, states that 80% of the effects come from 20% of the causes. It helps explain why great investors can be wrong most of the time and still make money. A few big winners make a massive difference to the eventual outcome.

WHY MANY FUND MANAGERS ARE DOOMED TO FAIL

Freeman-Shor writes that many fund managers find it nearly impossible to be Connoisseurs.

Firstly, many professional investors over-diversify when they invest because they are managing career risk. Most are judged by their bosses and employers based on how they perform against an index or peer group over ashort period of time. This militates against concentrating investments in potential long-term winners.

Secondly, regulators–based on investment theories from the 1970s–have put into place rules that prohibit professional fund managers from holding large positions in just a handful of their very best money-making ideas.

Why?

Because they believed diversified portfolios represent less risk than a concentrated portfolio of stocks. The reality, however, is that all you are doing is swapping one type of risk for another. You are exchanging company specific risk (idiosyncratic risk), which may be very low depending on the type of company you invest in, for market risk (systematic risk).

Risk hasn’t been reduced, it has been transferred.

The legendary investor Warren Buffett has written that if you know the companies you’re investing in very well and if you’ve focused only on your very best ideas, risk is actually lower than if you added more ideas about which you had both less conviction and less knowledge.

ACADEMIC SUPPORT FOR ‘BEST IDEAS’ INVESTING

There was a paper that looked at the performance of investment managers’ best ideas. They found:

    • The single highest-conviction stock of every manager taken together outperformed the market, as well as the other stocks in those managers’ portfolios, by approximately 1-4% a quarter. That is a staggering 4-16% a year. Over a ten-year time frame, that means these stocks could have outperformed the market by a phenomenal 48-341%!
    • The managers’ top five stocks also outperformed the market, as well as the other stocks in those managers’ portfolios, significantly.
    • The managers’ worst ideas–those stocks with the lowest weighting–performed significantly worse than the managers’ best ideas.

The study also found that there was little overlap in terms of the specific best ideas of the investors they studied. The bottom line: Success comes from investing inyour best idea.

The authors of the paper conclude:

What if each mutual fund manager had only to pick a few stocks, their best ideas? Could they outperform under those circumstances? We document strong evidence that they could, as the best ideas of the active managers generate up to an order of magnitude more alpha than their portfolio as a whole.

The paper also notes:

The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over diversify, i.e. pick more stocks than their best alpha-generating ideas.

Again:

…the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolios that are not outperformers… [in other words] managers attempt to maximise profits by maximizing assets under management… while investors benefit from concentration… managers under most commonly-used fee structures are better off with a more diversified portfolio.

DANGERS OF BEING A CONNOISSEUR

Freeman-Shor notes that while being a Connoisseur generates the highest returns, it is not easy and there are dangers, three in particular:

(1) You can be too late. After a stock has increased a greal deal, at some point it won’t and the investor may be too late. I would add: As long as the intrinsic value is higher than the current stock price, or as long as the ROE is sustainably high (if you’re buying a higher quality business as your value investment strategy) and the stock price reasonable, then you should be OK.

(2) Momentum can be illusory–and end abruptly. See the previous point.

One must also beware of bubbles. Freeman-Shor mentions the book by Charles Mackay,Extraordinary Popular Delusions and the Madness of Crowds (1841).

His research showed how people lose the ability to think rationally under pressures of crowd behavior. At the height of a bull market or in the depths of a bear market people become herd-minded.

This suggests that sipping some of those profits over time makes a lot of sense. While you stay invested and therefore have the potential to win big, you are mitigating the potential damage should the shares disappoint.

(3) You can get stuck. If panic takes over, it can be difficult to sell.

 

CONCLUSION: THE HABITS OF SUCCESS

Freeman-Shor writes:

Having had the privilege of investing over a billion dollars with the best investors in the world, and managing them on a daily basis for over eight years, my preconceptions about successful investors have been shattered.

I discovered that the success enjoyed by top investors is not due to possessing a special gift, nor from having a privileged upbringing (though some who worked for me did). Nor is it down to being born geniuses, though many were very smart. Instead, any success ultimately came down to just one thing: execution.

This was the common thread that connected all of them. And the secrets of successful execution were really just a matter of habit.

Each had learned the unseen art of executing ideas in a way that meant that even if they were wrong most of the time, they would still make a lot of money.

These successful investors didn’t have any clairvoyant forecasting abilities, but they knew what to do when they were winning or losing. Freeman-Shor:

If they were losing they knew they had to materially adapt, like a poker player being dealt a poor hand. A losing position was feedback from the market showing them that they were wrong to invest when they did. They knew that doing nothing, or a little, was futile. They had each independently developed a habit of significantly reducing or materially buying more shares when they were losing.

When winning, to take an analogy from baseball, the successful investors knew they had to try to hit a home run, as opposed to stealing first base. This meant that they had developed the hidden habit of being resolved to stay invested in a winning position even when inside they were burning to take the profits they had made, and their inner voice was screaming, ‘Take the profit before you lose it!’

Freeman-Shor adds the following:

Success in investing is open to anyone, whatever their level of education or background, whether old or young, experienced or inexperienced. You simply need to materially adapt when losing and remain faithful when winning.

If you have the discipline to do that, you can succeed.

I have no doubt that many professional investors reading this will neither change the way they invest nor adopt the winning habits I have revealed. They will consider them too simple or common. Most think they are just too smart and that they know best. They are overconfident in the same way all drivers think they are better than average. It’s their loss.

Freeman-Shor makes an additional, important point:

Some people may worry that adopting the habits of the successful investing tribes means losing their identity–or looking to invest with ideas that aren’t really theirs. The good news is that the investors within each group all had radically different opinions about almost everything. Their habits of execution overlapped, but the ideas that got them into an investment in the first place could not have been more different.

 

THE WINNER’S CHECKLIST: THE FIVE WINNING HABITS OF INVESTMENT TITANS

(1) BEST IDEAS ONLY. You should only invest in your very best ideas. Period. One or two big winners is essential for success.

(2) POSITION SIZE MATTERS. Again, it’s essential not to over-diversify. Invest only in your very best ideas. But have a handful of these ideas, not just one, because sometimes there are unforseen events or bad luck.

(3) BE GREEDY WHEN WINNING. You have to let your winners run. Embrace the possibility of the big win. Embrace the right tail, the statistical long shots, of the distribution curve. Give your investments the possibility of growing into ‘ten baggers.’

(4) MATERIALLY ADAPT WHEN YOU ARE LOSING. Either add significantly to a losing position or sell out. If you add more, you can turn a loser into a winner.

(5) ONLY INVEST IN LIQUID STOCKS. How liquid a stock is depends in part on how much you’re investing. If you’re investing $10 million or less, then most of the best investments will be microcap stocks.

 

THE LOSER’S CHECKLIST: THE FIVE LOSING HABITS OF MOST INVESTORS

(1) INVEST IN LOTS OF IDEAS. As noted earlier, Warren Buffett has pointed out that you should concentrate on your best ideas and that adding more ideas than that would onlyincrease risk anddecrease returns. Or as Charlie Munger said:

Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.

(2) INVEST A SMALL AMOUNT IN EACH IDEA. This is related to the previous point. If you do not invest big in your best ideas, you won’t be able to do very well because a few big winners are what make the difference between an extraordinary track record and a mediocre one.

(3) TAKE SMALL PROFITS. If you sell too much of your best ideas before giving them a chance to really run, you are cutting off your best chance for excellent overall results.

(4) STAY IN AN INVESTMENT IDEA AND REFUSE TO ADAPT WHEN LOSING

(5) DO NOT CONSIDER LIQUIDITY

 

 

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 with improving fundamentals and positive momentum. We rank microcap stocks based on these and similar criteria.

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

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

 

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

My e-mail: jb@boolefund.com

 

 

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

The Education of a Value Investor

August 17, 2025

I have now read The Education of a Value Investor, by Guy Spier, several times.  It’s a very honest and insightful description of Guy Spier’s evolution from arrogant and envious youth to kind, ethical, humble, and successful value investor in the mold of his heroes – including the value investors Mohnish Pabrai, Warren Buffett, and Charlie Munger.

Spier recounts how, after graduating near the top of his class at Oxford and then getting an MBA at Harvard, he decided to take a job at D. H. Blair, an ethically challenged place.  Spier realized that part of his job was to dress up bad deals.  Being unable to admit that he had made a mistake, Spier ended up tarnishing his reputation badly by playing along instead of quitting.

Spier’s story is about the journey “from that dark place toward the Nirvana where I now live.”

Besides the lesson that one should never do anything unethical, Spier also learned just how important the environment is:

We like to think that we change our environment, but the truth is that it changes us.  So we have to be extraordinarily careful to choose the right environment….

 

THE PERILS OF AN ELITE EDUCATION

Spier observes that having an education from a top university often does not prevent one from making foolish and immoral decisions, especially when money or power is involved:

Our top universities mold all these brilliant minds.  But these people – including me – still make foolish and often immoral choices.  This also goes for my countless peers who, despite their elite training, failed to walk away from nefarious situations in other investment banks, brokerages, credit-rating agencies, bond insurance companies, and mortgage lenders.

Having stumbled quite badly, Spier felt sufficiently humbled and humiliated that he was willing to reexamine everything he believed.  Thus, in the wake of the worst set of decisions of his life, Spier learned important lessons about Wall Street and about himself that he never could have learned at Oxford or Harvard.

For one thing, Spier learned that quite a few people are willing to distort the truth in order to further their “own narrow self-interest.”  But having discovered Warren Buffett, who is both highly ethical and arguably the best investor ever, Spier began to see that there is another way to succeed.  “This discovery changed my life.”

 

WHAT WOULD WARREN BUFFETT DO?  WHAT WOULD CHARLIE MUNGER DO?  WHAT WOULD MARCUS AURELIUS DO?

Spier argues that choosing the right heroes to emulate is very powerful:

There is a wisdom here that goes far beyond the narrow world of investing.  What I’m about to tell you may be the single most important secret I’ve discovered in all my decades of studying and stumbling.  If you truly apply this lesson, I’m certain that you will have a much better life, even if you ignore everything else I write!

Having found the right heroes, one can become more like them gradually if one not only studies them relentlessly, but also tries to model their behavior.  For example, it is effective to ask oneself:  “What would Warren Buffett do if he were in my shoes right now?  What would Charlie Munger do?  What would Marcus Aurelius do?”

This is a surprisingly powerful principle: modeling the right heroes.  It can work just as well with eminent dead people, as Munger has pointed out.  One can relentlessly study and then model Socrates or Jesus, Epictetus or Seneca, Washington or Lincoln.  With enough studying and enough effort to copy / model, one’s behavior will gradually improve to be more like that of one’s chosen heroes.

 

ENVIRONMENT TRUMPS INTELLECT

Our minds are not strong enough on their own to overcome the environment:

…I felt that my mind was in Omaha, and I believed that I could use the force of my intellect to rise above my environment.  But I was wrong: as I gradually discovered, our environment is much stronger than our intellect.  Remarkably few investors – either amateur or professional – truly understand this critical point.  Great investors like Warren Buffett (who left New York and returned to Omaha) and Sir John Templeton (who settled in the Bahamas) clearly grasped this idea, which took me much longer to learn.

For long-term value investors, the farther away from Wall Street one is, the easier it is to master the skills of patience, rationality, and independent thinking.

 

CAUSES OF MISJUDGMENT

Charlie Munger gave a talk in 1995 at Harvard on 24 causes of misjudgment.  At the time, as Spier writes, this worldly wisdom – combining powerful psychology with economics and business – was not available anywhere else.  Munger’s talk provides deep insight into human behavior.  Link to speech: http://www.rbcpa.com/mungerspeech_june_95.pdf

Decades of experiments by Daniel Kahneman, Amos Tversky, and others have shown that humans have two mental systems: an intuitive system that operates automatically (and subconsciously) and a reasoning system that requires conscious effort.  Through years of focused training involving timely feedback, some people can train themselves to regularly overcome their subconscious and automatic biases through the correct use of logic, math, or statistics.

But the biases never disappear.  Even Kahneman admits that, despite his deep knowledge of biases, he is still automatically “wildly overconfident” unless he makes the conscious effort to slow down and to use his reasoning system.

 

LUNCH WITH WARREN

Guy Spier and Mohnish Pabrai had the winning bid for lunch with Warren Buffett – the proceeds go to GLIDE, a charity.

One thing Spier learned – directly and indirectly – from lunch with Warren is that the more one genuinely tries to help others, the happier life becomes.  Writes Spier:

As I hope you can see from my experience, when your consciousness or mental attitude shifts, remarkable things begin to happen.  That shift is the ultimate business tool and life tool.

At the lunch, Warren repeated a crucial lesson:

It’s very important always to live your life by an inner scorecard, not an outer scorecard.

In other words, it is essential to live in accord with what one knows at one’s core to be right, and never be swayed by external forces such as peer pressure.  Buffett pointed out that too often people justify misguided or wrong actions by reassuring themselves that ‘everyone else is doing it.’

Moreover, Buffett said:

People will always stop you from doing the right thing if it’s unconventional.

Spier asked Buffett if it gets easier to do the right thing.  After pausing for a moment, Buffett said: ‘A little.’

Buffett also stressed the virtue of patience when it comes to investing:

If you’re even a slightly above average investor who spends less than you earn, over a lifetime you cannot help but get very wealthy – if you’re patient.

Spier realized that he could learn to copy many of the successful behaviors of Warren Buffett, but that he could never be Warren Buffett.  Spier observes that what he learned from Warren was to become the best and most authentic version of Guy Spier.

 

HANDLING ADVERSITY

One effective way Spier learned to deal with adversity was by:

…studying heroes of mine who had successfully handled adversity, then imagining that they were by my side so that I could model their attitudes and behavior.  One historical figure I used in this way was the Roman emperor and Stoic philosopher Marcus Aurelius.  At night, I read excerpts from his Meditations.  He wrote of the need to welcome adversity with gratitude as an opportunity to prove one’s courage, fortitude, and resilience.  I found this particularly helpful at a time when I couldn’t allow myself to become fearful.

Moreover, Spier writes about heroes who have overcome serious mistakes:

I also tried to imagine how Sir Ernest Shackleton would have felt in my shoes.  He had made grievous mistakes on his great expedition to Antarctica – for example, failing to land his ship, Endurance, when he could and then abandoning his first camp too soon.  Yet he succeeded in putting these errors behind him, and he ultimately saved the lives of everyone on his team.  This helped me to realize that my own mistakes were an acceptable part of the process.  Indeed, how could I possibly pilot the wealth of my friends and family without making mistakes or encountering the occasional storm?  Like Shackleton, I needed to see that all was not lost and to retain my belief that I would make it through to the other side.

 

CREATING THE IDEAL ENVIRONMENT

Overcoming our cognitive biases and irrational tendencies is not a matter of simply deciding to use one’s rational system.  Rather, it requires many years of training along with specific tools or procedures that help reduce the number of mistakes:

Through painful experience… I discovered that it’s critical to banish the false assumption that I am truly capable of rational thought.  Instead, I’ve found that one of my only advantages as an investor is the humble realization of just how flawed my brain really is.  Once I accepted this, I could design an array of practical work-arounds based on my awareness of the minefield within my mind. 

No human being is perfectly rational.  Every human being has at one time or another made an irrational decision.  We all have mental shortcomings:

…The truth is, all of us have mental shortcomings, though yours may be dramatically different from mine.  With this in mind, I began to realize just how critical it is for investors to structure their environment to counter their mental weaknesses, idiosyncrasies, and irrational tendencies.

Spier describes how hard he worked to create an ideal environment with the absolute minimum of factors that could negatively impact his ability to think rationally:

Following my move to Zurich, I focused tremendous energy on this task of creating the ideal environment in which to invest – one in which I’d be able to act slightly more rationally.  The goal isn’t to be smarter.  It’s to construct an environment in which my brain isn’t subjected to quite such an extreme barrage of distractions and disturbing forces that can exacerbate my irrationality.  For me, this has been a life-changing idea.  I hope that I can do it justice here because it’s radically improved my approach to investing, while also bringing me a happier and calmer life.

As we shall see in a later chapter, I would also overhaul my basic habits and investment procedures to work around my irrationality.  My brain would still be hopelessly imperfect. But these changes would subtly tilt the playing field to my advantage.  To my mind, this is infinitely more helpful than focusing on things like analysts’ quarterly earnings reports, Tobin’s Q ratio, or pundits’ useless market predictions – the sort of noise that preoccupies most investors.

 

LEARNING TO TAP DANCE

Spier, like Pabrai, believes that mastering the game of bridge improves one’s ability to think probabilistically:

Indeed, as a preparation for investing, bridge is truly the ultimate game.  If I were putting together a curriculum on value investing, bridge would undoubtedly be a part of it!

For investors, the beauty of bridge lies in the fact that it involves elements of chance, probabilistic thinking, and asymmetric information.  When the cards are dealt, the only ones you can look at are your own.  But as the cards are played, the probabilistic and asymmetric nature of the game becomes exquisite!

With my bridge hat on, I’m always searching for the underlying truth, based on insufficient information.  The game has helped me to recognize that it’s simply not possible to have a complete understanding of anything.  We’re never truly going to get to the bottom of what’s going on inside a company, so we have to make probabilistic inferences.

Chess is another game that can improve one’s cognition in other areas.  Spier cites the lesson given by chess champion Edward Lasker:

When you see a good move, look for a better one.  

The lesson for investing:

When you see a good investment, look for a better investment.

Spier also learned, both from having fun at games such as bridge and chess, and from watching business people including Steve Jobs and Warren Buffett, that having a more playful attitude might help.  More importantly, whether via meditation or via other hobbies, if one could cultivate inner peace, that could make one a better investor.

The great investor Ray Dalio has often mentioned transcendental meditation as leading to a peaceful state of mind where rationality can be maximized and emotions minimized.  See: https://www.youtube.com/watch?v=zM-2hGA-k5E

Spier explains:

To give you an analogy, when you drop a stone in a calm pond, you see the ripples.  Likewise, in investing, if I want to see the big ideas, I need a peaceful and contented mind.

 

INVESTING TOOLS

Having written about various ways that he has made his environment as peaceful as possible – he also has a library full of great books (1/3 of which are unread), with no internet or phone – Spier next turns to ‘rules and routines that we can apply consistently.’

In the aftermath of the financial crisis, I worked hard to establish for myself this more structured approach to investing, thereby bringing more order and predictability to my behavior while also reducing the complexity of my decision-making process.  Simplifying everything makes sense, given the brain’s limited processing power”!

Some of these rules are broadly applicable; others are more idiosyncratic and may work better for me than for you.  What’s more, this remains a work in progress – a game plan that I keep revising as I learn from experience what works best.  Still, I’m convinced that it will help you enormously if you start thinking about your own investment processes in this structured, systematic way.  Pilots internalize an explicit set of rules and procedures that guide their every action and ensure the safety of themselves and their passengers.  Investors who are serious about achieving good returns without undue risk should follow their example.

Here are Spier’s rules:

Rule #1 – Stop Checking the Stock Price

A constantly moving stock price influences the brain – largely on a subconscious level – to want to take action.  But for the long-term value investor, the best thing is almost always to do nothing at all.  Thus, it is better only to check prices once per week, or even once per quarter or once per year:

Checking the stock price too frequently uses up my limited willpower since it requires me to expend unnecessary mental energy simply resisting these calls to action.  Given that my mental energy is a scarce resource, I want to direct it in more constructive ways.

We also know from behavioral finance research by Daniel Kahneman and Amos Tversky that investors feel the pain of loss twice as acutely as the pleasure from gain.  So I need to protect my brain from the emotional storm that occurs when I see that my stocks – or the market – are down.  If there’s average volatility, the market is typically up in most years over a 20-year period.  But if I check it frequently, there’s a much higher probability that it will be down at that particular moment… Why, then, put myself in a position where I may have a negative emotional reaction to this short-term drop, which sends all the wrong signals to my brain?

…After all, Buffett didn’t make billions off companies like American Express and Coca-Cola by focusing on the meaningless movements of the stock ticker.

 

Rule #2 – If Someone Tries to Sell You Something, Don’t Buy It

The brain will often make terrible decisions in response to detailed pitches from gifted salespeople.

Rule #3 – Don’t Talk to Management

Beware of CEO’s and other top management, no matter how charismatic, persuasive, and amiable they seem.  Most managers have natural biases towards their own companies.

Rule #4 – Gather Investment Research in the Right Order

We know from Munger’s speech on the causes of human misjudgment that the first idea to enter the brain tends to be the one that sticks.

Spier starts with corporate filings – ‘meat and vegetables’ – before consuming news and other types of information.

Rule #5 – Discuss Your Investment Ideas Only with People Who Have No Axe to Grind

The idea is to try to find knowledgeable people who can communicate in an objective and logical way, minimizing the influence of various biases.

Rule #6 – Never Buy or Sell Stocks When the Market is Open

This again relates to the fact that flashing stock prices push the brain subconsciously towards action:

When it comes to buying and selling stocks, I need to detach myself from the price action of the market, which can stir up my emotions, stimulate my desire to act, and cloud my judgment.  So I have a rule, inspired by Mohnish, that I don’t trade stocks while the market is open.  Instead, I prefer to wait until trading hours have ended.

Rule #7 – If a Stock Tumbles after You Buy It, Don’t Sell It for Two Years

When you’ve lost a lot of money, many negative emotions occur.

Mohnish developed a rule to deal with the psychological forces aroused in these situations: if he buys a stock and it goes down, he won’t allow himself to sell it for two years.

…Once again, it acts as a circuit breaker, a way to slow me down and improve my odds of making rational decisions.  Even more important, it forces me to be more careful before buying a stock since I know that I’ll have to live with my mistake for at least two years.  That knowledge helps me to avoid a lot of bad investments.  In fact, before buying a stock, I consciously assume that the price will immediately fall by 50 percent, and I ask myself if I’ll be able to live through it.  I then buy only the amount that I could handle emotionally if this were to happen.

Mohnish’s rule is a variation on an important idea that Buffett has often shared with students:

I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it, so that you had 20 punches – representing investments that you got to make in a lifetime.  And once you’d punched through the card, you couldn’t make any more investments at all.  Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about.  So you’d do much better.

Rule #8 – Don’t Talk about Your Current Investments

Once we’ve made a public statement, it’s psychologically difficult to back away from what we’ve said.  The automatic intuitive system in our brains tries to quickly remove doubt by jumping to conclusions.  This system also tries to eliminate any apparent inconsistencies in order to maintain a coherent – albeit highly simplified – story about the world.

But it’s not just our intuitive system that focuses on confirming evidence.  Even our logical system – the system that can do math and statistics – uses a positive test strategy:  When testing a given hypothesis, our logical system looks for confirming evidence rather than disconfirming evidence.  This is the opposite of what works best in science.

Thus, once we express a view, our brain tends to see all the reasons why the view must be correct and our brain tends to be blind to reasons why the view might be wrong.

 

AN INVESTOR’S CHECKLIST

Atul Gawande, a former Rhodes scholar, is a surgeon at Brigham and Women’s Hospital in Boston, a professor of surgery at Harvard Medical School, and a renowned author.  He’s ‘a remarkable blend of practitioner and thinker, and also an exceptionally nice guy.’  In December 2007, Gawande published a story in The New Yorker entitled “The Checklist”:  http://www.newyorker.com/magazine/2007/12/10/the-checklist

One of Gawande’s main points is that ‘intensive-care medicine has grown so far beyond ordinary complexity that avoiding daily mistakes is proving impossible even for our super-specialists.’

Gawande then described the work of Peter Pronovost, a critical-care specialist at Johns Hopkins Hospital.  Pronovost designed a checklist after a particular patient nearly died:

Pronovost took a single sheet of paper and listed all of the steps required to avoid the infection that had almost killed the man.  These steps were all ‘no-brainers,’ yet it turned out that doctors skipped at least one step with over a third of their patients.  When the hospital began to use checklists, numerous deaths were prevented.  This was partly because checklists helped with memory recall, ‘especially with mundane matters that are easily overlooked,’ and partly because they made explicit the importance of certain precautions.  Other hospitals followed suit, adopting checklists as a pragmatic way of coping with complexity.

Mohnish Pabrai and Guy Spier, following Charlie Munger, realized that they could develop a useful checklist for value investing.  The checklist makes sense as a way to overcome the subconscious biases of the human intuitive system.  Moreover, humans have what Spier calls “cocaine brain”:

the intoxicating prospect of making money can arouse the same reward circuits in the brain that are stimulated by drugs, making the rational mind ignore supposedly extraneous details that are actually very relevant.  Needless to say, this mental state is not the best condition in which to conduct a cool and dispassionate analysis of investment risk.

An effective investor’s checklist is based on a careful analysis of past mistakes, both by oneself and by others.

My own checklist, which borrows shamelessly from [Mohnish Pabrai’s], includes about 70 items, but it continues to evolve.  Before pulling the trigger on any investment, I pull out the checklist from my computer or the filing cabinet near my desk to see what I might be missing.  Sometimes, this takes me as little as 15 minutes, but it’s led me to abandon literally dozens of investments that I might otherwise have made…

As I’ve discovered from having ADD, the mind has a way of skipping over certain pieces of information – including rudimentary stuff like where I’ve left my keys.  This also happens during the investment process.  The checklist is invaluable because it redirects and challenges the investor’s wandering attention in a systematic manner…

That said, it’s important to recognize that my checklist should not be your checklist.  This isn’t something you can outsource since your checklist has to reflect your own unique experience, knowledge, and previous mistakes.  It’s critical to go through the arduous process of analyzing where things have gone wrong for you in the past so you can see if there are any recurring patterns or particular areas of vulnerability.

It is very important to note that there are at least four categories of investment mistakes, all of which must be identified, studied, and learned from:

    • A mistake where the investment does poorly because the intrinsic value of the business in question turns out to be lower than one thought;
    • A mistake of omission, where one fails to invest in a stock that one knows is cheap;
    • A mistake of selling the stock too soon.  Often a value investment will fail to move for years.  When it finally does move, many value investors will sell far too soon, sometimes missing out on an additional 300-500% return (or even more).  Value investors Peter Cundill and Robert Robotti have discussed this mistake.
    • A mistake where the investment does well, but one realizes that the good outcome was due to luck and that one’s analysis was incorrect.  It is often difficult to identify this type of mistake because the outcome of the investment is good, but it’s crucial to do so, otherwise one’s future results will be penalized.

Here is the value investor Chris Davis talking about how he and his colleagues frame their mistakes on the wall in order never to forget the lessons:  http://davisfunds.com/document/video/mistake_wall

Davis points out that, as an investor, one should always be improving with age.  As Buffett and Munger say, lifelong learning is a key to success, especially in investing, where all knowledge is cumulative.   Frequently one’s current decisions are better and more profitable as a result of having learned the right lessons from past mistakes.

 

DOING BUSINESS THE BUFFETT-PABRAI WAY

Buffett:

Hang out with people better than you, and you cannot help but improve.

Pabrai likes to quote Ronald Reagan:

There’s no limit to what you can do if you don’t mind who gets the credit.

Buffett also talks about the central importance of treating others as one wishes to be treated:

The more love you give, the more love you get.

Spier says that this may be the most important lesson of all.  The key is to value each person as an end rather than a means.  It helps to remember that one is a work in progress and also that one is mortal.  Pabrai:

I am but ashes and dust.

Spier explains that he tries to do things for people he meets.  Over time, he has learned to distinguish givers from takers.

The crazy thing is that, when you start to live this way, everything becomes so much more joyful.  There is a sense of flow and alignment with the universe that I never felt when everything was about what I could take for myself…

I’m not telling you this to be self-congratulatory as there are countless people who do so much more good than I do.  The point is simply that life has improved immeasurably since I began to live this way.  In truth, I’ve become increasingly addicted to the positive emotions awakened in me by these activities… One thing is for sure: I receive way more by giving than I ever did by taking.  So, paradoxically, my attempts at selflessness may actually be pretty selfish.

 

THE QUEST FOR TRUE VALUE

Buffett calls it the inner scorecard and Spier calls it the inner journey:

The inner journey is that path to becoming the best version of ourselves that we can be, and this strikes me as the only true path in life.  It involves asking questions such as:  What is my wealth for?  What give my life meaning?  And how can I use my gifts to help others?

Templeton also devoted much of his life to the inner journey.  Indeed, his greatest legacy is his charitable foundation, which explores ‘the Big Questions of human purpose and ultimate reality,’ including complexity, evolution, infinity, creativity, forgiveness, love, gratitude, and free will.  The foundation’s motto is ‘How little we know, how eager to learn.’

In my experience, the inner journey is not only more fulfilling but is also a key to becoming a better investor.  If I don’t understand my inner landscape – including my fears, insecurities, desires, biases, and attitude to money – I’m likely to be mugged by reality.  This happened early in my career, when my greed and arrogance led me to D. H. Blair… [also later in New York with envy]

By embarking on the inner journey, I became more self-aware and began to see these flaws more clearly.  I could work to overcome them only once I acknowledged them.  But these traits were so deepseated that I also had to find practical ways to navigate around them.

The important thing is to understand not only human biases in general, but also one’s own unique brain.  Also, some lessons can only be learned through difficult experiences – including mistakes:

Adversity may, in fact, be the best teacher of all.  The only trouble is that it takes a long time to live through our mistakes and then learn from them, and it’s a painful process.

It doesn’t matter exactly how you do the inner journey, just that you do it.

[The] real reward of this inner transformation is not just enduring investment success.  It’s the gift of becoming the best person we can be.  That, surely, is the ultimate prize. 

 

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 with improving fundamentals and positive momentum. We rank microcap stocks based on these and similar criteria.

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Investing the Templeton Way

August 10, 2025

John Templeton is one of the greatest value investors of all time as well as one of the greatest global investors of all time. Thus, his methods are worth studying carefully. The book,Investing the Templeton Way: The Market-Beating Strategies of Value Investing’s Legendary Bargain Hunter, is an excellent summary of Templeton’s methods. It is written by John Templeton’s niece Lauren C. Templeton and her husband Scott Phillips, both of whom are professional investors.

In the Forward to the book, Templeton remarks:

We should be deeply grateful to have been born in this age of unbelievable prosperity…

Throughout history, people have focused too little on the opportunities that problems present in investing and in life in general. The twenty-first century offers great hope and glorious promise, perhaps a new golden age of opportunity.

Templeton also notes that he is a value investor:

There are many investing methods available, but I have had the most success when purchasing stocks priced far too low in relation to their intrinsic worth. Throughout my investment career, I have searched the world for the best bargain stocks available.

Templeton shares his motto:

To buy when others are despondently selling and to sell when others are avidly buying requires the greatest of fortitude and pays the greatest ultimate reward.

Finally, Templeton observes:

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

This is very similar to Warren Buffett’s advice:

I’ll tell you the secret to getting rich. Close the doors. Be greedy when others are fearful and fearful when others are greedy.

Here is an outline of this blog post:

    • The Birth of a Bargain Hunter
    • The First Trade in Maximum Pessimism
    • The Uncommon Common Sense of Global Investing
    • The First to Spot the Rising Sun
    • The Death of Equities or the Birth of a Bull Market?
    • No Trouble to Short the Bubble
    • Crisis Equals Opportunity
    • History Rhymes
    • When Bonds are Not Boring
    • The Sleeping Dragon Awakes

 

THE BIRTH OF A BARGAIN HUNTER

John Templeton learned early from his parents the virtues of thrift, industriousness, curiosity, and quiet self-assuredness. The author Lauren Templeton says,

If I had to characterize his personality in one phrase, it would be ‘eternally optimistic.’

Authors Lauren Templeton and Scott Philips then write that John Templeton–whom they call “Uncle John”–was a value investor, which they define as follows:

We consider a value investor to be an individual who attempts to pay less than what he or she believes is the true value of a specific asset or object. At the core of this definition is a simple but critical assumption: The price of an asset or object can differ from its true value or worth.

The authors mention that John Templeton probably got his first lesson in value investing from watching his father, Harvey Sr., a lawyer in Winchester, Tennessee. Harvey Sr. tried many methods of making extra money, such as running a cotton gin, selling insurance, renting property, and buying farm land. When it came to buying farmland, Harvey Sr. would only bid at auctions that failed to get any bids. So he bought some cheap properties that ended up being worth much more decades later.

The authors note that a great irony of the stock market is that when prices drop significantly, there are few buyers even though it’s the best time to buy.

Another formative experience for Uncle John was when his father made a fortune in the cotton futures market. He announced to John and John’s brother that neither they, their children, nor their grandchildren would have to work. Only a few days later, Harvey Sr. came home and announced, “Boys, we’ve lost it all; we’re ruined.” This likely caused John to learn not only about the importance of savings, but also about the ethereal nature of paper wealth and the importance of risk management.

The authors record that Uncle John and his wife, Judith, made saving money into a game. For instance, they furnished their first apartment for $25 (less than $500 today). One of Uncle John’s favorite purchases was paying $5 for a $200 sofa bed. A few years later, after having their first child, they bought a house for $5,000 in cash, which they sold five years later for $17,000. The compounded annual return on that investment was close to 28 percent. Uncle John never used debt of any kind, including never having a mortgage. The authors note:

Seeing the lengths to which Uncle John and Judith went to track down bargains is important because it is wholly analogous to the same intensive search process that Uncle John employed in searching for bargain stocks on a worldwide basis. In a sense, when Uncle John was poring over Value Line stock reports, company filings, and other materials in search of a cheap stock, this practice was an extension of an innate desire to buy something selling for less than what he supposed was its true worth. Whether it is furniture, a house, a meal, a stock, or a bond, it doesn’t matter: Look for a bargain.

The authors reveal that Uncle John often spoke of a bargain as something that sells for 20 cents on the dollar, an 80% discount. It’s not easy to find this good of a bargain, but it’s a worthy goal. Also, keep in mind that Templeton was saving up to launch his own investment counsel practice, which he later did with great success.

The authors continue:

Often in the world of business you will find that the most successful practitioners are driven to heights by a noble purpose. Although some successful businesspeople are driven by money, many are successful because of altruistic intentions. Although it often is misunderstood, Sam Walton’s vision at Wal-Mart was to lower the cost of goods for Americans. He reasoned that this would put more discretionary money in their pockets and thus improve their lives. Henry Ford wanted to bring an automobile to the masses rather than sell to the wealthy alone like all the other carmarkets at that time. Rose Blumkin, the original proprietor of Nebraska Furniture Mart (probably the most successful furniture store to date, now owned by Berkshire Hathaway), always told people that her objective was to make nice furniture affordable to improve the lives of her customers. This concept of “doing well by doing good” was popularized by Benjamin Franklin, and it has been a winning recipe for business ever since.

It is no wonder, then, that Uncle John’s early love affair with thrift and saving guided him to share his gift for compounding his investors’ money in the best bargain stocks he could discover. Uncle John’s practice of thrift, his talent for bargain hunting, and his fascination with the compounding of interest was the exact formula necessary to make good on the advice of his mother, Vella: ‘Find a need and fill it.’ The need he identified was improving people’s lives by helping them create wealth, and his ability to fill that need was honed over the many years that led up to the launching of his own practice. By the time Uncle John began his own practice, he had determined his contribution to his fellow men and women and was executing that strategy during every waking moment.

After completing Yale undergrad, Templeton went to Oxford on a Rhodes Scholarship. During his breaks, he traveled widely. He also read ahead of time about each place he visited. The result was that Templeton gained knowledge about many different countries and cultures, which helped him later as an international investor.

Most U.S. investors only invested in U.S. stocks, largely because they believed the U.S. stock market was the only one that mattered. Templeton, on the other hand, invested all over the world. For Templeton, if a stock was a bargain, it was a bargain, regardless of where in the world it was. Of course, finding such global bargains entailed avoiding specific countries where there was political turmoil such as Germany in the late 1930s.

The authors note:

The point is that even back in the first half of the twentieth century, when no one else bought foreign stocks, Uncle John was comfortable investing in other countries because he had taken the time to become knowledgeable rather than be guided by biases.

The authors add:

If there is one thread that stretches throughout Uncle John’s investing career, it is his ability to sit back and act with wisdom, not just smarts, although he has plenty of those too. When Uncle John was a young child, friends and acquaintences of his mother always said the same thing about him, which was that he was ‘born old.’ The character trait that people saw in him as a young child was a unique blend of common sense and wisdom for someone with very little life experience. Incidentally, that is what enables him to play a cool hand when it comes to the market. It sounds so simple: Because he possesses innate wisdom and calmness, he is routinely able to see things that others cannot. The fact is that it is simple but extremely uncommon.

Simple wisdom is often lacking for most investors:

Many investors say that they are anxious for a big sell-off in the stock market so that they can pick up bargains. The facts state the case differently, though, when we see the Dow Jones fall 22.6 percent in a single day. Where were all those enthusiastic buyers when the Dow carried a price/earnings (P/E) ratio of 6.8 in 1979 and stayed at those low levels for a few years? What we find when we ask these questions is that buying stocks when no one else will is difficult for the majority of investors. Incidentally, that is the best way to get a bargain, and getting a bargain leads to the best returns.

It is all a matter ofperspective, and Uncle John’s perspective on the market is very unusual despite how simple it appears. Consider this type of perspective in Uncle John’s own words: ‘People are always asking me where the outlook is good, but that’s the wrong question. The right question is: Where is the outlook most miserable?’ The obvious application of this concept in practice is to avoid following the crowd. The crowd in this case consists of the majority of buyers in the stock market who continuously flock to the stocks whose prospects look the best. Avoiding situations in which the prospects look the best is counterintuitive to the way we conduct our normal day-to-day lives.

The authors continue with an observation about Templeton’s move from New York to the Bahamas:

Uncle John always remarks that his results improved after he moved to Nassau because he was forced to think far differenly than the rest of Wall Street.

Warren Buffett, arguably the greatest investor of all time, lives in the quiet, small city of Omaha, Nebraska, rather than in New York.

Uncle John’s ability to take advantage of the market’s occasional folly or naive misconceptions was honed throughout his childhood and into this college years by sitting at, of all places, the poker table. Uncle John in his earlier days was an expert poker player, or at the very least he was an expert compared to the boys in Winchester and, later, Yale and Oxford.

Templeton used poker winnings in order to pay for part of his education at Yale. Templeton excelled at keeping track of cards and calculating probabilities, while simultaneously understanding the abilities and strategies of other players. Roughly 25 percent of Templeton’s education funding can from poker winnings. The remaining 75 percent came from working student jobs and winning academic scholarships.

The authors write:

Let’s say you are playing poker with the same group of friends as always and one player has a habit of bluffing under certain circumstances. Since you have learned to spot this player’s bluffs, you usually can wait until he confidently raises the pot and then call when you are ready to take all of his money. Well, you cannot exactly call someone’s hand in the stock market, but if a stock is trading at an exorbitant level in comparison to its measures of prospective earnings, cash flows, and the like, you can conclude that the market for that stock, like your friend, is a bit full of it. In that case, you can be assured that your friend eventually will lose his shirt; and similarly, the market for that expensive stock will fall when investors figure out they are holding not a full house but a pair of threes.

 

THE FIRST TRADE IN MAXIMUM PESSIMISM

The authors write:

One of the key features of an asset bubble is that the market prices associated with the assets get much too high when the buyers are swept away by optimism and then later, after the market crashes, get much too low compared with the value of the assets as the sellers become pessimistic. This exaggerated rise and fall typified the years preceding and following the crash of 1929. Most important, this misbehavior of a stock price relative to the value of the company is not relegated to periods of market bubbles but can be a normal characteristic of daily, weekly, monthly, or yearly stock prices… The notion that a company and the stock price that supposedly represents its value in the market can become divorced from each other has its popular roots in the work and writings of Benjamin Graham, the coauthor of Security Analysis. Graham postulated, correctly in our opinion, that every company has an intrinsic value; in other words, every company can be assigned a reasonable estimate of what it is worth. However, in spite of this, the market for a company’s stock can fluctuate independently of the company’s value.

The authors later add:

This relationship is at the core of value investing: buying things for less than they are worth. That is the idea. As you will come to see later, you can arrive at this conclusion from a number of different directions. Most important, this strategy should permeate all your investing, whether you are dealing in stocks, real estate, or even art, baseball cards, or stamps. Identifying a discrepancy between what an asset is worth and its market price is the name of the game in every case. Just remember that in each case the price of something and the value of that thing can be far different. From here on, we will refer to this practice of buying things for less than they are worth as finding a bargain.

Many investors, even smart investors, can forget the difference between a stock price and the value of the company. People can fall for a story about a company and forget the calculate intrinsic value based on the data. The authors write:

Bargain hunters should never adopt a one-stop investment strategy that is based on well-told stories whether the stories come from your neighbor, your barber, or the smartest analyst on Wall Street. Bargain hunters must rely on their own assessment of whether the stock price is far enough below what they believe a company is worth. This is the sole guiding light on the horizon, and skepticism is the compass. Buying stocks solely on the basis of stories about companies is like letting the mythological sirens entice you onto the rocks of the shoreline. That rocky shoreline is scattered with the bodies of investors who listen to stories.

With respect to identnifying overvalued stocks, the authors write:

A tremendous body of research conducted over the last 50 years empirically confirms that stocks carrying a high ratio of price to sales, price to earnings, or price to book value make bad investments over the long run.

Furthermore, the authors assert:

…if you scanned your list of stocks ranked from the highest to lowest ratios of price to sales, price to earnings, price to book, and price to cash flow, you might discover that at the bottom of the list are some of the most unattractive, unexciting companies in the market. Perversely, these companies have been proven over time to have the most rewarding stocks you can purchase. If you chose to focus only on the bottom 10 percent of that list for an investment, you would be increasing the probability of your success as an investor a great deal. Careful bargain hunters find that the bottom of this barrel is a fertile hunting ground for successful stock investments.

Later, the authors write:

When investors overreact to bad news and sell their stocks off feverishly, they are increasing the inventory of bargains for you to choose from; this is the perspective of a bargain hunter. As a successful bargain hunter, it is to your advantage to have emotional sellers in the market beecause they create opportunities. Similarly, it is to your advantage to have sellers in the market who are guided solely by the news headlines, the charts they look at, superstition, ‘hot tips,’ or anything else that diverts them from investing on the basis of the stock price relative to a company’s fair value. The point is that these misguided participants are in the market and should be thought of as your friends. They will create bargain opportunities for you as well as the best returns after you purchase shares. In Uncle John’s words (tongue in cheek), these are the very people you want to help. Your role as a bargain hunter is to accomodate them by offering to buy the stocks they are desperate to sell and sell them the stocks they are desperate to buy.

Uncle John has the benefit of seven decades of experience in the market. His accumulation of experiences has made spotting bargains in the stock market second nature for him. We noticed throughout our time investing under him that he kept getting better with each year he continued to invest.

Often what causes stock prices to drop are business problems. One of the keys to successful value investing is learning to distinguish between problems that are either minor or solvable and problems that are either major or unsolvable. The authors write:

Understanding the history of the market is a huge asset for investing. This is the case not because events repeat themselves exactly but because patterns of events and the way the people who make up the market react can be typical and predictable. History shows that people overreact to surprises [especially negative surprises] in the stock market. They always have and always will. Grasping that fact sets the table for bargain hunters to scoop up cheap stocks when a surprise occurs, and anticipating and looking forward to these surprises provides bargain hunters with the mindset to act decisively when the opportunity arrives. Salivating for a big surprise that sends stocks into a frenzied sell-off is a common daydream for bargain hunters.

At the beginning of World War II, the U.S. stock market declined 49 percent. Templeton thought this was a massive overreaction because he believed the United States would enter the war and would therefore need a huge amount of commodities and other products, which would be a massive stimulus for many American businesses. On this basis, Templeton borrowed money–he already had plenty of cash but wanted to capitalize on this opportunity–and bought shares of every stock trading below $1. Over the course of the next four years, Templeton’s investment quadrupled.

Note that of the 104 companies that Templeton purchased, 37 were already in bankruptcy. Templeton calculated that the stocks of marginal companies would perform particularly well once the U.S. started producing commodities and other items for the war. In the end, only 4 out of 104 investments Templeton made didn’t work. Had Templeton only purchased the better companies, his results would have been far less good. This is a lesson that a value investor should remain flexible.

The authors compared the results of some typical marginal companies Templeton invested in with the results of some typical better companies Templeton invested in. As a group, the stocks of some typical marginal companies produced a 1,085% return whereas the stocks of some typical better companies only returned 11%.

Although Templeton’s investments had performed exceedingly well, he still recognized that he had actually sold a bit too early for some of his investments, some of which subsequently increased significantly. Templeton reviewed his process for selling and made some modifications, which the authors discuss in the coming chapters.

 

THE UNCOMMON COMMON SENSE OF GLOBAL INVESTING

Although global investing is more accepted today, there were many decades–including when Templeton was doing most of his investing–when that was clearly not the case. The authors write:

When Uncle John launched the Templeton Growth Fund in November 1954, he was on the cutting edge of global investing. Often referred to as the “Dean of Global Investing” byForbes magazine, Uncle John never had a problem looking past geographical borders to find a bargain stock to purchase. There are two commonsense reasons for leaving the domestic market behind to find bargain stocks. The first is to widen and deepen the pool of possible bargains. If your goal as a bargain hunter is to purchase only the stocks that offer the largest differential between the stock market price and your calculation of what a business is worth, searching worldwide for these bargains makes sense. For one thing, the bargain inventory from which to choose is exponentially larger. For instance, your inventory for selection may jump from approximately 3,000 stocks in the United States to approximately 20,000 worldwide. Therefore, your chances to succeed over the long-haul are much higher if you stay flexible and let the various stock markets around the world tell you where to invest.

In addition to obtaining a wider selection to choose from, it is common to find relatively better bargains in one country than in another. If your mission is to exploit the opportunities created by pessimism, fear, or negativity, it is likely that one country will have a better outlook than another. The differing outlooks and sentiment surrounding the various countries creates asymmetry in the pricing of the assets in one country versus another. Put more simply, differing outlooks may make stocks a better bargain in one country than in another.

The authors also point out the by investing globally, you gain diversification. No one can predict which global market will perform best and exactly when it will do so. By spreading your investments across multiple countries, you can lower your risk without necessarily lowering your return. Often it can take three to four years for a value investment to pay off, although sometimes it is sooner than that and sometimes later. If, on the other hand, you were to wait for sentiment to change from negative to positive before investing, then you would be following the crowd and in many cases you would achieve lower investment returns than if you had invested ahead of the crowd.

To be clear: The crowd often achieves results that are average. Net of fees, the crowd by definition will typically perform worse than a low-cost index fund.

Important Note: One thing that is not discussed in this book is investing in microcap stocks. Very few professional investors ever even consider microcap stocks. Therefore, if you focus there and you’re willing to do your homework thoroughly, it stands to reason that you could do well. Warren Buffett famously commented in 1999 that if he were managing $1 million or $10 million, he would be fully invested. Why would Buffett be fully invested during a bubble in U.S. stocks? Because undervalued microcap stocks can sometimes perform well even as larger stocks experience a bubble and the inevitable bust. In the same quote, Buffett guarantees that he could get 50% annual returns by investing in the most undervalued microcap stocks.

The authors comment:

What may be overlooked by some… is the strong performance of the Templeton Growth Fund during the 1970s. By nearly all accounts, the 1970s was a difficult era to invest in as it was characterized by a number of treacherous factors. There was the rise and fall of the famed story stocks known as the Nifty Fifty that grossly misled investors into heavy losses. If that was not enough, investors also grappled with surging inflation, energy crises, and sluggish economic growth. That decade provides a solid empirical argument for the benefits of bargain hunting combined with diversification. In light of all the fluctuation in the economic environment and the lack of a discernably positive trend, the stock market of the 1970s was defined by the fact that the index ended at the same level at which it began the decade. If you had invested in the Dow stocks at the beginning of the 1970s, chances are that you were invested for the entire 10 years with nothing to show for it. Taking into account the rate of inflation, you would have lost wealth as purchasing power eroded heavily during that time.

The authors pose a question and then answer it:

Does the stock market have to go up for you to make money? The simple answer is no. If you are executing your strategy as a bargain hunter correctly–purchasing only the stocks that are lowest in relation to your estimation of their companies’ worth–you effectively are investing in only the best opportunities available. In using this method, you are not necessarily tagging along with the performance of the market unless, coincidentally, the stocks that have the lowest price in relation to their worth happen to be in one of the popular market proxies, such as the Dow Jones Industrial Average, the S&P 500, or the NASDAQ. This has happened before, for example, in the early 1980s, when Uncle John loaded up on the ‘famous name stocks’ in the United States as their P/E ratios had become thoroughly depressed to less than half their long-term averages. More often than not, though, your collection of stocks will be unknown to most or avoided by most. The broader idea at work here is to piece together on a stock-by-stock basis your most attractive collection of bargains available in the market.

One important related point is that, as a value investor, you never make a macroeconomic call about a particular country. Templeton was known for seeming to pick the best countries to invest in. But he always examined stocks on a case-by-case basis. Templeton carefully picked the cheapest individual stocks he could find, wherever he could find them. This strategy often led him to be highly exposed to one country or to a few countries. But this resulted from bottom-up stock-picking, not from a top-down macroeconomic call.

The authors wisely point out:

The appropriate way to look at the ‘stock market’ is to view it as a collection of stocks rather than an index number. When you view the market on a stock-by-stock basis, you will find that ay any particular time the stock market contains a number of individual bull markets and bear markets. In fact, each stock is its own stock market; that is, each stock is composed of a number of buyers and sellers. In applying this perspective, it is possible to locate a number of stocks that could perform well during a bear market for the indexes or poorly during a bull market for the indexes. (my emphasis)

While you may outperform during a bear market by investing in specific undervalued stocks, you are also likely to trail at times during a bull market. The authors comment:

History shows that although your overall performance as an investor may be superior to the market averages, you can expect periods in which your performance falls short of the market. Sometimes you may underperform by a wide margin. Your edge as a bargain hunter is to have conviction that you did your homework up front and that time is on your side. The market eventually will recognize what you already know A few years of underperformance compared to the market should beexpected.

If you accept this basic reality at the outset, you will have the psychological strength not to cut and run when the ball does not bounce your way in the short term. The urge to switch out of your losing investments and into ‘better’ investments–usually meaning something that is rising in price–may be overwhelming. It is important to resist these urges if your original analysis and research are sound. No matter whose track record you are examining among the great mutual fund investors who have been at it for a decade or more, you will see that they went through periods of underperformance in spite of their long-term ability to outperform the market.

The authors explain that, during the 1970s, the Templeton Growth Fund produced 22 percent annual compound returns versus 4.6 percent for the Dow. But the Templeton Growth Fund had lackluster results in 1970, 1971, and 1975 (minus 8.9 percent). Had an investor abandoned the Templeton Growth Fund after a flat year or after a negative year, they would have missed out on some outstanding returns. This also illustrates, again, that if you invest in undervalued stocks wherever in the world you can find them, you can produce excellent long-term returns even if there are bear markets in some or most of the global stock markets.

The authors quote advice from John Templeton:

‘The time to reflect on your investing methods is when you are most successful, not when you are making the most mistakes.’

Today, some investors complain about the lack of information when it comes to investing internationally. The authors note:

To complicate the issue, the naysayers have this one right! It is generally true that there is less information available on foreign companies, particularly if you are looking to invest in emerging markets. However, your perspective on this reality can hep seal your fate as a global bargain hunter. Do you see the glass half empty? Are you scared off by the lack of information? Or do you see the glass as half full? Can youtake advantage of this lack of information and seize it as an opportunity to make an investment ahead of the crowd? Uncle John is the eternal optimist, and his practical response is to roll up his sleeves and do his homework. Bargain hunters need to realize that finding stocks about which information is lacking is an effective way to find mispricings.

A good example of these information gaps and a working example of how Uncle John tackled them comes from his purchase of the Mexican telephone company Telefonos de Mexico in the mid-1980s. At that time, the company’s reported numbers were unreliable in Uncle John’s opinion. His solution was to count the number of telephones in that country and multiply that number by the rate the citizens were paying. This required a great deal of work and research, but he then was able to determine that the stock price was far too low compared with what the company was worth, using his own projections. This example may sound a bit extreme, but it is a good illustration of what a bargain hunter must be prepared to do in searching for the truth.

The authors say that the Mexican telephone company stock had gotten cheap because of the lack of information combined with the unwillingness of other investors to search for the information. The authors write:

Often, the only hurdle is your unwillingness to work just a bit harder than the next guy or gal to get the answers. Uncle John always considers this intense work ethic as a basic philosophy underlying success, whether in investing or in any other pursuit. This belief in an exponential payoff to working harder than the next person is whta he refers to as the ‘doctrine of the extra ounce.’ This is akin to a famous piece of advice offered by Henry Ford: ‘Genius is 1 percent inspiration and 99 percent perspiration.’ Uncle John believes that in all walks of life, those who became moderately successful did almost as much work as those who were themost successful. In other words, what separates the best from all the rest is a willingness to put in that one extra hour of reading, that one extra hour of conditioning, that one extra hour of training, that one extra hour of study. Everyone has run across someone who was loaded with natural talent in his or her profession, sport, or classroom but never generated the amount of success that was there for the taking. This reveals that sometimes being the brightest student or the most gifted athlete is a handicap. This is true in every walk of life and every pursuit, not just investing. The best bargain hunters realize that the one extra annual report they read, the one extra competing company they interview, or the one extra newspaper article they scan may be the tipping point for the best investment they ever make.

The authors note:

…we have found that the market is still teeming with stocks that have no research coverage or only a few analysts covering them. These stocks should be considered prime hunting ground for bargain hunters who are willing to put in the work and do some original bottom-up analysis. Stocks in the foreign markets with very little research coverage can carry major inefficiencies involving what is occurring in their businesses and how the market perceives those businesses. Looking for and spotting these mismatches is a tried-and-true technique for successful global bargain hunting.

My Note: There are thousands of microcap stocks that have no research coverage at all. A bargain hunter should not only look globally, but should also look at many of the smallest stocks globally. I noted earlier Buffett’s assertion that he could get 50 percent per year returns by investing in microcap stocks, even as larger stocks were about to enter a bear market.

The authors next note that Templeton used a low P/E ratio as a way to identify potentially good investments.

This may strike some as very simplistic, but the truth is that the P/E ratio (price divided by earnings per share) is a good proxy orstarting point for valuation. Low P/Es led Uncle John into Japan in the 1960s, the United States in the 1980s, and South Korea in the late 1990s.

The idea is that you want to pay as little as possible for future earnings:

To tilt the probabilities of success in your favor, you should search for a stock priced exceptionally low relative to the earnings of a company that has better than averagelong-term growth prospects and better than averagelong-term earnings power…. To give you some idea of what his benchmarks of value were, Uncle John often looked for stocks that were trading at no more than five times the current share price divided by his estimate of earnings five years into the future… Likewise, he has remarked that occasionally he was able to pay only one to two times his estimate of earnings to be reported in the coming year. That, of course, is dealing in an extreme situation of depressed value. However, this is exactly what bargain hunters must be on the lookout for:extreme cases of mispricing.

Of course, it’s quite difficult to forecast the future earnings of a company, especially five years into the future. But most analysts use historical figures to make such forecasts. You have to assume average performance relative to a company’s history, which can include some great performance but also some lousy performance. Of course, if there is a really compelling reason to expect stellar future performance, then if the price is right, you may have found an excellent investment. The most important question is: what are the competitive advantages of the company? As Warren Buffett has remarked,

‘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.’

If the company has a durable competitive advantage, it becomes easier to forecast future earnings and therefore easier to determine if today’s stock price represent a bargain relative to those future earnings.

When it comes to curriences, Templeton assumed that currency trends tend to last for years. Also, less risky currencies exist in countries with modest borrowing and high savings rates. One potential problem in democracies is the voters tend to prefer more spending rather than less. When politicians give the voters more spending, this eventually leads to inflation if the country has to keep increasing its overall government debt levels. The higher the inflation, the faster the currency in question is losing value.

Templeton had a way of measuring the riskiness of investing in a given country:

First, if you want to avoid companies operating in riskier currencies, focus on companies with over 25 percent of their business performed in countries that export more goods than they import. From another perspective this means that the exporter is accumulating reserves, or savings, and the purchase of its goods from other nations also can create upward pressure on the exporter’s currency (which thus should stabilize or even increase in value). The second thing to determine is that the country does not have government debts that exceed 25 percent of its annual gross national product. This measure gives bargain hunters a benchmark for what a conservatively managed government balance sheet should look like. The problem that heavily indebted countries run into occurs when creditors or investors fear that they will not be repaid or will be repaid with a currency that has been devalued. When creditors and investors become worried for these reasons, the flight from debt or investments they hold in the heavily indebted nation creates selling in that country’s currency, and the selling causes it to lose value.

Another basket of risks for bargain hunters to consider relates to the political landscape of a country they are considering for investment. As we mentioned above, Uncle John is a huge proponent of free enterprise and the freedom of individuals to pursue their interests.

China is a good example, the authors note, of a government that believes in capitalism and freer markets. Although the government in China is communist, the amazing wealth created in that country is because of its capitalist and free market realities. Venezuela, on the other hand, is supposedly a democracy, but its leader has nationalized assets and transferred ownership from private to public hands. Venezuela should be competely avoided by global bargain hunters. After all, what is a business worth to global investors if the government can simply nationalize its assets? The authors write:

The consequences of nationalized assets are often chronic underinvestment of outside capital and public capital, followed by the eventual underutilization and underperformance of the nationalized assets. As a bargain hunter, you should avoid these situations at all costs.

The bottom line:

…nationalizing assets not only represents a poor investment but also goes against a deep philosophical belief that Uncle John holds. That belief is that free enterprise and the competition that results from it lead to progress. Progress is a very good and necessary thing for businesses. Progress is also a very good and necessary thing in all walks of life, whether technology, science, or any other discipline. When competition is stifled, progress is too.

My Note: As Ray Dalio points out inPrinciples for Dealing with the Changing World Order, the most fundamental force in human life is the force of evolution. Evolution and innovation are what cause the economy to keep growing–through improvements in productivity–making most people better off on a per capita basis.

Both the United States and China, although using different political systems, are set up to maximize the improvements in productivity that result from the force of evolution being unleashed in free market competition. To varying extents, many other countries around the world are set up to unleash the force of evolution through free market competition.

 

THE FIRST TO SPOT THE RISING SUN

The authors record:

There is no question that his heavy investment in Japan was led principally by the demonstrably low P/E ratios and high growth rates that the stocks and their companies carried in the 1950s and 1960s, but his intention to sit tight in the holdings and wait for their market values to rise no doubt was driven by viewing firsthand the same qualities that he held in such high esteem: thrift, focused determination, and hard work. The people of Japan embodied those ideals, and the companies that employed them became economic manifestations of those characteristics.

Although Japan was viewed as a producer of inferior cheap products during the 1950s, the country was already transforming itself into an industrial power. During the 1960s, Japan’s GDP grew at 10.5 percent per year, more than twice the GDP in the United States.

Templeton invested his personal savings into Japan in the 1950s. But Japan had a policy of not allowing foreign investors to withdraw their investments. As a result, Templeton waited before investing his clients’ money. Templeton thought that eventually Japan would open its markets, and by the 1960s he was right.

The authors compare:

In the early 1960s, the Japanese economy was growing at an average rate of 10 percent and the U.S. economy was growing at an average rate of around 4 percent. In other words, the Japanese economy was expanding 2.5 times faster than the U.S. economy, but many stocks in Japan cost 80 percent less than the average of stocks in the United States (4x P/E versus 19.5x P/E). These are tremendous discrepancies, particularly when we consider investors’ long-standing love affair with high-growth companies. How could such a discrepancy in the pricing of assets exist? There are many cited reasons. The reasons relate to the prevailing conventional wisdom at the time or simple misunderstandings. The first reason is that investing overseas, particularly somewhere as exotic sa Japan in the 1960s, was basically too avant-garde for the time.

Moreover, the reasons given for not investing included the following:

‘Fluctuations in stock prices are too extreme.’

‘There is not enough information.’

The authors write:

Believe it or not, those are direct quotations. As we can see, two of the main objections among active investors… were the exact things that Uncle John looked for in his search for bargains around the world. Ironically, these two characteristics that kept investors away from Japan were the very things Uncle John found attractive in an investment environment. Furthermore, these are just the reasons offered by professional investors. There was another, broader layer of negative sentiment among the public in the developed markets. That public sentiment was something along the lines of ‘Why would anyone invest in Japan? After all, they lost the war. They make trinkets in their low-wage factories and could never match the power and might of the United States in business.’ Those biases against the Japanese were inaccurate, unfair, and ignorant. Most important to the bargain hunter, though, without their existence the prices of those stocks would not have been so low relative to the intrinsic worth of their companies.

The authors add:

Welcome to the world of neglected stocks. This realm is one of your most cherished sanctuaries as a bargain hunter. In many cases, when you are exploiting neglected stocks, you are not necessarily dealing with a large array of ‘problems’ at the company level or even the industry level. Instead, you are tackling a heavy misconception or the mere obscurity of a stock in the broader market. You might question how the market could overlook or ignore what was occurring in Japan at the time and chalk it up to the ‘unsophisticated’ nature of investors in the 1960s. You might believe that these situations no longer occur in the modern market.

But this is not necessarily true. These kinds of bargains continue to appear form time to time in various countries and regions around the world. The authors say:

Sometimes the best opportunities are in plain view, but when investors see other investors passing them by or deriding them, they too pass. Social proof is a powerful force, but work hard not to let it guide your investment decisions. Often, what can happen–and what did happen in the case of Japan in the 1950s and 1960s–is that the entire economy can be transformed unnoticed by the crowd simply because they were unwilling to look in that direction.

Undervalued stocks may involve companies that are not expected to grow or they may involve companies that are expected to grow. The authors write:

Uncle John’s main goal is to buy something for substantially less than its worth. If that means purchasing somethingn with limited growth potential, that is okay; if it means buying something that should grow at a double-digit clip for the next 10 years, that is even better. If the company is growing, the point is to avoid paying for the growth. Growth in a company is a wonderful thing; your returns on a stock can go on for years if you spot good bargains in growing companies. However, this is not an excuse to pay too much. If you hypothesize that a company is about to knock the cover off the ball and be a long-term grower and then discover that the stock price has been bid up in anticipation of that growth, move on. There is no reward for getting the fundamentals right if they already are built into the stock price. As a bargain hunter, you should be focused on extreme mismatches between the way a stock is priced and what it is worth, not simple nuances. These mismatches can occur in any type of company, at least from time to time. Thus, as a successful bargain hunter you must remain agnostic about the superficial distinction between a value investor and a growth investor and resist creating biases that prevent you from spotting bargains.

Over time, Templeton thought carefully about when to sell a stock. He came up with the notion that the time to sell a stock is “when you have found a much better stock to replace it.” The authors note:

This practice of comparison is a productive exercise because it makes the decision to sell far easier than it is when you focus on the stock and the company in isolation. When a stock price is approaching your assessment of what it is worth, that is a good time to be searching for a possible replacement…

To prevent the possibility of churning your stocks and creating wasteful activity, Uncle John recommends that you purchase a replacement only when you have found a stock that is 50 percent better.

Later, the authors write:

For Uncle John the decision to exit Japan was simple; he was finding better bargains in Canada, Australia, and the United States. There was no qualitative factor that guided the decision; instead, the decision was predicated on the simple calculations of stock prices compared with the values of the companies. Applying qualitative reasoning in this decision-making process would have muddled his judgment, and maintaining clear judgment is a central tenet in successful bargain hunting.

 

THE DEATH OF EQUITIES OR THE BIRTH OF A BULL MARKET?

In August 1979,Business Week had the following statement:

The death of equities looks like an almost permanent condition.

During the decade of the 1970s, U.S. stocks moved sideways and also experienced a couple of big drops. As a result, many investors did feel that equities were “dead.” The cover of Business Week said “The Death of Equities.”

Moreover, investors who had invested in commodities, real estate, or collectibles had done quite well during the 1970s. The authors point out:

Of course, nearly 30 years later the magazine cover and the article penned on this theme are thought of mostly as a joke. Many point to the cover as a fantastic buy signal for the stock market and an equally good time to exit commodities. Bargain hunters in the stock market should have taken the magazine cover and the views that supported it as a point of maximum pessimism. The market of 1979 and the three years that followed represented a state of nirvana for bargain hunters.

The authors then comment on the fact that finally pension funds gave up on stocks and were preparing to invest in real estate, futures, gold, and even diamonds. The authors write:

When we think about this… it appears to be saying that the last holdouts in stocks are ready to sell. So if we have reached a point where the last group of sellers is exiting the market, can prices fall much more after they finish selling? No. If the last batch of sellers leaves the market, you must have a keen eye to be the buyer on the other side. Once all the sellers are gone, logically, there are only buyers left in the market. Conversely, what about commodities? They had been on a good run, and now the last group of buyers was coming into that market. Once they were in, who else was left to buy commodities and bid them higher? No one. It should not be taken as a coincidence that the commodities market and the stock market were on the verge of trading places once the last group of sellers in one because the last group of buyers in the other. This is an example of the mechanical logic that underlies contrarian investing.

The authors reiterate the fact that whenever there is a bubble, whether in stocks, commodities, or something else, you hear statements that it is a “new age” for investing in it. You also tend to hear that “older investors don’t get it.” Ironically, older investors were the ones who owned stocks from 1979 to 1982, the bottom of the stock market and the beginning of an 18-year secular bull market in stocks. In investing, being older is an advantage because investing is a game where you get better with age and experience.

In brief, it was widely thought that it was “the death of equities” and a “new age” for commodities. Exactly the opposite was true. It was one of the best times in history to buy equities and one of the worst times in history to buy commodities.

A value investor could have recognized that equities were at one of their cheapest points in history simply by looking at P/E (price-to-earnings) ratio’s, which were near all-time lows. Similarly, the P/E ratio’s for commodity-related stocks were near all-time highs.

As usual, Templeton coolly evaluated the situation from a value investor’s point of view. He saw that U.S. equities had exceptionally low P/E ratio’s.

By the time 1980 rolled around, Uncle John had 60 percent of his funds invested in the United States. That was in stark contrast to the stock market consensus at the time, which was that equities were dying on the vine thanks to runaway inflation. Investors ran away from U.S. stocks as if they were a building on fire, but Uncle John took the opposite approach and calmly walked in the front door to size up the damage. He did benefit from a fresh perspective on the market since he had not been riding U.S. stocks down into the pit of despair along with everyone else over the previous 10 years…

Why was Uncle John so bullish on American stocks when no one else would touch them with a 10-foot pole? One part of the answer is simple: No one would touch them with a 10-foot pole. The second part is that this prevailing attitude left some of the best-known, most-heralded companies in the United States, members of the Dow, trading at historical lows relative to earnings as well as book value, among other measures.

In fact, Uncle John researched the matter and could not find an instance in thehistory of the U.S. market in which stocks had been cheaper. Keep in mind that this includes the Great Depression and the crash that began in 1929…. the 1979 average P/E ratio of 6.8 was in fact the lowest market on record. In contrast… the long-term average P/E ratio for the Dow is 14.2x.

The authors then note that Templeton used many different measures, not just the P/E ratio, to determine when stocks were undervalued and thus a bargain.

Uncle John’s approach to bargain hunting always involved being able to apply one of the ‘100 yardsticks of value’ that were available to a securities analyst. There were two good reasons for taking this approach. The first and perhaps most important is that if you are limited to a single method of evaluating stocks, you periodically will go through times, even years, when your method does not work. This concept is analogous to why you should never invest solely in just one country’s stock market for the lifetime of your investments. If you stick with one region, country, market, or industry, there will be periods when you will underperform the market averages… Thus, if you rely on only a P/E ratio to evaluate stocks, there will be times when you cannot find value with that measure, but perhaps you could have with another, such as the ratio of price to cash flow. For that matter, one cannot guarantee that your method for bargain hunting will not become obsolete.

…The second good reason to use many yardsticks of value is to accumulate confirmation of your findings from different methods. If you can see that a stock is a bargain on five different measures, that should increase your conviction that the stock is a bargain. Raising your conviction level is an important psychological asset as you face the volatility of the stock market.

Note: The Boole Microcap Fund uses five metrics for measuring cheapness:

    • EV/EBITDA – enterprise value to EBITDA
    • P/E – price to earnings ratio
    • P/B – price to book ratio
    • P/CF – price to cash flow ratio
    • P/S – price to sales ratio

The authors continue by noting that Templeton found that many U.S. companies in the late 1970s and early 1980s were trading at a low P/B (price-to-book value). When a company has a low P/B ratio, that means the market has low expectations for the business in question. Often these low expectations are justified if the business is performing poorly and will probably keep performing poorly. However, sometimes a low P/B is based on temporary rather than permanent problems, in which case the stock may be a bargain.

Furthermore, Templeton realized that thereplacement value of the assets for many businesses was actually much higher than the stated book value of the assets. As a result, the companies with low P/E were actually trading at exceptionally low price/replacement value. In fact, Templeton argued that on this basis stocks were at all-time historical lows. The price/replacement value was about 0.59. The authors comment:

The practice of looking deeper into the numbers goes back to our lesson about Uncle John’s doctrine of the extra ounce. Only bargain hunters willing to put in extra work and extra thought would have uncovered the notion that stocks had never been cheaper in the U.S. market when viewed in terms of their replacement value.

In a similar vein, there is a parallel between this replacement value analysis and the analysis that Uncle John used to uncover the hidden value in the Japanese market that was discussed in Chapter 4. In the instance of Japan, Uncle John made adjustments to the earnings of Japanese companies to account for the unreported earnings of the subsidiary companies held by a parent company. In this case, Uncle John uncovered hidden value by adjusting the asset values of U.S. companies to their market values. In both cases, Uncle John exploited an inefficiency in information that was not seen by casual observers.

Another clue that Templeton focused on indicating that stocks were significantly undervalued was that there was a large number of corporate takeovers. Most businesses are well aware of what their competitors are doing. When a competitor becomes undervalued, many businesses will try to acquire it. So the fact that there were many corporate takeovers means many businesses thought some of their competitors were undervalued. The authors note:

Uncle John became even more encouraged that the market was full of bargains when he saw that the prices competitors were willing to pay for those companies ranged from 50 percent to 100 percent above the market value of the target’s stock price. This observation can translate into an everyday bargain-hunting strategy. Many astute bargain hunters keep an active watch on the market values of companies whose value becomes too low relative to historical takeover levels in the industry. The most common way bargain hunters detect these relationships is by examining the “enterprise value” of a stock relative to its earnings calculated before interesting, depreciation charges, and tax charges (commonly called EBITDA, an acronym for earnings before interest, taxes, depreciation, and amortization). The enterprise value of a firm is simply the stock market equity value of the company plus the amount of debt the company has minus the amount of cash the company carries on the balance sheet. The idea behind the ratio in this use is to get an idea of what a company would cost to purchase in its entirety, since you would have to purchase the equity from the shareholders and assume the company’s debt or pay it off.

The point in this calculation is to get a thumbnail sketch of what the takeover value of a company is relative to its “cashlike” earnings. We say that EBITDA is “cashlike” because it often is used as a proxy for cash earnings, but it has some obvious blind spots. In a working example, if we divide the enterprise value of our company by its EBITDA and find that the company’s enterprise value is 3 times its EBITDA and we have observed competitors in the industry buying other companies for 6 times their EBITDA, we may be able to conclude that the stock is a bargain on this basis.

Yet another thing that Templeton saw was that many companies were buying back their own stock. When business leaders, many of whom understand their company and its value well, are buying back stock, that means they believe the stock is very undervalued.

The last clue that Templeton noticed was that there was an overwhelming amount of cash on the sidelines.

In 1982, Templeton appeared on the Louis Rukeyser showWall Street Week. He predicted that the Dow, then trading in the low 800s, would reach 3,000 over the coming ten years. Viewers of the show and other market watchers thought Templeton had lost his mind. But Templeton was using simple arithmetic.

Uncle John said that if corporate profits grew at their long-term average growth rate of about 7 percent and inflation remained at an expected run rate of around 6 to 7 percent, overall profits would increase approximately 14 percent a year. If those 14 percent gains compounded annually, the values of the stocks would nearly double over the next five years, and if that held up, they would double again in the next five. This corporate earnings activity alone would not require the stock market to assign a higher P/E multple in order to double. However, with the Dow’s P/E ratio at around 7x compared with the long-term average of 14x, it was reasonable to see the index getting a lift from a return to the average P/E ratio as well. Then, with all the money sitting on the sidelines and not being invested by institutional buyers, he believed that they was latent firepower to be deployed that would help drive the index higher. In sum, with the environment as poor as it was and all the bad news priced into stocks, the probabilities of conditions improving were very much in his favor as well as the favor of all those holding U.S. stocks. In the nine years that followed, his prediction proved correct.

Templeton had the courage not only to examine the situation of U.S. stocks with an open mind, but also to act once he realized how cheap U.S. stocks were. One strange thing about people is that, even if they realize there are bargains among stocks, most people will not buy them until much later when the stocks are no longer great bargains. In other words, most people feel comfortable following the crowd and so they miss chances to buy bargain stocks.

The authors conclude the chapter:

The way to overcome this human handicap is to rely on quantitative reasoning versus qualitative reasoning. Uncle John always told us that he was quantitative in practice and “never likes a company, only stocks.” If your investing methodology is based primarily on calculating the value of a company and looking for prices that are lowest in relation to that value, you would not miss the opportunity found in the death of equities market. However, if you take your cue only from market observers, newspapers, or friends, you will be dissuaded from investing in stocks where the outlook is not favorable. In contrast, if you are independent-minded and focus primarily on numbers versus public opinion, you can create a virtuous investment strategy that will endure in all market conditions. Put another way, if you are finding stocks that are trading at their all-time lows relative to their estimate worth and you find that all other investors have quit the market for those stocks, you are exploiting the point of maximum pessimism, which is the best time to invest.

 

NO TROUBLE TO SHORT THE BUBBLE

Lauren C. Templeton describes visiting her Uncle John Templeton in early 1999. Lauren asked him if he was buying technology stocks.

…[Templeton] described a number of financial market bubbles that spanned centuries, going back to tulips in Holland in the 1630s. There was a Mississippi bubble conceived by French speculators, a South Sea bubble in England, and of course a railroad boom and bust. Even in more modern times there have been speculative bubbles in wireless radio communication, cars, and televisions. Uncle John has always been fascinated by this behavior, even to the point of having the Templeton Foundation Press issue a reprint of Extraordinary Popular Delusions and the Madness of Crowds. What I found most remarkable about this recounting of economic activity that morphs into public euphoria were the common threads of economic circumstances and human behavior in each instance. When you take the time to study the events, even the ones going back centuries, there are familiar elements in each one. If you remember the Internet bubble, you probably have a rough sense of deja vu when you examine the South Sea bubble in spite of the fact that it occurred in eighteenth-century England.

The authors continue:

Take the automobile industry. In its nascent stages during the early 1900s there were few barriers to entry in the business. Just as the late 1990s and 2000 displayed a virtual explosion of dot-com companies, the early commercialization of the automobile in the United States in the period 1900-1908 brought a flurry of 500 automobile manufacturers into the industry. The early automobile producers were really assemblers of parts rather than large-scale manufacturers, just as many early dot-coms simply had an idea and could build a Web site. In either case it did not require much capital to start up a business. Similarly, the public did not seem to contemplate the fate of the initially large number of players, and only the sheer force of competition eventually separated the winners from the losers.

This stands to reason, because the public usually grossly overestimates the industry at the outset. In both industries whose booms and manias were separated by nearly 100 years, the large number of original players shrank dramatically after the busts. Once competition forced the companies to survive on their own ability to make money rather than by raising money from investors, the party ended for the ones just along for the ride. For every General Motors there are several New Era Motors Inc., and for every eBay there are several Webvans. During the building mania phases when the public joins the fray, its willingness to support anything attached to the new industry is maximized. In turn, investors often supply capital to even the most suspect newly hatched operators. Those operators go belly-up when they are no longer supplied with capital, and the naive investors who backed them lose tremendous sums.

Another common thread in every stock mania is the outward display of optimism, with little regard for downside risk. Typically, this optimism is buoyed by outrageous projections of growth for the industry. Also, that growth is perceived to develop in a straight-line fashion without significant disruption. When the automoble industry started a period of rapid growth during the 1910s, the unbridled optimism of endless growth was embraced as a simplefact. Coinciding with this notion of endless growth was a latent assumption that there would not be a disruption in growth; instead, it would continue in a straight-line fashion.

The authors point out that in technology bubbles, it is often trumpeted that there is a “new age.” This tends to be true in terms of the benefits of the new technology. But that does not change the fact that there are so many new companies, most of which will never earn a profit and thus aren’t good investments for a bargain hunter. The authors write:

Remember the first rule in bargain hunting for stocks: Distinguish between the stock price and the company the stock represents. In this case speculators took the bright idea and bought it regardless of the stock price. The stock price was irrelevant except that it was assumed it would continue to go higher becuase those companies were changing the world and nothing could stop their growth. Speculators are always drawn into these investments because of the allure of theidea and the growth that is sure to follow. As the automobile frenzy ensued in the years that followed, it became clear that the stock market had fallen under its spell of endless growth and profits.

The authors continue:

The auto stock traders bought cars with their winnings in the early 1900s, and the day traders of the 1990s took nice trips and bought electronics. Different time, same story. This behavior can lead to disastrous consequences when the speculators become more aggressive in spending their assumed wealth, which can be gone before the end of the trading day. Similarly, when a large part of the public connects patterns with a forecast of increasing stock prices, it can have negative consequences for the economy when stock prices collapse and spending falls.

In the South Sea bubble in 1720, the South Sea Company, a merchant shipping vessel company, struck a deal with the British parliament. The South Sea Company would assume England’s debt, which the government would secure by giving South Sea a monopoly on trade in the Spanish Americas. The authors report:

Seizing the opportunity, the South Sea operators quickly devised a plan to retire all of England’s debt in a similar fashion with the sale of equity. Once the deal was approved and the stock was sold, visions of endless mines of gold and silver in South America and the riches that would accrue took hold of the public imagination. Moreover, the directors of the company pushed those rumors to raise the stock price. The draw of riches from the New World was too much to resist, and the English public became consumed with trading South Sea stock. Observers who were befuddled by the day traders of the late 1990s would have been equally floored by the maverick day traders of South Sea stock in 1720. Day traders have been an ongoing fixture in bubbles dating back at least to eighteenth-century England. In every instance, their willingness to leave all their worldly duties behind in exchange for stock market riches has been unquenchable.

As thePall Mall Gazette recorded in 1720:

“Landlords sold their ancestral estates; clergymen, philosophers, professors, dissenting ministers, men of fashion, poor widows, as well as the usual speculators on ‘Change, flung all their possessions into the new stock.”

The authors write:

The South Sea bubble, much like the Internet bubble, enticed all members of society. The simple fact is that the attraction of easy wealth to a human is unbounded by time or geography. No member of society is exempt. Even the best minds of the time fall prey to it; Sir Isaac Newton lost substantially in the bubble.

There were people who warned against the South Sea bubble. But there are always naysayers against bubbles, and the public tends to bowl right over the naysayers against bubbles. In the dot-com bubble, day traders were glorified while old guard bargain hunters were criticized for missing the easy new wealth. For instance, Julian Robertson and Warren Buffett, two of the greatest investors in history, were not long dot-com stocks and were criticized accordingly. There was aBarron’s article titled, “What’s Wrong, Warren?” The article said:

“To be blunt, Buffett, who turns 70 in 2000, is viewed by an increasing number of investors as too conservative, even passe.”

Moreover, during bubbles, there are always unscrupulous figures that emerge to take advantage of the situation. Bernie Ebbers, the CEO of MCI WorldCom, was one such figure. The company used its inflated share price as currency to buy out competitors. However, eventually the company couldn’t find any more acquisitions, and so its reported earnings stopped going up and then later evaporated. So Ebbers began fraudulent accounting in order to mask the declining conditions of the business. Eventually the fraud came to light and Ebbers was imprisoned. Investors ended up losing $180 billion.

The authors then mention Abraham White, who played a prominent role in the wireless telegraph bubble of 1904. Guglielmo Marconi launched Marconi Wireless Telegraph Company, while a rival Lee De Forest formed the Wireless Telegraph Company of America. De Forest, trying to catch the leader Marconi, needed to raise capital. He met Abraham White.

White’s tactics as president can be be described as promotion on steroids with the intent of raising as much money as possible from the public. There were publicity stunts such as fastening a wireless tower to a car and parking it on Wall Street, and they constructed a useless wireless tower in Atlanta to gain public attention. Before long, White had raised the capital amount to $5 milion, or about $116 million in today’s dollars. Shortly thereafter he merged the company with the International Wireless Company, [a] group of equally shady characters… Reportedly, the International Wireless Company, once the American Wireless Telephone and Telegraph Company, had been transformed under a string of acquisitions consisting of suspect stock-jobbing operators. The combined company was thought to be worth $15 million ($350 million in 2006 dollars).

White pushed De Forest out and then focused on trying to inflate the stock price. He issued phony financial reports to the press and sent promising prospectuses to investors. He also used carnival-like publicity stunts. Here is what White said in one speech:

“A few hundred dollars invested in De Forest stock now will make you independent for life. Tremendous developments are under way. Just as soon as the company is on a dividend basis the stock should advance to figures practically without limit. If set aside for two years it is morally certain to be in demand at 1,000 percent or more present prices. Those who buy will receive returns little less than marvelous. A hundred dollars put into this stock now for your children will make them independently rich when they reach their majority.”

Money that came in from share sales were listed in the financial statements as revenue. Thus the only way to boost revenue was to sell more shares. White started exaggerating more than ever. He promised President Roosevelt wireless messages to Manila in 18 months. White promised a San Francisco-New York line. He promised instant messages from the Pacific coast to China. The authors write:

By 1920, Abe White’s game was over. The feds raided his offices in New York, citing the reams of literature that had been sent out extolling marvelous growth and an impregnable financial condition. In sum, they were looking for mail fraud on the basis of the deluge of fantastical mailings and solicitations sent form the United Wireless offices. What they found probably surprised them. The feds discovered that the supposed assets of the company of $14 million did not exist; the value of the company’s assets was about $400,000. The directors had controlled the stock through a lockup for the public holders by stamping the shares nontransferrable until 1911. In the meantime, the directors kept adjusting the prices of the stock upward on the basis of new contracts (which were in fact money-losing) in $5 increments. The stock began selling at $1.50 and was adjusted over time to $50. In the meantime the directors unloaded their stock on the captive public, who could not sell it, at ever higher prices. This scheme resulted in the fleecing of 28,000 shareholders who had been rabid for wireless company shares. The feds relieved Abe White of his 15 million shares, which, priced at $50 before the raid, had run his personal stake to $750 million in 1910, or about $16.2 billion in today’s dollars.

The stories of Bernie Ebbers and Abe White unveil the ugly sides of stock manias. Both show how crooks exploited greed among naive speculators and sold them a bag of lies. However, even in the perfectly legal and morally acceptable circumstances surrounding stock manias, investors buy into a constant succession of newly issued stocks at exorbitant prices on the basis of what can only be called naive misconceptions.

In most stock manias, companies selling stock to the public for the first time through initial public offering (IPO) are even more frequent. In the dot-com bubble, most companies that IPOed did so at vastly inflated prices, given that most of these companies ended up being worth zero.

John Templeton recognized the dot-com mania for what it was: a huge bubble. Author Lauren C. Templeton writes:

I was at home with my parents for Christmas in 1999 when my father walked into the room and told me he had just received a fax from Uncle John. The fax contained a relatively long list of NASDAQ technology stocks that Uncle John recommended selling short.

Again keep in mind that there were many technology stocks whose businesses were worth zero. The P/E ratio of the NASDAQ in December 1999 was 151.7x. Truly unbelievable!

However, leading up to 1999, there were many intelligent investors who tried to sell short the technology bubble. These short sellers were crushed as stock prices kept rising. The authors record:

Stocks went higher because the crowd willed them higher with more buying. Stocks went higher simply because they had gone higher the day before. Neophytes became stock market geniuses after one trade. Day traders were running the show, and the main feature was momentum. It was the only program, and if you did not like it, there was nothing else playing. The concept of valuing a stock or the notion that a stock’s prices should be constrained by the company it represented was masked by the party tub of tech Kool-Aid, and too many people were drinking from it.

The authors talk about the perils of being early as a value investor. When you’re long a stock that you believe is undervalued, but you’re early, you can have paper losses on your position. But a stock that goes down becomes a smaller problem relative to the portfolio and is bearable. The most you can lose is 100% if the stock goes to zero.

However, when you’re short a stock, you could potentially lose infinite amounts because there’s no limit on how high a stock can climb. Therefore, it’s much more treacherous trying to short overvalued stocks, especially in a bubble when all stocks keep screaming higher. There were many, many short sellers in 1997 to 1999 who lost tons of money and had to close their positions, locking in those losses.

So the question is: How do you short technology bubble stocks? The authors write:

If only there was a way to figure outo what would spark the selling in those stocks and bring down the biggest charade in the history of twentieth-century markets. There was. Uncle John took a different perspective on this phenomenon to discover a hidden gem in the market and a highly probable approach to generating short sell profits rather than losses. If there is one psychological element present in a stock market bubble, it is greed. It is an old flaw among humans, and it is manifested routinely in the stock market.

The point is that there were buyers who were eager to cash out. The young and old executives of the technology firms that were coming to the stock market in an IPO wanted to sell.

There are a couple of useful observations about IPOs in general that we can make as bargain hunters. The first is that typically managers offer stock to the public when there is great enthusiasm for shares in an absolute sense. It is widely accepted that no one can time the tops and bottoms of stock market runs, but it generally is accepted that a sudden surge in IPOs suggests that a market is inflating because managers and investment bankers try to maximize the amount of money they can raise for the company when they take it public. Coincidentally, their efforts can run in parallel with more expensive market levels or, for that matter, with the later stages of a bull market. The second observation is that when IPOs are made, the enthusiasm for the shares often pushes the offering price above its intrinsic value because of the heavier than normal demand. It is not unusual to see shares fall in price months after an IPO takes place as enthusiasm and demand die down and normalize when the stock is traded freely in the open market.

The authors continue:

In the IPO market of 1999 and 2000, the new-issue market was a quick way for business managers to cash out their inflated stakes at the public’s expense, and in many cases there were abuses. Uncle John recognized that among all the participants in the technology stock bubble, those stockholders had the biggest incentive to sell. Those company managers, or “insiders,” knew what kind of hand they were holding (a weak one) and were more than ready to cash out and take their winnings early.

That said, often there is a lockup period of 6 months during which insiders cannot sell after the IPO. Templeton thought that when insiders were able to sell, they would do so, which would create the catalyst for the technology stock bubble to finally pop. Day traders had the strategy of buying what was going up and selling what was going down. If stocks were widely declining as insiders were selling, that would create a chain reaction in which day traders would also sell. This would create a huge crash in technology shares.

Uncle John devised a strategy to sell short technology shares 11 days or so before the lockup expired in anticipation of heavy selling by insiders once they were allowed to unload their shares on the public. He concentrated on technology issues whose values had increased three times over the initial offering price. He reasoned that stocks that had increased that much in value provided an extra incentive to insiders to cash out and sell their holdings. In sum, he found 84 stocks that met this criterion and decided to place a position of $2.2 million into each short sell.

All told, he bet $185 milliopn of his own money that tech stocks would plummet at the height of the bubble. In the second week of March 2000, plummet they did…

Templeton taught to buy at the point of maximum pessimism, which is when there are no sellers left. By the same logic, you want to sell (or short sell) at the point of maximum optimism, which is when there are no buyers left.

All of that said, it’s wise to use stop-losses if you decide to try to short bubble stocks. In other words, determine ahead of time that you will close your short position if the stock goes up, say, 20% or more. Templeton used an approach like this to control his losses from short selling. Specifically, when a stock came out of its lockup period, if it increased strongly, Templeton closed his short position.

 

CRISIS EQUALS OPPORTUNITY

The authors write:

One way to think about the strategy of purchasing shares in the wake of a crisis is to relate the current crises to the same strategies that a bargain hunter employs on a daily basis in common market conditions. First, the bargain hunter searches for stocks that have fallen in price and are priced too low relative to their intrinsic value. Typically, the best opportunities to capture these bargains come during periods of highly volatile stock prices. Second, the bargain hunter searches for situations in which a large misconception has driven stock prices down, such as the arrival of near-term difficulties for a business that are temporary in nature and should correct over time. In other words, bargain hunters look for stocks that have become mispriced as a result of temporary changes in the near-term perspectives of selling. Third, the bargain hunter always investigates stocks when the outlook is worst according to the market, not best.

A crisis sends all these events into overdrive. Put another way, when the market sells off in a panic or crisis, all the market phenomena a bargain hunter desires condense into a brief and compact period: maybe a day, a few weeks, a few months, perhaps even longer. Typically, though, the events and reactions to them do not last long. Because of their ability to grip sellers, panics and crises create by far the best opportunities to pick up bargains, which drop into your lap if you have the ability to stay seated while everyone else dashes out the door.

To summarize, bargain hunters seek volatility in stock prices to find opportunities, and panicked selling creates the most volatility, usually at historically high levels. Bargain hunters seek misconception, and panicked selling is the height of misconcepton because of the overwhelming presence of fear. People’s fears become exaggerated in a crisis, and so do their reactions. The typical reaction is to sell in a crisis, and the force of that selling also is exaggerated. Bargain hunters look to take advantage of temporary problems that are exaggerated in the minds of sellers because of the sellers’ near-term focus. History shows that crises always appear worse at the outset and that all panics are subdued in time. When panics die down, stock prices rise.

When bargain hunters maintain the right perspective on crises and panics, they buy when everyone else is selling, which tends to produce excellent investment results. The authors note:

If you have the psychological ability to add to your investments during future panics, you already have distinguished yourself as a superior investor. If you can find the resolve to buy when the situation looks most bleak, you will have the upper hand in the stock market.

There is a strong historical precedent for buying in the wake of panic in the stock market, and those panics can come from a number of directions. Panicked selling can arise form a political event (threat, assassination), an economic event (oil embargo, Asian financial crisis), or an act of war (Korean War, Gulf War, September 11 attacks). Regardless of the underlying event, when markets make a concerted effort to sell on the basis of a negative surprise, bargain hunters should be looking to buy some of the shares others wish to sell.

Here is a list of recent crises including the number of days for the stock market to hit its low point, plus the percentage change of the drop:

Crisis Event Date Duration to Lows (days) % Change to Low
Attack on Pearl Harbor 12/7/1941 12 -8.2%
Korean War 6/25/1950 13 -12.0%
President Eisenhower’s Heart Attack 9/26/1955 12 -10.0%
Blue Monday–1962 Panic 5/28/1962 21 -12.4%
Cuban Missile Crisis 10/14/1962 8 -4.8%
President Kennedy Assassination 11/22/1963 1 -2.9%
1987 Crash 10/19/1987 1 -22.6%
United Airlines LBO Failure 10/13/1989 1 -6.9%
Persian Gulf War 8/2/1990 50 -18.4%
Asian Financial Crisis 10/27//1997 1 -7.2%
September 11 9/11/2001 5 -14.3%

The maximum number of days for the stock market to reach its low point was 50, whereas the average number of days for the stock market to reach its low point was close to 11 days. Four out of eleven crisis took only one day for the stock market to reach its bottom.

These events seem to happen a few times per decade. The authors comment:

The truth is that most seasoned bargain hunters salivate for these events and remain in constant anticipation for them because of the opportunities they afford. Whenever you observe people in the stock market who want to sell, you should feel the same urgency to buy.

The authors continue:

The basic premise here is that the best time to buy is when there is blood in the streets, even if some of it is your own. Do not waste time watching your profits shrink or your losses add up. Do not go on the defensive with the rest of the market; instead, go on an offensive mission to find the bargains coming to the table. The goal in investing is to raise your long-term returns, not to scramble to sell. Fixate on your goal.

You must also cope with negative news because negative news sells whereas positive news does not.

You can be sure that once the bad news becomes public, a thousand Chicken Littles will come out to proclaim that the sky is falling. They will appear on the television, in the newspaper, and on the Internet and will draw a lot of attention. Smart bargain hunters keep a skeptical but open mind when processing this information. Is the sky falling? History has shown repeatedly that it is not.

Sometimes a given crisis is compared to the 1929 crash, the Great Depression, or the 1987 crash. These are worst case scenarios that are rarely (if ever) relevant to the crisis at hand. Even 1987, while a large drop, was a one-day event and was far from being anything like the Great Depression, although comparisons inevitably were made.

The authors describe great leaders, who distiguish themselves when the chips are down. They then write:

Similarly, the most successful investors are defined by their actions in a bear market, not a bull market. Making money is relatively easy when the entire stock market is rising. Aggressively seeking the opportunity provided through deep adversity when the stock market is in a free fall requires far more than the ability to analyze a company. It requires a mindset that looks for a chance to shine, and this requires confidence and courage. The only way to execute under this pressure is to have a deep-seated belief in your abilities and the conviction that you are correct in your actions.

Templeton had a list of stocks that he wanted to buy if the stock prices fell signficantly. In order to help ensure that he would buy while the market was selling off, Templeton placed long-term buy orders for specific stocks at levels far below (such as 40-50% below) their current prices.

The authors caution that it’s important, when selecting which companies to buy during a selloff, that you select companies that have low debt or no debt. Otherwise, the company you pick won’t necessarily survive a recession or economic downturn. Low debt or no debt is also an important criterion that Warren Buffett uses.

The authors also point out that you should examine the net income of the company over time:

…you will want to measure the variability of its results over time as they are subject to different business conditions in the industry or the overall economy. If the company was accustomed to losing money during any of its prior annual periods, this should be taken into consideration in purchasing its stock in case business conditions worsen. Of course, this is a worthy consideration before investing in any stock regardless of future conditions.

 

HISTORY RHYMES

The Asian financial crisis started with the devaluation of Thailand’s currency (the Thai baht) in July 1997. The authors record:

If the two currencies are misaligned too far, lenders to the government may realize that it cannot honor its ability to convert the currencies. This realization can lead to a “run” on the currency as lenders and exponentially more investors speculating in the currency’s collapse rush to sell baht and convert to U.S. dollars. If the government cannot honor those transfers, its typical response is to “devalue” the currency or release the stated pegged ratio that had been in place. An example would be if you had 10 units of the local currency that equaled 1 U.S. dollar but the government did not have enough U.S. dollars on hand to accommodate the market and responded by saying that it now takes 20 units to buy 1 U.S. dollar.

The local currency buys far fewer U.S. dollars, or it takes a lot more local currency to buy a dollar. Either way you look at it, it is a bad deal for people who want the government to honor its prior policy of converting local currency to U.S. dollars. If the market senses that there is a high probability that the government will not be able to honor its obligation to convert the currency, a mad dash may ensue to pull money out before the government changes the peg. The end result is a panicked selling of the government’s currency that drives its price down as well as the prices of assets denominated in that currency, such as stocks.

This dynamic became catastrophic for banks in a country such as Thailand, which secured its capital for lending by borrowing at the low interest rates for the U.S. dollar. The bottom line is that if the local currency drops in value, loans taken out in U.S. dollars effectively increase in size. If U.S. dollar loans increase too much, it can bankrupt the bank.

After the Thai baht lost significant value, investors then started worrying about other Asian countries whose currencies were pegged to the U.S. dollar. As a result, there was heavy selling of these Asian currencies. The authors note:

However, part of the problem in the case of Asia was that a group of countries referred to as the Asian miracles had posted strong growth rates in their economies over a number of years, and that attracted investors. Over time the heavy investment led to too much money coming into the country, followed by overdevelopment in some sectors of the economy. The overdevelopment would not generate the returns necessary to pay back lenders or investors. In some ways, those countries were victims of their own success. Nevertheless, the end result was a chain reaction of selling in those countries’ currencies as investors rushed to pull their money out as fast as possible. The chain reaction leaped from Thailand to Malaysia, Indonesia, the Philippines, Singapore, and finally South Korea. Eventually, similar fundamental dynamics led to deeply depressed currency values in Russia, Brazil, and Argentina in the years that followed.

Templeton singled out South Korea as a particularly interesting place in which to invest. He had already identified the country as possibly “the next Japan.” The authors say:

The reasons Uncle John may have considered South Korea to be the next Japan for investors could be seen in their striking similarities from an economic standpoint. South Korea in effect was implementing the same game plan that had propelled Japan to economic success after its devastation in World War II. South Korea had the same basic circumstances when it emerged from the Korean War. It was a country that was left in an economic quagmire and forced to rebuild. Although it took a bit longer to get on the right track, South Korea often is referred to as thebest case of an economy rising from poverty to industrial power.

The authors compare South Korea with Japan:

First, both countries had heavy rates of domestic saving that funded investment in their economies. Second, both were exporters but also, and perhaps more important,ambitious exporters. In other words, Japan was dismissed as an unsophisticated producer of trinkets and cheap goods when it began rebuilding its economy after World War II. South Korea had that reputation as it embarked on its economic journey to emerge as a powerful industrial nation. It has been noted that well before South Korea developed its heavy industrial capabilities, it was known for exporting textile goods, and in its early stages of development its top exports were all basic “cheap” items. For instance, in 1963 South Korea’s third biggest export was human hair wigs. South Korea was directing itself down a path of progressive industrialization, and its economy was one of the fastest growing in the world as measured by growth in GDP. The country’s economy had the highest average growth in the world over the 27-year period leading up to the Asian financial crisis.

Over the same period, the government’s direction of resources and capital into export-led businesses transformed the export mix from textiles and wigs to electronics and automobiles. In addition to the overall higher growth rate, South Korea was able to resist signficant pauses in its growth as only the oil shock crisis of 1980 derailed a long period of uninterrupted high growth…

South Korea, like Japan, became less dependent on foreign borrowing and had ever-increasing domestic savings rates. South Korea’s savings rate was above 30 percent until the 2000s.

When some of the noted chaebols, such as Kia Motors, Jinro, and Haitai, sought bankruptcy protection for failure to cover their interest payments in the summer of 1997, investors turned an increasingly critical eye toward South Korea and its financial situation. The fear was that those bankruptcies and ones that could follow would feed back into the banking system. Similarly, with large proportions of debt denominated in foreign currency, the appearance of risk was high. From a perception standpoint, outside observers had no way to measure the potential severity of the problem, because disclosure was limited and the banks were controlled by the government. Without being able to measure the problem, investors assumed the worst.

However, overall South Korea’s government borrowing was relatively modest at less than 20 percent of GDP before the crisis. Nonetheless, South Korea had a real problem: A much larger percentage of its loans were in short-term maturities that had to be rolled over or extended on a regular basis. That meant that the country’s debt had to be renewed in the middle of a regional financial meltdown. The problem of defaulting borrowers in the Korean chaebol system was made worse by the simultaneous financial difficulties in Thailand and Malaysia.

One problem Korea shared with those countries was that they all seemed to have one major lender in common: Japan. When the Japanese realized that they had so much exposure to the spreading defaults and bankruptcies in the region, they did not hesitate to pull the plug on South Korea. The result was a near cessation of lending activity to South Korea despite the fact that its situation was not as dire as that of other countries.

Nonetheless, traders began heavily shorting the Korean won. At first, the country wasted its reserves trying to support its currency. This was futile, and after the country could no longer support its currency, the currency collapsed and that took down all asset markets with it, including the stock market.

The International Monetary Fund (IMF) arranged a $58.5 billion loan for South Korea, but it came with conditions. South Korean had to open its financial markets to foreign investors and remove inefficient firms from the market. South Korea agreed in early 1998. South Koreans were not happy about inefficient firms being shut down because they were accustomed to holding a job indefinitely because of labor restrictions. Furthermore, the government raised interest rates to prevent further deterioration in its currency. This contributed to a recession, which further heightened the skepticism of investors with regard to South Korea.

Of course, Templeton, ever the contrarian, now decided to invest in South Korea because he thought the country was close to “maximum pessimism.” Moreover, the P/E ratio’s in South Korea were low. If an investor could look past the short-term difficulties including recession, the long-term outlook for South Korea remained very bright.

Most investors were of course avoiding South Korea. Most investors, no matter how intelligent, do not have the willingness to buy near the point of maximum pessimism.

In the case of South Korea, although Templeton did invest in some individual stocks, he also invested in the Matthews Korea Fund, which had just declined 65%. Investing in a mutual fund (or hedge fund) means you have to ensure that the mutual fund manager is a value investor, consistently buying stocks at low P/E ratio’s. You also want a mutual fund or hedge fund that has good long-term performance. If the short-term performance has been bad, that often represents a buying opportunity.

The Matthews Korea Fund ended up returning 278.5% from July, 1998, to July 1999. It was the best-performing mutual fund in the world over that time period.

The authors comment:

Whereas most value investors in the United States were befuddled by the Internet frenzy, Uncle John was ringing up the best returns the market could offer. This is the virtue of global bargain hunting. Being a devout bargain hunter in only the United States would have kept you on the sidelines in 1999. In contrast, being a global bargain hunter would have produced even better performance than was available gambling in the greatest stock mania of modern times. Bargain hunting trumps the greater fool theorem once again.

In August 2004, Templeton invested $50 million into the Korean car manufacturer Kia Motors. It has a P/E of 4.8x and was growing at almost 28 percent a year. The stock then increased 174 percent.

The authors conclude the chapter:

Bargain hunters who understand history, focus on the long term and seek to buy at the point of maximum pessimism can appreciate the fact that these patterns repeat themselves over time, again and again. Different place, different time; same story, same results. While you may not be able to identify theexact repeating circumstances of emerging industrial powers in the future experiencing temporary problems you can be sure to find some that rhyme.

 

WHEN BONDS ARE NOT BORING

While Templeton shorted the U.S. stock market in early 2000, betting $185 million of his own money aqnd making a tidy profit, he was always very careful when dealing with other people’s money. So his advice in March 2000, when asked, was to buy zero coupon bonds. This was extraordinarily good advice. When the economy slowed down, the Fed lowered interest rates several times, which significantly boosted the prices of zero coupon bonds.

Note: A zero coupon bond, instead of paying semiannual interest payments, incorporates the interest into the initial price of the bond so that the total capital gains over the life of the bond will include interest payments and the repayment of the principal. The authors give the example of a 30-year zero coupon bond that pays 5 percent interest on a semiannual basis. The price of this bond is about $227, which will become $1,000 by the time the bond matures.

Because Templeton thought the economy would slow and the Federal Reserve would therefore lower interest to boost the economy, the buyer of a 30-year zero coupon bond could make significant money over the course of just a few years. Remember that the investor would initially pay $227 for a 3o-year zero coupon bond. But if the Fed were to lower interest rates to stimulate the economy, the price of the 30-year zero coupon bond would jump up to reflect the new lower rates.

Before even considering these capital gains, though, it’s important to point out that, in early 2000, a U.S. investor could either (i) buy U.S. stocks and risk a 50 percent decline from very high P/E levels or (ii) buy U.S. government bonds yielding 6.3 percent. That’s an easy decision.

But now back to the point about the Federal Reserve lowering interest rates. The U.S. markets had gotten used to Alan Greenspan, the chair of the Federal Reserve, lowering interest rates when the economy was in danger of entering a recession or when stocks were crashing or when a financial crisis was possible, that the term the Greenspan put was invented. The idea was that markets would always get bailed out by the Fed lowering rates at any sign of trouble.

A final step in Templeton’s recommendation was to buy 30-year zero coupon bonds from Canada, Australia, or New Zealand. All of these countries had positive trade balances, small budget deficits (or surpluses in some cases), and low levels of government debt.

In March 2000, Canadian 30-year zero coupon bonds were yielding 5.3 percent. As interest rates fell, those bonds would increase in price. Rates actually declined to 4.9 percent, creating a 31.9 percent capital gain for the 30-year zero coupon bonds. Translated back into U.S. dollars, the gain was 43.4 percent, or 12.8 percent anuualized.

Furthermore, Templeton recommended using borrowed money to purchase the Canadian 30-year zero coupon bonds. An investor could borrow from the Japanese government at 0.1 percent. Templeton recommended 2x leverage, which means instead of 43.4 percent the return would be 86.8 percent.

In other words, while U.S. stocks declined roughly 50 percent from early 2000 over the next few years, Templeton’s recommended investment strategy of borrowing from the Japanese government at 0.1 percent and buying 30-year Canadian zero coupon bonds generated a return of more than 86 percent over the same time period. The three-year annualized return of Templeton’s recommended strategy was 25.5 percent.

The authors write:

The point of the discussion is that for a bargain hunter, it always pays to make relative comparisons. Sometimes the comparisons must extend into securities such as bonds. Although it represented an extreme situation in which Uncle John could not locate enough bargain stocks to place his money in, his process was sound enough to lead him into a profitable situation. His process is and always has been defined by commonsense decision making and a willingness to do things others do not. If we review his thought process on this trade, it came down to some simple questions: Should I risk losing substantial amounts of money in an inflated stock market or should I earn the 5 or 6 percent available in various long-term bond markets? Anyone can see the logic behind this decision. The reasoning is simple, not complicated.

The authors further point out that Templeton’s strategy was to hold the bonds until there were cheap stocks, which would certainly be the case if the U.S. stock market declined 50 percent overall.

That said, Templeton was concerned about a housing bubble in the U.S. He noticed that many homebuyers were paying four to five times more for a house than it would cost to contruct it.

Using his global lense, Templeton found a new market where there were bargains: China.

 

THE SLEEPING DRAGON AWAKENS

Templeton had identified China as the next great place to invest when he appeared in 1988 onWall Street Week with Louis Rukeyser. Then in a March 1990 interview forFortune maganize, Templeton said the following:

“Hong Kong is rich in entrepreneurs who can start and run businesses, and there’s a great shortage in mainland China of people who know how to do that. As a result, Hong Kong is likely to become the commercial and financial center for over a billion people, just as Manhatten is the commercial and financial center for a quarter of a billion people.”

The authors comment:

Today most readers and observers of financial markets take the significant economic presence of China in the world for granted. However, when Uncle John described China as the next great economic power in the world in 1988, nearly 20 years earlier, that was very forward thinking. Forward thinking is the calling card of successful bargain hunters.

The authors then compare Japan, Korea, and China.

All three countries had hit rock bottom, and Uncle John believed they were certain to emerge from that period of despair. In the case of Japan, the country had been rendered economically prostrate by its disastrous fate in World War II. It was left in such a state of ruin that investors believed it would remain an irrelevant economic backwater going forward. In the same vein, when Japan began to rebuild, it attracted little serious attention from the major industrial nations, including the United States and Europe. The industrial nations saw no impending threat from Japan, a producer of “cheap trinkets” in the 1950s.

South Korea was a nation left in economic devastation by the destruction caused by the Korean War. Much like Japan before it, South Korea relied heavily on the financial aid of developed nations as it went through a rebuilding process during the 1960s. When it took aim at becoming an industrial power, few believed there was any such capability in a country whose third largest export at that time was human hair wigs.

In the case of China, no historical headline war event sent the country into an economic tailspin. With a slightly closer look, though, we can see that political events within China during the middle to late twentieth century dismantled its economy and left the nation in shambles. More specifically, we are referring to the regime of the communist leader Mao Tse-Tung and then the Cultural Revolution. Both of those events left the country with the results that would have followed from losing a major war.

The authors continue:

The Great Leap Forward was an economic strategy developed and implemented by Mao in 1958 to move the country toward joint industrial and agrarian progress. A central tenet of that strategy was that the state could manage the agricultural process, which then would generate the funds necessary for industrial ventures into steel production and eventually more advanced goods. The first move by Mao to install the program involved the widespread collectivization of farmland into communes… This essentially meant that all property ownership was abolished, and reports suggest that 700 million Chinese were relocated into farming communes, with about 5,000 families per commune. Once the families were relocated, they were forced to work in the fields to produce food for the country and fund the industrialization process.

Most bargain hunters will recall from earlier chapters that when the government nationalizes or expropriates private property, whether land or a business, that stifles productivity and kills the spirit of progress. Countries that implement those strategies make horrible investments as the effects are manifested in the economy. In the case of China, the initial steps set the country on a fast track in the wrong direction. Partly because of Mao’s willingness to lock up or expunge anyone who spoke against his policies and partly because of his stubbornness in not admitting a mistake sooner, the end result was massive starvation and loss of life.

To make matters worse, local government officials inflated the communes’ production statistics, perhaps out of hope for government praise or out of fear of the threat of retribution.

In the end, roughly 30 million Chinese starved to death and the same number of births were lost or postponed.

Mao conceded power to the prominent officials Liu Shaoqi and Deng Xiaopeng. In 1966, Mao tried to regain his lost influence by instigating the Cultural Revolution. Mao did this because the new leadership had become popular by reversing his reforms from the Great Leap Forward.

One consequence of Mao’s Cultural Revolution was the rise of the Red Guard, who began as a group of students defending Maoism. Mao thought this was a way to spread socialism throughout China.

Part of that process was the eradication of “the four olds”: old customs, old culture, old habits, and old ideas. The Red Guards had unlimited authority to enforce this dismissal of the four olds, and since they numbered in the millions, they exercised it ruthlessly. The army and police were instructed to stand down and not interfere with the Red Guards’ actions or they would be considered to be defending the bourgeoisie and prosecuted.

The Red Guards took the opportunity to destroy churches, ancient buildings, antiques, books, and paintings and to torture and kill innocent people. Some estimates put the casualties from the Cultural Revolution at 500,000 people or more…. The Cultural Revolution’s spirit of radical bullying persisted until the “gang of four” was arrested in 1976. The gang was a group of powerful and high-ranking instigators (including Mao’s estranged wife) who were central to the drive of the Cultural Revolution under Mao.

The authors add:

As terrible as this event sounds from a humanitarian perspective, its consequences were equally severe and lasting on China’s economy. During the Cultural Revolution nearly all economic activity shut down as the populace became concerned primarily with persecuting the old ways or running from persecution. The government’s financial resources were redirected to support the Red Guard, and anyone who qualified as an “intellectual” was sent to a work camp for reeducation, including the two leaders Mao purged. College entrance exams were canceled, and education stalled. The lost 10 years in the educational system produced a gaping hole in China’s progress.

Only in 1977, after Deng Xiaopeng reemerged from a work camp to lead China again, did the country reinstitute its education system and implement serious reforms to undo the substantial damage caused by Mao over the previous two decades…

With Deng in control in 1977, China instituted a complete reversal and an open repudiation of the Cultural Revolution. Deng’s intention to elevate the Chinese from their despair was made clear in 1979, when he said that “to get rich is glorious.”

Deng found a successful economic model near to China: Japan.

As you may recall from our earlier discussions of Japan and South Korea, there is a basic recipe that each of those Asian countries applied to rebuild its economy rapidly. The Chinese were attracted to that recipe and began implementing it in their own way. In each instance, a heavy savings rate is a major prerequisite for economic success. A high savings rate is an attribute that Uncle John often favors in making foreign investments. China proved adept at creating a large rate of saving across the country. In fact, by the time Uncle John had mentioned China as the next great nation for investment in 1988, the country had achieved one of the highest savings rates in the world alongside Korea and Japan.

This heavy savings rate was the same strategy used by Japan and Korea to build financial reserves and finance industrial growth. That growth would drive increasing exports with more value-added content over time. China was determined to have the same success in exports that Japan and Korea had experienced in their rebuilding processes. Like them, China began at the low end of the market by manufacturing textiles and “cheap stuff” for export. That concentration on exports most often produced a trade surplus, which is another economic condition that Uncle John likes to find in a country.

… China was falling in love with capitalism and, of course, the spoils that follow business success. The people needed little more than Deng’s prompt to strike while the iron was hot.

The authors later write:

Perhaps more important than the ambition of the Chinese was their ability to execute their strategy. If we take a look at the country’s exports and their composition over time, we can see the familiar progression from a onetime exporter of low-grade textiles mature to an exporter of industrial machinery and higher-value-added products. If we compare the percentage of exports accounted for by textiles in 1992 with the percentage in 2005, we see a dramatic reversal. That reversal was accompanied by tremendous growth and a higher percentage of exports in machinery, mechanical appliances, and electrical equipment. In sum, textiles shrank to half their original percentage from 1992 and machinery increased to a percentage that was three times the 1992 level. This reversal from low-value-added goods to more sophisticated exports of industrial goods mirrors the earlier advances in Japan and Korea.

China successfully transformed itself from a socialist system to a capitalism system. China is now on track to overtaking the United States and becoming the largest economy in the world.

When the authors discussed China with Templeton, he said the following:

“The thing to always remember about China has to do with the people… You must not think of them as communists or capitalists… They are Chinese first, and that is how they see themselves.”

Templeton advised investing in China via investors who have their “feet on the ground” and who are up-to-date on local information. Templeton also found two stocks in China in September 2004: China Life Insurance and China Mobile.

Templeton viewed China Life as a way to access the strength of the Chinese currency without paying a premium. The stock traded as an ADR on the New York Stock Exchange. The company would invest the premiums in the same currencies in which they did business, so as to minimize the risk of adverse currency developments. Thus, buying China Life was a way for Templeton to access the local Chinese currency, which he found attractive over the long term. Also, Templeton feared a decline in the U.S. dollar based on U.S. trade deficits combined with U.S. government debt levels.

Templeton’s China Life investment increased 1,050 percent over three years, a phenomenal investment.

Templeton’s other stock investment was China Mobile. The company had a P/E of 11x, plus a growth rate of 20 percent. So the PEG ratio (P/E divided by growth rate) was only 0.55, one of the cheapest stocks in the wireless telecommunications industry. The worldwide wireless telecommunication 2004 group average PEG ratio was 0.84.

Templeton’s China Mobile investment ended up returning 656% over three years, another outstanding investment.

Templeton began advising that instead of forecasting a company’s earnings five years into the future, you should now try to forecast a company’s earnings ten years into the future. The authors write:

…by focusing on the future prospects of a company as much as 10 years into the future, a bargain hunter has to think about the competitive positioning of a company in the market. In short, bargain hunters must devote a large majority of their efforts to determining the competitive advantage of a business in relation to its competitors. This requires putting a great deal of effort into studying not only the company whose stock you are considering for purchase but also that company’s competitors in the market.

Uncle John always said that when he visited a company in his early days as an analyst, he always got the best information from the company’s competitors, not from the company itself. The aim of this analysis is to get a sense of how well a company will be able to maintain its profitability into the future. This is a key consideration if you are going to make an estimation of a company’s earnings 10 years ahead.

The authors point out that a basic rule of economics is that excess profits attract competition, which tends to reduce those profits. How defensible are the company’s profit margins in the face of increasing competition? If a company has a sustainable competitive advantage–which is also something Warren Buffett and Charlie Munger look for–then that is an encouraging sign. Whether its a low-cost advantage, a brand image advantage, a market share advantage, pricing power, or some other advantage, it pays to figure out if the company does have a competitive advantage and whether it is sustainable far into the future.

A key question is: How easy would it be for someone to replicate the business in question? The more difficult it would be to replicate a given business, the more valuable that company’s earnings are to an investor.

The authors conclude:

Always looking for investments differently than others do (whether in a different country, with a different method, with a different time horizon, with a different level of optimism, or with a different level of pessimism) is the only way to separate yourself from the crowd. By now you should know that the only way to achieve superior investment results is to buy what others are despondently selling and sell what others are avidly buying in the market.

The authors quote Templeton:

“If you want to have a better performance than the crowd, you must do things differently from the crowd.”

 

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: jb@boolefund.com

 

 

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

Business Adventures

August 3, 2025

In 1991, when Bill Gates met Warren Buffett, Gates asked him to recommend his favorite business book. Buffett immediately replied, “It’s Business Adventures, by John Brooks. I’ll send you my copy.” Gates wrote in 2014:

Today, more than two decades after Warren lent it to me–and more than four decades after it was first published–Business Adventures remains the best business book I’ve ever read. John Brooks is still my favorite business writer.

It’s certainly true that many of the particulars of business have changed. But the fundamentals have not. Brooks’s deeper insights about business are just as relevant today as they were back then. In terms of its longevity, Business Adventures stands alongside Benjamin Graham’s The Intelligent Investor, the 1949 book that Warren says is the best book on investing that he has ever read.

See: https://www.gatesnotes.com/Books/Business-Adventures

I’ve had the enormous pleasure of readingBusiness Adventures twice. John Brooks is quite simply a terrific business writer.

Each chapter of the book is a separate business adventure. Outline:

  • The Fluctuation
  • The Fate of the Edsel
  • A Reasonable Amount of Time
  • Xerox Xerox Xerox Xerox
  • Making the Customers Whole
  • The Impacted Philosophers
  • The Last Great Corner
  • A Second Sort of Life
  • Stockholder Season
  • One Free Bite

 

THE FLUCTUATION

Brooks recounts J.P. Morgan’s famous answer when an acquaintance asked him what the stock market would do: “It will fluctuate.” Brooks then writes:

Apart from the economic advantages and disadvantages of stock exchanges – the advantage that they provide a free flow of capital to finance industrial expansion, for instance, and the disadvantage that they provide an all too convenient way for the unlucky, the imprudent, and the gullible to lose their money – their development has created a whole pattern of social behavior, complete with customs, language, and predictable responses to given events.

Brooks explains that the pattern emerged fully at the first important stock exchange in 1611 in Amsterdam. Brooks mentions that Joseph de la Vega published, in 1688, a book about the first Dutch stock traders. The book was aptly titled,Confusion of Confusions.

And the pattern persists on the New York Stock Exchange. (Brooks was writing in the 1960’s, but many of his descriptions still apply.) Brooks adds that a few Dutchmen haggling in the rain might seem to be rather far from the millions of participants in the 1960’s. However:

The first stock exchange was, inadvertently, a laboratory in which new human reactions were revealed. By the same token, the New York Stock Exchange is also a sociological test tube, forever contributing to the human species’ self-understanding.

On Monday, May 28, 1962, the Dow Jones Average dropped 34.95 points, or more than it had dropped on any day since October 28, 1929. The volume was the seventh-largest ever. Then on Tuesday, May 29, after most stocks opened down, the market reversed itself and surged upward with a large gain of 27.03. The trading volume on Tuesday was the highest ever except for October 29, 1929. Then on Thursday, May 31, after a holiday on Wednesday, the Dow rose 9.40 points on the fifth-greatest volume ever.

Brooks:

The crisis ran its course in three days, but needless to say, the post-mortems took longer. One of de la Vega’s observations about the Amsterdam traders was that they were ‘very clever in inventing reasons’ for a sudden rise or fall in stock prices, and the Wall Street pundits certainly needed all the cleverness they could muster to explain why, in the middle of an excellent business year, the market had suddenly taken its second-worst nose dive ever up to that moment.

Many rated President Kennedy’s April crackdown on the steel industry’s planned price increase as one of the most likely causes. Beyond that, there were comparisons to 1929. However, there were more differences than similarities, writes Brooks. For one thing, margin requirements were far higher in 1962 than in 1929. Nonetheless, the weekend before the May 1962 crash, many securities dealers were occupied sending out margin calls.

In 1929, it was not uncommon for people to have only 10% equity, with 90% of the stock position based on borrowed money. (The early Amsterdam exchange was similar.) Since the crash in 1929, margin requirements had been raised to 50% equity (leaving 50% borrowed).

Brooks says the stock market had been falling for most of 1962 up until crash. But apparently the news before the May crash was good. Not that news has any necessary relationship with stock movements, although most financial reporting services seem to assume otherwise. After a mixed opening – some stocks up, some down – on Monday, May 28, volume spiked as selling became predominant. Volume kept going up thereafter as the selling continued. Brooks:

Evidence that people are selling stocks at a time when they ought to be eating lunch is always regarded as a serious matter.

One problem in this crash was that the tape – which records the prices of stock trades – got delayed by 55 minutes due to the huge volume. Some brokerage firms tried to devise their own systems to deal with this issue. For instance, Merrill Lynch floor brokers – if they had time – would shout the results of trades into a floorside telephone connected to a “squawk box” in the firm’s head office.

Brooks remarks:

All that summer, and even into the following year, security analysts and other experts cranked out their explanations of what had happened, and so great were the logic, solemnity, and detail of these diagnoses that they lost only a little of their force through the fact that hardly any of the authors had had the slightest idea what was going to happen before the crisis occurred.

Brooks then points out that an unprecedented 56.8 percent of the total volume in the crash had been individual investors. Somewhat surprisingly, mutual funds were a stabilizing factor. During the Monday sell-off, mutual funds bought more than they sold. And as stocks surged on Thursday, mutual funds sold more than they bought. Brooks concludes:

In the last analysis, the cause of the 1962 crisis remains unfathomable; what is known is that it occurred, and that something like it could occur again.

 

THE FATE OF THE EDSEL

1955 was the year of the automobile, writes Brooks. American auto makers sold over 7 million cars, a million more than in any previous year. Ford Motor Company decided that year to make a new car in the medium-price range of $2,400 to $4,000. Brooks continues:

[Ford] went ahead and designed it more or less in comformity with the fashion of the day, which was for cars that were long, wide, low, lavishly decorated with chrome, liberally supplied with gadgets… Two years later, in September, 1957, Ford put its new car, the Edsel, on the market, to the accompaniment of more fanfare than had attended the arrival of any new car since the same company’s Model A, brought out thirty years earlier. The total amount spent on the Edsel before the first specimen went on sale was announced as a quarter of a billion dollars; its launching… was more costly than any other consumer product in history. As a starter toward getting its investment back, Ford counted on selling at least 200,000 Edsels the first year.

There may be an aborigine somewhere in a remote rainforest who hasn’t yet heard that things failed to turn out that way… on November 19, 1959, having lost, according to some outside estimates, around $350 million on the Edsel, the Ford Company permanently discontinued its production.

Brooks asks:

How could this have happened? How could a company so mightily endowed with money, experience, and, presumably, brains have been guilty of such a monumental mistake?

Many claimed that Ford had paid too much attention to public-opinion polls and the motivational research it conducted. But Brooks adds that some non-scientific elements also played a roll. In particular, after a massive effort to come up with possible names for the car, science was ignored at the last minute and the Edsel was named for the father of the company’s president. Brooks:

As for the design, it was arrived at without even a pretense of consulting the polls, and by the method that has been standard for years in the designing of automobiles – that of simply pooling the hunches of sundry company committees.

The idea for the Edsel started years earlier. The company noticed that owners of cars would trade up to the medium-priced car as soon as they could. The problem was that Ford owners were not trading up to the Mercury, Ford’s medium-priced car, but to the medium-priced cars of its rivals, General Motors and Chrysler.

Late in 1952, a group called the Forward Product Planning Committee gave much of the detailed work to the Lincoln-Mercury Division, run by Richard Krafve (pronounced “Kraffy”). In 1954, after two years’ work, the Forward Product Planning Committee submitted to the executive committee a six-volume report. In brief, the report predicted that there would be seventy million cars in the U.S. by 1965, and more than 40 percent of all cars sold would be in the medium-price range. Brooks:

On the other hand, the Ford bosses were well aware of the enormous risks connected with putting a new car on the market. They knew, for example, that of the 2,900 American makes that had been introduced since the beginning of the automobile age… only about twenty were still around.

But Ford executives felt optimistic. They set up another agency, the Special Products Division, again with Krafve in charge. The new car was referred to as the “E”-Car among Ford designers and workers. “E” for Experimental. Roy A. Brown was in charge of the E-car’s design. Brown stated that they sought to make a car that was unique as compared to the other nineteen cars on the road at the time.

Brooks observes that Krafve later calculated that he and his associates would make at least four thousand decisions in designing the E-Car. He thought that if they got every decision right, they could create the perfectly designed car. Krafve admitted later, however, that there wasn’t really enough time for perfection. They would make modifications, and then modifications of those modifications. Then time would run out and they had to settle on the most recent modifications.

Brooks comments:

One of the most persuasive and frequently cited explanations of the Edsel’s failure is that it was a victim of the time lag between the decision to produce it and the act of putting it on the market. It was easy to see a few years later, when smaller and less powerful cars, euphemistically called “compacts,” had become so popular as to turn the old automobile status-ladder upside down, that the Edsel was a giant step in the wrong direction, but it far from easy to see that in fat, tail-finny 1955.

As part of the marketing effort, the Special Products Division tapped David Wallace, director of planning for market research. Wallace:

‘We concluded that cars are a means to a sort of dream fulfillment. There’s some irrational factor in people that makes them want one kind of car rather than another – something that has nothing to do with the mechanism at all but with the car’s personality, as the customer imagines it. What we wanted to do, naturally, was to give the E-Car the personality that would make the greatest number of people want it.’

Wallace’s group decided to get interviews of 1,600 car buyers. The conclusion, in a nutshell, was that the E-Car could be “the smart car for the younger executive or professional family on its way up.”

As for the name of the car, Krafve had suggested to the members of the Ford family that the new car be named the Edsel Ford – the name of their father. The three Ford brothers replied that their father probably wouldn’t want the car named after him. Therefore, they suggested that the Special Products Division look for another name.

The Special Products Division conducted a large research project regarding the best name for the E-Car. At one point, Wallace interviewed the poet Marianne Moore about a possible name. A bit later, the Special Products Division contacted Foote, Cone & Belding, an advertising agency, to help with finding a name.

The advertising agency produced 18,000 names, which they then carefully pruned to 6,000. Wallace told them that was still way too many names from which to pick. So Foote, Cone & Belding did an all-out three-day session to cut the list down to 10 names. They divided into two groups for this task. By chance, when each group produced its list of 10 names, 4 of the names were the same: Corsair, Citation, Pacer, and Ranger.

Wallace thought that Corsair was clearly the best name. However, the Ford executive committee had a meeting at a time when all three Ford brothers were away. Executive vice-president Ernest R. Breech, chairman of the board, led the meeting. When Breech saw the final list of 10 names, he said he didn’t like any of them.

So Breech and the others were shown another list of names that hadn’t quite made the top 10. The Edsel had been kept on this second list – despite the three Ford brothers being against it – for some reason, perhaps because it was the originally suggested name. When the group came to the name “Edsel,” Breech firmly said, “Let’s call it that.” Breech added that since there were going to be four models of the E-Car, the four favorite names – Corsair, Citation, Pacer, and Ranger – could still be used as sub-names.

Brooks writes that Foote, Cone & Belding presumably didn’t react well to the chosen name, “Edsel,” after their exhaustive research to come up with the best possible names. But the Special Products Division had an even worse reaction. However, there were a few, including Krafve, would didn’t object to the name.

Krafve was named Vice-President of the Ford Motor Company and General Manager, Edsel Division. Meanwhile, Edsels were being road-tested. Brown and other designers were already working on the subsequent year’s model. A new set of retail dealers was already being put together. Foote, Cone & Belding was hard at work on strategies for advertising and selling Edsels. In fact, Fairfax M. Cone himself was leading this effort.

Cone decided to use Wallace’s idea of “the smart car for the younger executive or professional family on its way up.” But Cone amended it to: “the smart car for the younger middle-income family or professional family on its way up.” Cone was apparently quite confident, since he described his advertising ideas for the Edsel to some reporters. Brooks notes with amusement:

Like a chess master that has no doubt that he will win, he could afford to explicate the brilliance of his moves even as he made them.

Normally, a large manufacturer launches a new car through dealers already handling some of its other makes. But Krafve got permission to go all-out on the Edsel. He could contact dealers for other car manufacturers and even dealers for other divisions of Ford. Krafve set a goal of signing up 1,200 dealers – who had good sales records – by September 4, 1957.

Brooks remarks that Krafve had set a high goal, since a dealer’s decision to sell a new car is major. Dealers typically have one hundred thousand dollars – more than 8x that in 2019 dollars – invested in their dealerships.

J. C. (Larry) Doyle, second to Krafve, led the Edsel sales effort. Doyle had been with Ford for 40 years. Brooks records that Doyle was somewhat of a maverick in his field. He was kind and considerate, and he didn’t put much stock in the psychological studies of car buyers. But he knew how to sell cars, which is why he was called on for the Edsel campaign.

Doyle put Edsels into a few dealerships, but kept them hidden from view. Then he went about recruiting top dealers. Many dealers were curious about what the Edsel looked like. But Doyle’s group would only show dealers the car if they listened to a one-hour pitch. This approach worked. It seems that quite a few dealers were so convinced by the pitch that they signed up without even looking at the car in any detail.

C. Gayle Warnock, director of public relations at Ford, was in charge of keeping public interest in the Edsel – which was already high – as strong as possible. Warnock told Krafve that public interest might be too strong, to the extent that people would be disappointed when they discovered that the Edsel was a car. Brooks:

It was agreed that the safest way to tread the tightrope between overplaying and underplaying the Edsel would be to say nothing about the car as a whole but to reveal its individual charms a little at a time – a sort of automotive strip tease…

Brooks continues:

That summer, too, was a time of speechmaking by an Edsel foursome consisting of Krafve, Doyle, J. Emmet Judge, who was Edsel’s director of merchandise and product planning, and Robert F. G. Copeland, its assistant general sales manager for advertising, sales promotion, and training. Ranging separately up and down and across the nation, the four orators moved around so fast and so tirelessly, that Warnock, lest he lost track of them, took to indicating their whereabouts with colored pins on a map in his office. ‘Let’s see, Krafve goes from Atlanta to New Orleans, Doyle from Council Bluffs to Salt Lake City,’ Warnock would muse of a morning in Dearborn, sipping his second cup of coffee and then getting up to yank the pins out and jab them in again.

Needless to say, this was by far the largest advertising campaign ever conducted by Ford. This included a three-day press preview, with 250 reporters from all over the country. On one afternoon, the press were taken to the track to see stunt drivers in Edsels doing all kinds of tricks. Brooks quotes the Foote, Cone man:

‘You looked over this green Michigan hill, and there were those glorious Edsels, performing gloriously in unison. It was beautiful. It was like the Rockettes. It was exciting. Morale was high.’

Brooks then writes about the advertising on September 3 – “E-Day-minus-one”:

The tone for Edsel Day’s blizzard of publicity was set by an ad, published in newspapers all over the country, in which the Edsel shared the spotlight with the Ford Company’s President Ford and Chairman Breech. In the ad, Ford looked like a dignified young father, Breech like a dignified gentleman holding a full house against a possible straight, the Edsel just looked like an Edsel. The accompanying text declared that the decision to produce the car had been ‘based on what we knew, guessed, felt, believed, suspected – about you,’ and added, ‘YOU are the reason behind the Edsel.’ The tone was calm and confident. There did not seem to be much room for doubt about the reality of that full house.

The interior of the Edsel, as predicted by Krafve, had an almost absurd number of push-buttons.

The two larger models – the Corsair and the Citation – were 219 inches long, two inches longer than the biggest of the Oldsmobiles. And they were 80 inches wide, “or about as wide as passenger cars ever get,” notes Brooks. Each had 345 horsepower, making it more powerful than any other American car at the time of launching.

Brooks records that the car received mixed press after it was launched. In January, 1958,Consumer Reports wrote:

The Edsel has no important basic advantage over other brands. The car is almost entirely conventional in construction…

Three months later,Consumer Reports wrote:

[The Edsel] is more uselessly overpowered… more gadget bedecked, more hung with expensive accessories than any other car in its price class.

This report gave the Corsair and the Citation the bottom position in its competitive ratings.

Brooks says there were several factors in the downfall of the Edsel. It wasn’t just that the design fell short, nor was it simply that the company relied too much on psychological research. For one, many of the early Edsels suffered from a surprising variety of imperfections. It turned out that only about half the early Edsels functioned properly.

Brooks recounts:

For the first ten days of October, nine of which were business days, there were only 2,751 deliveries – an average of just over three hundred cars a day. In order to sell the 200,000 cars per year that would make the Edsel operation profitable the Ford Motor Company would have to move an average of between six and seven hundred each business day – a good many more than three hundred a day. On the night of Sunday, October 13th, Ford put on a mammoth television spectacular for Edsel, pre-empting the time ordinarily allotted to the Ed Sullivan show, but though the program cost $400,000 and starred Bing Crosby and Frank Sinatra, it failed to cause any sharp spurt in sales. Now it was obvious that things were not going well at all.

Among the former executives of the Edsel Division, opinions differ as to the exact moment when the portents of doom became unmistakable… The obvious sacrificial victim was Brown, whose stock had gone through the roof at the time of the regally accoladed debut of his design, in August, 1955. Now, without having done anything further, for either better or worse, the poor fellow became the company scapegoat…

Ford re-committed to selling the Edsel in virtually every way that it could. Sales eventually increased, but not nearly enough. Ultimately, the company had to stop production. The net loss for Ford was roughly $350 million.

Krafve rejects that the Edsel failed due to a poor choice of the name. He maintains that it was a mistake of timing. Had they produced the car two years earlier, when medium-sized cars were still highly popular, the Edsel would have been a success. Brown agrees with Krafve that it was a mistake of timing.

Doyle says it was a buyers’ strike. He claims not to understand at all why the American public suddenly switched its taste from medium-sized cars to smaller-sized cars.

Wallace argued that the Russian launch of the sputnik had caused many Americans to start viewing Detroit products as bad, especially medium-priced cars.

Brooks concludes by noting that Ford did not get hurt by this setback, nor did the majority of people associated with the Edsel. In 1958, net income per share dropped from $5.40 to $2.12, and Ford stock dropped from a 1957 high of $60 to a low of $40. However, by 1959, net income per-share jumped to $8.24 and the stock hit $90.

The Ford executives associated with the Edsel advanced in their careers, for the most part. Moreover, writes Brooks:

The subsequent euphoria of these former Edsel men did not stem entirely from the fact of their economic survival; they appear to have been enriched spiritually. They are inclined to speak of their Edsel experience – except for those still with Ford, who are inclined to speak of it as little as possible – with the verve and garrulity of old comrades-in-arms hashing over their most thrilling campaign.

 

A REASONABLE AMOUNT OF TIME

Brooks:

Most nineteenth-century American fortunes were enlarged by, if they were not actually founded on, the practice of insider trading…

Not until 1934 did Congress pass the Securities Exchange Act, which forbids insider trading. Later, a 1942 rule 10B-5 held that no stock trader could “make any untrue statement of a material fact or… omit to state a material fact.” However, observes Brooks, this rule had basically been overlooked for the subsequent couple of decades. It was argued that insiders needed the incentive of being able to profit in order to bring forth their best efforts. Further, some authorities said that insider trading helped the markets function more smoothly. Finally, it was held that most stock traders “possess and conceal information of one sort or another.”

In short, the S.E.C. seemed to be refraining from doing anything regarding insider trading. But this changed when a civil complaint was made against Texas Gulf Sulphur Company. The case was tried in the United States District Court in Foley Square May 9 to June 21, 1966. The presiding judge was Dudley J. Bonsal, says Brooks, who remarked at one point, “I guess we all agree that we are plowing new ground here to some extent.”

In March 1959, Texas Gulf, a New York-based company and the world’s leader producer of sulphur, began conducting aerial surveys over a vast area of eastern Canada. They weren’t looking for sulphur or gold, but for sulphides – sulphur in combination with other useful minerals such as zinc and copper. Texas Gulf wanted to diversify its production.

These surveys took place over two years. Many areas of interest were noted. The company concluded that several hundred areas were most promising, including a segment called Kidd-55, which was fifteen miles north of Timmins, Ontario, an old gold-mining town several hundred miles northwest of Toronto.

The first challenge was to get title to do exploratory drilling on Kidd-55. It wasn’t until June, 1963, that Texas Gulf was able to begin exploring on the northeast quarter of Kidd-55. After Texas Gulf engineer, Richard H. Clayton, completed a ground electromagnetic survey and was convinced the area had potential, the company decided to drill. Drilling began on November 8. Brooks writes:

The man in charge of the drilling crew was a young Texas Gulf geologist named Kenneth Darke, a cigar smoker with a rakish gleam in his eye, who looked a good deal more like the traditional notion of a mining prospector than that of the organization man that he was.

A cylindrical sample an inch and a quarter in diameter was brought out of the earth. Darke studied it critically inch by inch using only his eyes and his knowledge. On November 10, Darke telephoned his immediate superior, Walter Holyk, chief geologist of Texas Gulf, to report the findings at that point.

The same night, Holyk called his superior, Richard D. Mollison, a vice president of Texas Gulf. Mollison then called his superior, Charles F. Fogarty, executive vice president and the No. 2 man at the company. Further reports were made the next day. Soon Holyk, Mollison, and Fogarty decided to travel to Kidd-55 to take a look for themselves.

By November 12, Holyk was on site helping Darke examine samples. Holyk was a Canadian in his forties with a doctorate in geology from MIT. The weather had turned bad. Also, much of the stuff came up covered in dirt and grease, and had to be washed with gasoline. Nonetheless, Holyk arrived at an initial estimate of the core’s content. There seemed to be average copper content of 1.15% and average zinc content of 8.64%. If true and if it was not just in one narrow area, this appeared to be a huge discovery. Brooks:

Getting title would take time if it were possible at all, but meanwhile there were several steps that the company could and did take. The drill rig was moved away from the site of the test hole. Cut saplings were stuck in the ground around the hole, to restore the appearance of the place to a semblance of its natural state. A second test hole was drilled, as ostentatiously as possible, some distance away, at a place where a barren core was expected – and found. All of these camouflage measures, which were in conformity with long-established practice among miners who suspect that they have made a strike, were supplemented by an order from Texas Gulf’s president, Claude O. Stephens, that no one outside the actual exploration group, even within the company, should be told what had been found. Late in November, the core was shipped off, in sections, to the Union Assay Office in Salt Lake City for scientific analysis of its contents. And meanwhile, of course, Texas Gulf began discreetly putting out feelers for the purchase of the rest of Kidd-55.

Brooks adds:

And meanwhile other measures, which may or may not have been related to the events of north of Timmins, were being taken. On November 12th, Fogarty bought three hundred shares of Texas Gulf stock; on the 15th he added seven hundred more shares, on November 19th five hundred more, and on November 26th two hundred more. Clayton bought two hundred on the 15th, Mollison one hundred on the same day; and Mrs. Holyk bought fifty on the 29th and one hundred more on December 10th. But these purchases, as things turned out, were only the harbingers of a period of apparently intense affection for Texas Gulf stock among certain of its officers and employees, and even some of their friends.

The results of the sample test confirmed Holyk’s estimates. Also found were 3.94 ounces of silver per ton. In late December, while in the Washington, D.C. area, Darke recommended Texas Gulf stock to a girl he knew there and her mother. They later became known as “tippees,” while a few people they later told naturally became “sub-tippees.” Between December 30 and February 17, Darke’s tippees and sub-tippees purchased 2,100 shares of Texas Gulf stock and also bought calls on another 1,500 shares.

In the first three months of 1964, Darke bought 300 shares of Texas Gulf stock, purchased calls on 3,000 more shares, and added several more persons to his burgeoning list of tippees. Holyk and his wife bought a large number of calls on Texas Gulf stock. They’d hardly heard of calls before, but calls “were getting to be quite the rage in Texas Gulf circles.”

Finally in the spring, Texas Gulf had the drilling rights it needed and was ready to proceed. Brooks:

After a final burst of purchases by Darke, his tippees, and his sub-tippees on March 30th and 31st (among them all, six hundred shares and calls on 5,100 more shares for the two days), drilling was resumed in the still-frozen muskeg at Kidd-55, with Holyk and Darke both on the site this time.

While the crew stayed on site, the geologists almost daily made the fifteen-mile trek to Simmins. With seven-foot snowdrifts, the trip took three and a half to four hours.

At some stage – later a matter of dispute – Texas Gulf realized that it had a workable mine of large proportions. Vice President Mollison arrived on site for a day. Brooks:

But before going he issued instructions for the drilling of a mill test hole, which would produce a relatively large core that could be used to determine the amenability of the mineral material to routine mill processing. Normally, a mill test hole is not drilled until a workable mine is believed to exist. And so it may have been in this case; two S.E.C. mining experts were to insist later, against contrary opinions of experts for the defense, that by the time Mollison gave his order, Texas Gulf had information on the basis of which it could have calculated that the ore reserves at Kidd-55 had a gross assay value of at least two hundred million dollars.

Brooks notes:

The famous Canadian mining grapevine was humming by now, and in retrospect the wonder is that it had been relatively quiet for so long.

On April 10, President Stephens had become concerned enough to ask a senior member of the board – Thomas S. Lamont of Morgan fame – whether Texas Gulf should issue a statement. Lamont told him he could wait until the reports were published in U.S. papers, but then he should issue a statement.

The following day, April 11, the reports poured forth in the U.S. papers. TheHerald Tribune called it “the biggest ore strike since gold was discovered more than 60 years ago in Canada.” Stephens instructed Fogarty to begin preparing a statement to be issued on Monday, April 13. Meanwhile, the estimated value of the mine seemed to be increasing by the hour as more and more copper and zinc ore was brought to the surface. Brooks writes:

However, Fogarty did not communicate with Timmins after Friday night, so the statement that he and his colleagues issued to the press on Sunday afternoon was not based on the most up-to-the-minute information. Whether because of that or for some other reason, the statement did not convey the idea that Texas Gulf thought it had a new Comstock Lode. Characterizing the published reports as exaggerated and unreliable, it admitted that recent drilling on ‘one property near Timmins’ had led to ‘preliminary indications that more drilling would be required for proper evaluation of the prospect;’ went on to say that ‘the drilling done to date has not been conclusive;’ and then, putting the same thought in what can hardly be called another way, added that ‘the work done to date has not been sufficient to reach definitive conclusions.’

The wording of this press release was sufficient to put a damper on any expectations that may have arisen due to the newspaper stories the previous Friday. Texas Gulf stock had gone from around $17 the previous November to around $30 just before the stories. On Monday, the stock went to $32, but then came back down and even dipped below $29 in the subsequent two days.

Meanwhile, at Kidd-55, Mollison, Holyk, and Darke talked with a visiting reporter who had been shown around the place. Brooks:

The things they told the reporter make it clear, in retrospect, that whatever the drafters of the release may have believed on Sunday, the men at Kidd-55 knew on Monday that they had a mine and a big one. However, the world was not to know it, or at least not from that source, until Thursday morning, when the next issue of the Miner would appear in subscribers’ mail and on newstands.

Mollison and Holyk flew to Montreal Tuesday evening for the annual convention of the Canadian Institute of Mining and Metallurgy. They had arranged for that Wednesday, in the company of the Minister of Mines of the Province of Ontario and his deputy, to attend the convention. En route, they briefed the minister on Kidd-55. The minister decided he wanted to make an announcement as soon as possible. Mollison helped the minister draft the statement.

According to the copy Mollison kept, the announcement stated that “the information now in hand… gives the company confidence to allow me to announce that Texas Gulf Sulphur has a mineable body of zinc, copper, and silver ore of substantial dimensions that will be developed and brought to production as soon as possible.” Mollison and Holyk believed that the minister would make the announcement that evening. But for some reason, the minister didn’t.

Texas Gulf was to have a board of directors meeting that Thursday. Since better and better news had been coming in from Kidd-55, the company officers decided they should write a new press release, to be issued after the Thursday morning board meeting. This statement was based on the very latest information and it read, in part, “Texas Gulf Sulphur Company has made a major strike of zinc, copper, and silver in the Timmins area… Seven drill holes are now essentially complete and indicate an ore body of at least 800 feet in length, 300 feet in width, and having a vertical depth of more than 800 feet. This is a major discovery. The preliminary data indicate a reserve of more than 25 million tons of ore.”

The statement also noted that “considerably more data has been accumulated,” in order to explain the difference between this statement and the previous one. Indeed, the value of the ore was not the two hundred million dollars alleged to have been estimable a week earlier, but many times that.

The same day, engineer Clayton and company secretary Crawford bought 200 and 300 shares, respectively. The next morning, Crawford doubled his order.

The directors’ meeting ended at ten o’clock. Then 22 reporters entered the room. President Stephens read the new press release. Most reporters rushed out before he was finished to report the news.

The actions of two Texas Gulf directors, Coates and Lamont, during the next half hour were later to lead to the most controversial part of the S.E.C.’s complaint. As Brooks writes, the essence of the controversy was timing. The Texas Gulf news was released by the Dow Jones News Service, the well-known spot-news for investors. In fact, a piece of news is considered to be public the moment it crosses “the broad tape.”

The morning of April 16, 1964, a Dow Jones reporter was among those who attended the Texas Gulf press conference. He left early and called in the news around 10:10 or 10:15, according to his recollection. Normally, a news item this important would be printed on the Dow Jones machines two or three minutes after being phoned in. But for reasons unknown, the Texas Gulf story did not appear on the tape until 10:54. This delay was left unexplained during the trial based on irrelevance, says Brooks.

Coates, the Texan, around the end of the press conference, called his son-in-law, H. Fred Haemisegger, a stockbroker in Houston. Coates told Haemisegger about the Texas Gulf discovery, also saying that he waited to call until “after the public announcement” because he was “too old to get in trouble with the S.E.C.” Coates next placed an order for 2,000 shares of Texas Gulf stock for four family trusts. He was a trustee, but not a beneficiary. The stock had opened at $30. Haemisegger, by acting quickly, was able to buy a bit over $31.

Lamont hung around the press conference area for 20 minutes or so. He recounts that he “listened to chatter” and “slapped people on the back.” Then at 10:39 or 10:40, he called a friend at Morgan Guaranty Trust Company – Longstreet Hinton, the bank’s executive vice president and head of its trust department. Hinton had asked Lamont earlier in the week if he knew anything about the rumors of an ore discovery made by Texas Gulf. Lamont had said no then.

But during this phone call, Lamont told Hinton that he had some news now. Hinton asked whether it was good. Lamont replied either “pretty good” or “very good.” (Brooks notes that they mean the same thing in this context.) Hinton immediately called the bank’s trading department, got a quote on Texas Gulf, and placed an order for 3,000 shares for the account of the Nassau Hospital, of which he was treasurer. Hinton never bothered to look at the tape – despite being advised to do so by Lamont – because Hinton felt he already had the information he needed. (Lamont didn’t know about the inexplicable forty minute delay before the Texas Gulf news appeared on the tape.)

Then Hinton went to the office of the Morgan Guaranty officer in charge of pension trusts. Hinton recommended buying Texas Gulf. In less than half an hour, the bank had ordered 7,000 shares for its pension fund and profit-sharing account.

An hour after that – at 12:33 – Lamont purchased 3,000 shares for himself and his family, paying $34 1/2 for them. The stock closed above $36. It hit a high of over $58 later that month. Brooks:

…and by the end of 1966, when commercial production of ore was at last underway at Kidd-55 and the enormous new mine was expected to account for one-tenth of Canada’s total annual production of copper and one-quarter of its total annual production of zinc, the stock was selling at over 100. Anyone who had bought Texas Gulf between November 12th, 1963 and the morning (or even the lunch hour) of April 16th, 1964 had therefore at least tripled his money.

Brooks then introduces the trial:

Perhaps the most arresting aspect of the Texas Gulf trial – apart from the fact that a trial was taking place at all – was the vividness and variety of the defendants who came before Judge Bonsal, ranging as they did from a hot-eyed mining prospector like Clayton (a genuine Welchman with a degree in mining from the University of Cardiff) through vigorous and harried corporate nabobs like Fogarty and Stephens to a Texas wheeler-dealer like Coates and a polished Brahmin of finance like Lamont.

Darke did not appear at the trial, claiming his Canadian nationality. Brooks continues:

The S.E.C., after its counsel, Frank E. Kennamer Jr. had announced his intention to “drag to light and pillory the misconduct of these defendants,” asked the court to issue a permanent injunction forbidding Fogarty, Mollison, Clayton, Holyk, Darke, Crawford, and several other corporate insiders who had bought stock or calls between November 8th, 1963 and April 15th, 1964, from ever again “engaging in any act… which operates or would operate as a fraud or deceit upon any person in connection with purchase or sale of securities”; further – and here it was breaking entirely new ground – it prayed that the court order the defendants to make restitution to the persons they had allegedly defrauded by buying stock or calls from them on the basis of inside information. The S.E.C. also charged that the pessimistic April 12th press release was deliberately deceptive, and asked that because of it Texas Gulf be enjoined from “making any untrue statement of material fact or omitting to state a material fact.” Apart from any question of loss of corporate face, the nub of the matter here lay in the fact that such a judgment, if granted, might well open the way for legal action against the company by any stockholder who had sold his Texas Gulf stock to anybody in the interim between the first press release and the second one, and since the shares that had changed hands during that period had run into the millions, it was a nub indeed.

Regarding the November purchases, the defense argued that a workable mine was far from a sure thing based only on the first drill hole. Some even argued that the hole could have turned out to be a liability rather than an asset for Texas Gulf, based on what was known then. The people who bought stock or calls during the winter claimed that the hole had little or nothing to do with their decision. They stated that they thought Texas Gulf was a good investment in general. Clayton said his sudden appearance as a large investor was because he had just married a well-to-do wife. Brooks:

The S.E.C. countered with its own parade of experts, maintaining that the nature of the first core had been such as to make the existence of a rich mine an overwhelming probability, and that therefore those privy to the facts about it had possessed a material fact.

The S.E.C. also made much of the fact that Fogarty based the initial press release on information that was two days old. The defense countered that the company had been in a sensitive position. If it had issued an optimistic report that later turned out to be false, it could well be accused of fraud for that.

Judge Bonsal concluded that the definition of materiality must be conservative. He therefore decided that up until April 9th, when three converging drill holes positively established the three-dimensionality of the ore deposit, material information had not been in hand. Therefore, the decisions of insiders to buy stock before that date, even if based on initial drilling results, were legal “educated guesses.”

Case was thus dismissed against all educated guessers who had bought stock or calls, or recommended others do so, before the evening of April 9th. Brooks:

With Clayton and Crawford, who had been so injudicious as to buy or order stock on April 15th, it was another matter. The judge found no evidence that they had intended to deceive or defraud anyone, but they had made their purchases with the full knowledge that a great mine had been found and that it would be announced the next day – in short, with material private information in hand. Therefore they were found to have violated Rule 10B-5, and in due time would presumably be enjoined from doing such a thing again and made to offer restitution to the persons they bought their April 15th shares from – assuming, of course, that such persons can be found…

On the matter of the April 12th press release, the judge found that it was not false or misleading.

Still to be settled was the matter of Coates and Lamont making their purchases. The question was when it can be said that the information has officially been made public. This was the most important issue and would likely set a legal precedent.

The S.E.C. argued that the actions of Coates and Lamont were illegal because they occurred before the ore strike news had crossed the Dow Jones broad tape. The S.E.C. argued, furthermore, that even if Coates and Lamont had acted after the “official” announcement, it still would be illegal unless enough time had passed so that those who hadn’t attended the press conference, or even those who hadn’t seen the initial news cross the broad tape, had enough time to absorb the information.

Defense argued first that Coates and Lamont had every reason to believe that the news was already out, since Stephens said it had been released by the Ontario Minister of Mines the previous evening. So Coates and Lamont acted in good faith. Second, counsel argued that for all practical purposes, the news was out, via osmosis andThe Northern Miner. Brokerage offices and the Stock Exchange had been buzzing all morning. Lamont’s lawyers also argued that Lamont had merely told Hinton to look at the tape, not to buy any stock. Defense argued that the S.E.C. was asking the court to write new rules and then apply them retroactively, while the plaintiff was merely asking that an old rule 10B-5, be applied broadly.

As for Lamont’s waiting for two hours, until 12:33, before buying stock for himself, the S.E.C. took issue, as Brooks records:

‘It is the Commission’s position that even after corporate information has been published in the news media, insiders, are still under a duty to refrain from securities transactions until there had elapsed a reasonable amount of time in which the securities industry, the shareholders, and the investing public can evaluate the development and make informed investment decisions… Insiders must wait at least until the information is likely to have reached the average investor who follows the market and he has had some opportunity to consider it.’

In the Texas Gulf case, the S.E.C. argued that one hour and thirty-nine minutes was not “a reasonable amount of time.” What, then, is “a reasonable amount of time,” the S.E.C. was asked? The S.E.C.’s counsel, Kennamer, said it “would vary from case to case.” Kennamer added that it would be “a nearly impossible task to formulate a rigid set of rules that would apply in all situations of this sort.”

Brooks sums it up with a hint of irony:

Therefore, in the S.E.C.’s canon, the only way an insider could find out whether he had waited long enough before buying his company’s stock was by being hauled into court and seeing what the judge would decide.

Judge Bonsal rejected this argument by the S.E.C. Moreover, he took a narrower view that, based on legal precedent, the key moment was when the press release was read. The judge admitted that a better rule might be formulated according to which insiders had to wait at least some amount time after the initial press release so that other investors could absorb it. However, he didn’t think he should write such a rule. Nor should this matter be left up to the judge on a case-by-base basis. Thus, the complaints against Coates and Lamont were dismissed.

The S.E.C. appealed all the dismissals. Brooks concludes:

…in August, 1968, the U.S. Court of Appeals for the Second Circuit handed down a decision which flatly reversed Judge Bonsal’s findings on just about every score except the findings against Crawford and Clayton, which were affirmed. The Appeals Court found that the original November drill hole had provided material evidence of a valuable ore deposit, and that therefore Fogarty, Mollison, Darke, Holyk, and all other insiders who had bought Texas Gulf stock or calls on it during the winter were guilty of violations of the law; that the gloomy April 12th press release had been ambiguous and perhaps misleading; and that Coates had improperly and illegally jumped the gun in placing his orders right after the April 16th press conference. Only Lamont – the charges against whom had been dropped following his death shortly after the lower court decision – and a Texas Gulf office manager, John Murray, remained exonerated.

 

XEROX XEROX XEROX XEROX

There was no economical and practical way of making copies until after 1950. Brooks writes that the 1950’s were the pioneering years for mechanized office copying. Although people were starting to show a compulsion to make copies, the early copying machines suffered from a number of problems. Brooks:

…What was needed for the compulsion to flower into a mania was a technological breakthrough, and the breakthrough came at the turn of the decade with the advent of a machine that worked on a new principle, known as xerography, and was able to make dry, good-quality, permanent copies on ordinary paper with a minimum of trouble. The effect was immediate. Largely as a result of xerography, the estimated number of copies (as opposed to duplicates) made annually in the United States sprang from some twenty million in the mid-fifties to nine and a half billion in 1964, and to fourteen billion in 1966 – not to mention billions more in Europe, Asia, and Latin America. More than that, the attitude of educators towards printed textbooks and of business people toward written communication underwent a discernable change; avant-garde philosophers took to hailing xerography as a revolution comparable in importance to the invention of the wheel; and coin-operated copy machines began turning up in candy stores and beauty parlors…

The company responsible for the great breakthrough and the one on whose machines the majority of these billions of copies were made was of course, the Xerox Corporation, of Rochester, New York. As a result, it became the most spectacular big-business success of the nineteen-sixties. In 1959, the year the company – then called Haloid Xerox, Inc. – introduced its first automatic xerographic office copier, its sales were thirty-three million dollars. In 1961, they were sixty-six million, in 1963 a hundred and seventy-six million, and in 1966 over half a billion.

The company was extremely profitable. It ranked two hundred and seventy-first in Fortune’s ranking in 1967. However, in 1966 the company ranked sixty-third in net profits and probably ninth in the ratio of profits to sales and fifteenth in terms of market value. Brooks continues:

…Indeed, the enthusiasm the investing public showed for Xerox made its shares the stock market Golconda of the sixties. Anyone who bought its stock toward the end of 1959 and held on to it until early 1967 would have found his holding worth about sixty-six times its original price, and anyone who was really fore-sighted and bought Haloid in 1955 would have seen his original investment grow – one might almost say miraculously – a hundred and eighty times. Not surprisingly, a covey of “Xerox millionaires” sprang up – several hundred of them all told, most of whom either lived in the Rochester area or had come from there.

The Haloid company was started in Rochester in 1906. It manufactured photographic papers. It survived OK. But after the Second World War, due to an increase in competition and labor costs, the company was looking for new products.

More than a decade earlier, in 1938, an obscure thirty-two year-old inventor, Chester F. Carlson, was spending his spare time trying to invent an office copying machine. Carlson had a degree in physics from the California Institute of Technology. Carlson had hired Otto Kornei, a German refugee physicist, to help him. Their initial copying machine was unwieldy and produced much smoke and stench. Brooks:

The process, which Carlson called electrophotography, had – and has – five basic steps: sensitizing a photoconductive surface to light by giving it an electrostatic charge (for example, by rubbing it with fur); exposing this surface to a written page to form an electrostatic image; developing the latest image by dusting the surface with a powder that will adhere only to the charged areas; transferring the image to some sort of paper; and fixing the image by the application of heat.

Although each individual step was already used in other technologies, this particular combination of steps was new. Carlson carefully patented the process and began trying to sell it. Over the ensuing five years, Carlson tried to sell the rights to every important office-equipment company in the country. He was turned down every time. In 1944, Carlson finally convinced Battelle Memorial Institute to conduct further development work on the process in exchange for three-quarters of any future royalties.

In 1946, various people at Haloid, including Joseph C. Wilson – who was about to become president – had noticed the work that Battelle was doing. Wilson asked a friend of his, Sol M. Linowitz, a smart, public-spirited lawyer just back from service in the Navy, to research the work at Battelle as a “one-shot” job. The result was an agreement giving Haloid the rights to the Carlson process in exchange for royalties for Battelle and Carlson.

At one point in the research and development process, the Haloid people got so discouraged that they considered selling most of their xerography rights to International Business Machines. The research process became quite costly. But Haloid committed itself to seeing it through. It took full title of the Carlson process and assumed the full cost of development in exchange for shares in Haloid (for Battelle and Carlson). Brooks:

…The cost was staggering. Between 1947 and 1960, Haloid spent about seventy-five million dollars [over $800 million in 2019 dollars] on research in xerography, or about twice what it earned from its regular operations during that period; the balance was raised through borrowing and through the wholesale issuance of common stock to anyone who was kind, reckless, or prescient enough to take it. The University of Rochester, partly out of interest in a struggling local industry, bought an enormous quantity for its endowment fund at a price that subsequently, because of stock splits, amounted to fifty cents a share. ‘Please don’t be mad at us if we have to sell our Haloid stock in a couple of years to cut our losses on it,’ a university official nervously warned Wilson. Wilson promised not to be mad. Meanwhile, he and other executives of the company took most of their pay in the form of stock, and some of them went as far as to put up their savings and the mortgages on their houses to help the cause along.

In 1961, the company changed its name to Xerox Corporation. One unusual aspect to the story is that Xerox became rather public-minded. Brooks quotes Wilson:

‘To set high goals, to have almost unattainable aspirations, to imbue people with the belief that they can be achieved – these are as important as the balance sheet, perhaps more so.’

This rhetoric is not uncommon. But Xerox followed through by donating one and a half percent of its profits to educational and charitable institutions in 1965-1966. In 1966, Xerox committed itself to the “one-per-cent program,” also called the Cleveland Plan, according to which the company gives one percent of its pre-tax income annually to educational institutions, apart from any other charitable activities.

Furthermore, President Wilson said in 1964, “The corporation cannot refuse to take a stand on public issues of major concern.” As Brooks observes, this is “heresy” for a business because it could alienate customers or potential customers. Xerox’s chief stand was in favor of the United Nations. Brooks:

Early in 1964, the company decided to spend four million dollars – a year’s advertising budget – on underwriting a series of network-television programs dealing with the U.N., the programs to be unaccompanied by commercials or any other identification of Xerox apart from a statement at the beginning and end of each that Xerox had paid for it.

Xerox was inundated with letters opposing the company’s support of the U.N. Many said that the U.N. charter had been written by American Communists and that the U.N. was an instrument for depriving Americans of their Constitutional rights. Although only a few of these letters came from the John Birch Society, it turned out later that most of the letters were part of a meticulously planned Birch campaign. Xerox officers and directors were not intimidated. The U.N. series appeared in 1965 and was widely praised.

Furthermore, Xerox consistently committed itself to informing the users of its copiers of their legal responsibilities. It took this stand despite their commercial interest.

Brooks visited Xerox in order to talk with some of its people. First he spoke with Dr. Dessauer, a German-born engineer who had been in charge of the company’s research and engineering since 1938. It was Dessauer who first brought Carlson’s invention to the attention of Joseph Wilson. Brooks noticed a greeting card from fellow employees calling Dessauer the “Wizard.”

Dr. Dessauer told Brooks about the old days. Dessauer said money was the main problem. Many team members gambled heavily on the xerox project. Dessauer himself mortgaged his house. Early on, team members would often say the damn thing would never work. Even if it did work, the marketing people said there was only a market for a few thousand of the machines.

Next Brooks spoke with Dr. Harold E. Clark, who had been a professor of physics before coming to Haloid in 1949. Dr. Clark was in charge of the xerography-development program under Dr. Dessauer. Dr. Clark told Brooks that Chet Carlson’s invention was amazing. Also, no one else invented something similar at the same time, unlike the many simultaneous discoveries in scientific history. The only problem, said Dr. Clark, was that it wasn’t a good product.

The main trouble was that Carlson’s photoconductive surface, which was coated with sulphur, lost its qualities after it had made a few copies and became useless. Acting on a hunch unsupported by scientific theory, the Battelle researchers tried adding to the sulphur a small quantity of selenium, a non-metallic element previously used chiefly in electrical resistors and as a coloring material to redden glass. The selenium-and-sulphur surface worked a little better than the all-sulphur one, so the Battelle men tried adding a little more selenium. More improvement. They gradually kept increasing the percentage until they had a surface consisting entirely of selenium – no sulphur. That one worked best of all, and thus it was found, backhandedly, that selenium and selenium alone could make xerography practical.

Dr. Clark went on to tell Brooks that they basically patented one of the elements, of which there are not many more than one hundred. What is more, they still don’t understand how it works. There are no memory effects – no traces of previous copies are left on the selenium drum. A selenium-coated drum in the lab can last a million processes, or theoretically an infinite number. They don’t understand why. Dr. Clark concluded that they combined “Yankee tinkering and scientific inquiry.”

Brooks spoke with Linowitz, who only had a few minutes because he had just been appointed U.S. Ambassador to the Organization of American States. Linowitz told him:

…the qualities that made for the company’s success were idealism, tenacity, the courage to take risks, and enthusiasm.

Joseph Wilson told Brooks that his second major had been English literature. He thought he would be a teacher or work in administration at a university. Somehow he ended up at Harvard Business School, where he was a top student. After that, he joined Haloid, the family business, something he’d never planned on doing.

Regarding the company’s support of the U.N., Wilson explained that world cooperation was the company’s business, because without it there would be no world and thus no business. He went on to explain that elections were not the company’s business. But university education, civil rights, and employment of African-Americans were their business, to name just a few examples. So far, at least, Wilson said there hadn’t been a conflict between their civic duties and good business. But if such a conflict arose, he hoped that the company would honor its civic responsibilities.

 

MAKING THE CUSTOMERS WHOLE

On November 19th, 1963, the Stock Exchange became aware that two of its member firms – J. R. Williston & Beane, Inc., and Ira Haupt & Co. – were in serious financial trouble. This later became a crisis that was made worse by the assassination of JFK on November 22, 1963. Brooks:

It was the sudden souring of a speculation that these two firms (along with various brokers not members of the Stock Exchange) had become involved in on behalf of a single customer – the Allied Crude Vegetable Oil & Refining Co., of Bayonne, New Jersey. The speculation was in contracts to buy vast quantities of cotton-seed oil and soybean oil for future delivery.

Brooks then writes:

On the two previous business days – Friday the fifteenth and Monday the eighteenth – the prices had dropped an average of a little less than a cent and a half per pound, and as a result Haupt had demanded that Allied put up about fifteen million dollars in cash to keep the account seaworthy. Allied had declined to do this, so Haupt – like any broker when a customer operating on credit has defaulted – was faced with the necessity of selling out the Allied contracts to get back what it could of its advances. The suicidal extent of the risk that Haupt had undertaken is further indicated by the fact that while the firm’s capital in early November had amounted to only about eight million dollars, it had borrowed enough money to supply a single customer – Allied – with some thirty-seven million dollars to finance the oil speculations. Worse still, as things turned out it had accepted as collateral for some of these advances enormous amounts of actual cottonseed oil and soybean oil from Allied’s inventory, the presence of which in tanks at Bayonne was attested to by warehouse receipts stating the precise amount and kind of oil on hand. Haupt had borrowed the money it supplied Allied from various banks, passing along most of the warehouse receipts to the banks as collateral. All this would have been well and good if it had not developed later that many of the warehouse receipts were forged, that much of the oil they attested to was not, and probably never had been, in Bayonne, and that Allied’s President, Anthony De Angelis (who was later sent to jail on a whole parcel of charges), had apparently pulled off the biggest commercial fraud since that of Ivar Kreuger, the match king.

What began to emerge as the main issue was that Haupt had about twenty thousand individual stock-market customers, who had never heard of Allied or commodity trading. Williston & Beane had nine thousand individual customers. All these accounts were frozen when the two firms were suspended by the Stock Exchange. (Fortunately, the customers of Williston & Beane were made whole fairly rapidly.)

The Stock Exchange met with its member firms. They decided to make the customers of Haupt whole. G. Keith Funston, President of the Stock Exchange, urged the member firms to take over the matter. The firms replied that the Stock Exchange should do it. Funston replied, “If we do, you’ll have to repay us the amount we pay out.” So it was agreed that the payment would come out of the Exchange’s treasury, to be repaid later by the member firms.

Funston next led the negotiations with Haupt’s creditor banks. Their unanimous support was essential. Chief among the creditors were four local banks – Chase Manhattan, Morgan Guaranty Trust, First National City, and Manufacturers Hanover Trust. Funston proposed that the Exchange would put up the money to make the Haupt customers whole – about seven and a half million dollars. In return, for every dollar the Exchange put up, the banks would agree to defer collection on two dollars. So the banks would defer collection on about fifteen million.

The banks agreed to this on the condition that the Exchange’s claim to get back any of its contribution would come after the banks’ claims for their loans. Funston and his associates at the Exchange agreed to that. After more negotiating, there was a broad agreement on the general plan.

Early on Saturday, the Exchange’s board met and learned from Funston what was proposed. Almost immediately, several governors rose to state that it was a matter of principle. And so the board agreed with the plan. Later, Funston and his associates decided to put the Exchange’s chief examiner in charge of the liquidation of Haupt in order to ensure that its twenty thousand individual customers were made whole as soon as the Exchange had put up the cash. (The amount of cash would be at least seven and a half million, but possibly as high as twelve million.)

Fortunately, the American banks eventually all agreed to the final plan put forth by the Exchange. Brooks notes that the banks were “marvels of cooperation.” But agreement was still needed from the British banks. Initially, Funston was going to make the trip to England, but he couldn’t be spared.

Several other governors quickly volunteered to go, and one of them, Gustave L. Levy, was eventually selected, on the ground that his firm, Goldman, Sachs & Co., had had a long and close association with Kleinwort, Benson, one of the British banks, and that Levy himself was on excellent terms with some of the Kleinwort, Benson partners.

The British banks were very unhappy. But since their loans to Allied were unsecured, they didn’t have any room to negotiate. Still, they asked for time to think the matter over. This gave Levy an opportunity to meet with this Kleinwort, Benson friends. Brooks:

The circumstances of the reunion were obviously less than happy, but Levy says that his friends took a realistic view of their situation and, with heroic objectivity, actually helped their fellow-Britons to see the American side of the question.

The market was closed Monday for JFK’s funeral. Funston was still waiting for the call from Levy. After finally getting agreement from all the British banks, Levy placed the call to Funston.

Funston felt at this point that the final agreement had been wrapped up, since all he needed was the signatures of the fifteen Haupt general partners. The meeting with the Haupt partners ended up taking far longer than expected. Brooks:

One startling event broke the even tenor of this gloomy meeting… someone noticed an unfamiliar and strikingly youthful face in the crowd and asked its owner to identify himself. The unhesitating reply was, ‘I’m Russell Watson, a reporter for the Wall Street Journal.’ There was a short, stunned silence, in recognition of the fact that an untimely leak might still disturb the delicate balance of money and emotion that made up the agreement. Watson himself, who was twenty-four and had been on the Journal for a year, has since explained how he got into the meeting, and under what circumstances he left it. ‘I was new on the Stock Exchange beat then,’ he said afterward. ‘Earlier in the day, there had been word that Funston would probably hold a press conference sometime that evening, so I went over to the Exchange. At the main entrance, I asked a guard where Mr. Funston’s conference was. The guard said it was on the sixth floor, and ushered me into an elevator. I suppose he thought I was a banker, a Haupt partner, or a lawyer. On the sixth floor, people were milling around everywhere. I just walked off the elevator and into the office where the meeting was – nobody stopped me. I didn’t understand much of what was going on. I got the feeling that whatever was at stake, there was general agreement but still a lot of haggling over details to be done. I didn’t recognize anybody there but Funston. I stood around quietly for about five minutes before anybody noticed me, and then everybody said, pretty much at once, “Good God, get out of here!” They didn’t exactly kick me out, but I saw it was time to go.’

At fifteen minutes past midnight, finally all the parties signed an agreement.

As soon as the banks opened on Tuesday, the Exchange deposited seven and a half million dollars in an account on which the Haupt liquidator – James P. Mahony – could draw. The stock market had its greatest one-day rise in history. A week later, by December 2, $1,750,000 had been paid out to Haupt customers. By December 12, it was $5,400,000. And by Christmas, it was $6,700,000. By March 11, the pay-out had reached nine and a half million dollars and all the Haupt customers had been made whole.

  • Note: $9.5 million in 1963 would be approximately $76 million dollars today (in 2018), due to inflation.

Brooks describes the reaction:

In Washington, President Johnson interrupted his first business day in office to telephone Funston and congratulate him. The chairman of the S.E.C., William L. Cary, who was not ordinarily given to throwing bouquets at the Stock Exchange, said in December that it had furnished ‘a dramatic, impressive demonstration of its strength and concern for the public interest.’

Brooks later records:

Oddly, almost no one seems to have expressed gratitude to the British and American banks, which recouped something like half of their losses. It may be that people simply don’t thank banks, except in television commercials.

 

THE IMPACTED PHILOSOPHERS

Brooks opens this chapter by observing that communication is one of the biggest problems in American industry. (Remember he was writing in the 1960’s). Brooks:

This preoccupation with the difficulty of getting a thought out of one head and into another is something the industrialists share with a substantial number of intellectuals and creative writers, more and more of whom seemed inclined to regard communication, or the lack of it, as one of the greatest problems not just of industry, but of humanity.

Brooks then adds:

What has puzzled me is how and why, when foundations sponsor one study of communication after another, individuals and organizations fail so consistently to express themselves understandably, or how and why their listeners fail to grasp what they hear.

A few years ago, I acquired a two-volume publication of the United States Government Printing Office entitled Hearings Before the Subcommittee on Antitrust and Monopoly of the Committee on the Judiciary, United States Senate, Eighty-Seventh Congress, First Session, Pursuant to S. Res. 52, and after a fairly diligent perusal of its 1,459 pages I thought I could begin to see what the industrialists are talking about.

The hearings were conducted in April, May, and June of 1961 under the chairmanship of Senator Estes Kefauver of Tennessee. They concerned price-fixing and bid-rigging in conspiracies in the electrical-manufacturing industry. Brooks:

…Senator Kefauver felt that the whole matter needed a good airing. The transcript shows that it got one, and what the airing revealed – at least within the biggest company involved – was a breakdown in intramural communication so drastic as to make the building of the tower of Babel seem a triumph of organizational rapport.

Brooks explains a bit later:

The violations, the government alleged, were committed in connection with the sale of large and expensive pieces of apparatus of a variety that is required chiefly by public and private electric-utility companies (power transformers, switchgear assemblies, and turbine-generator units, among many others), and were the outcome of a series of meetings attended by executives of the supposedly competing companies – beginning at least as early as 1956 and continuing into 1959 – at which noncompetitive price levels were agreed upon, nominally sealed bids on individual contracts were rigged in advance, and each company was allocated a certain percentage of the available business.

Brooks explains that in an average year at the time of the conspiracies, about $1.75 billion – $14 billion in 2019 dollars – was spent on the sorts of machines in question, with nearly a quarter of that local, state, and federal government spending. Brooks gives a specific example, a 500,000-kilowatt turbine-generator, which sold for about $16 million (nearly $130 million in 2019 dollars), but was often discounted by 25 percent. If the companies wanted to, they could effectively charge $4 million extra (nearly $32 million extra in 2019 dollars). Any such additional costs as a result of price-fixing would, in the case of government purchases, ultimately fall on the taxpayer.

Brooks again:

To top it all off, there was a prevalent suspicion of hypocrisy in the very highest places. Neither the chairman of the board nor the president of General Electric, the largest of the corporate defendants, had been caught on the government’s dragnet, and the same was true of Westinghouse Electric, the second-largest; these four ultimate bosses let it be known that they had been entirely ignorant of what had been going on within their commands right up to the time the first testimony on the subject was given to the Justice Department. Many people, however, were not satisfied by these disclaimers, and, instead, took the position that the defendant executives were men in the middle, who had broken the law only in response either to actual orders or to a corporate climate favoring price-fixing, and who were now being allowed to suffer for the sins of their superiors. Among the unsatisfied was Judge Ganey himself, who said at the time of the sentencing, ‘One would be most naive indeed to believe that these violations of the law, so long persisted in, affecting so large a segment of the industry, and, finally, involving so many millions upon millions of dollars, were facts unknown to those responsible for the conduct of the corporation… I am convinced that in the great number of these defendants’ cases, they were torn between conscience and approved corporate policy, with the rewarding objectives of promotion, comfortable security, and large salaries.’

General Electric got most of the attention. It was, after all, by far the largest of those companies involved. General Electric penalized employees who admitted participation in the conspiracy. Some saw this as good behavior, while others thought it was G.E. trying to save higher-ups by making a few sacrifices.

G.E. maintained that top executives didn’t know. Judge Ganey thought otherwise. But Brooks realized it couldn’t be determined:

…For, as the testimony shows, the clear waters of moral responsibility at G.E. became hopelessly muddied by a struggle to communicate – a struggle so confused that in some cases, it would appear, if one of the big bosses at G.E. had ordered a subordinate to break the law, the message would somehow have been garbled in its reception, and if the subordinate had informed the boss that he was holding conspiratorial meetings with competitors, the boss might well have been under the impression that the subordinate was gossiping idly about lawn parties or pinochle lessons.

G.E., for at least eight years, has had a rule, Directive Policy 20.5, which explicitly forbids price-fixing, bid-rigging, and similar anticompetitive practices. The company regularly reissued 20.5 to new executives and asked them to sign their names to it.

The problem was that many, including those who signed, didn’t take 20.5 seriously. They thought it was just a legal device. They believed that meeting illegally with competitors was the accepted and standard practice. They concluded that if a superior told them to comply with 20.5, he was actually ordering him to violate it. Brooks:

Illogical as it might seem, this last assumption becomes comprehensible in light of the fact that, for a time, when some executives orally conveyed, or reconveyed, the order, they were apparently in the habit of accompanying it with an unmistakable wink.

Brooks gives an example of just such a meeting of sales managers in May 1948. Robert Paxton, an upper-level G.E. executive who later became the company’s president, addressed the group and gave the usual warnings about antitrust violations. William S. Ginn, a salesman under Paxton, interjected, “We didn’t see you wink.” Paxton replied, “There was no wink. We mean it, and these are the orders.”

Senator Kefauver asked Paxton how long he had known about such winks. Paxton said that in 1935, he saw his boss do it following an order. Paxton recounts that he became incensed. Since then, he had earned a reputation as an antiwink man.

In any case, Paxton’s seemingly unambiguous order in 1948 failed to get through to Ginn, who promptly began pricing-fixing with competitors. When asked about it thirteen years later, Ginn – having recently gotten out of jail and having lost his $135,000 a year job at G.E. – said he had gotten a contrary order from two other superiors, Henry V. B. Erben and Francis Fairman. Brooks:

Erben and Fairman, Ginn said, had been more articulate, persuasive, and forceful in issuing their order than Paxton had been in issuing his; Fairman, especially, Ginn stressed, had proved to be ‘a great communicator, a great philosopher, and, frankly, a great believer in stability of prices.’ Both Erben and Fairman had dismissed Paxton as naive, Ginn testified, and, in further summary of how he had been led astray, he said that ‘the people who were advocating the Devil were able to sell me better than the philosophers that were selling me the Lord.’

Unfortunately, Erben and Fairman had passed away before the hearing. So we don’t have their testimonies. Ginn consistently described Paxton as a philosopher-salesman on the side of the Lord.

In November, 1954, Ginn was made general manager of the transformer division. Ralph J. Cordiner, chairman of the board at G.E. since 1949, called Ginn down to New York to order him to comply strictly with Directive 20.5. Brooks:

Cordiner communicated this idea so successfully that it was clear enough to Ginn at the moment, but it remained so only as long as it took him, after leaving the chairman, to walk to Erben’s office.

Erben, Ginn’s direct superior, countermanded Cordiner’s order.

Erben’s extraordinary communicative prowess carried the day, and Ginn continued to meet with competitors.

At the end of 1954, Paxton took over Erben’s job and was thus Ginn’s direct superior. Ginn kept meeting with competitors, but he didn’t tell Paxton about it, knowing his opposition to the practice.

In January 1957, Ginn became general manager of G.E.’s turbine-generator division. Cordiner called him down again to instruct him to follow 20.5. This time, however, Ginn got the message. Why? “Because my air cover was gone,” Ginn explained to the Subcommittee. Brooks:

If Erben, who had not been Ginn’s boss since late in 1954, had been the source of his air cover, Ginn must have been without its protection for over two years, but, presumably, in the excitement of the price war he had failed to notice its absence.

In any case, Ginn apparently had reformed. Ginn circulated copies of 20.5 among all his division managers. He then instructed them not to even socialize with competitors.

It appears that Ginn had not been able to impart much of his shining new philosophy to others, and that at the root of his difficulty lay that old jinx, the problem of communicating.

Brooks quotes Ginn:

‘I have got to admit that I made a communication error. I didn’t sell this thing to the boys well enough… The price is so important in the complete running of a business that, philosophically, we have got to sell people not only just the fact that it is against the law, but… that it shouldn’t be done for many, many reasons. But it has got to be a philosophical approach and a communication approach…’

Frank E. Stehlik was general manager of the low-voltage-switchgear department from May, 1956 to February, 1960. Stehlik not only heard 20.5 directly from his superiors in oral and written communications. But, in addition, Stehlik was open to a more visceral type of communication he called “impacts.” Brooks explains:

Apparently, when something happened within the company that made an impression on him, he would consult an internal sort of metaphysical voltmeter to ascertain the force of the jolt he had received, and, from the reading he got, would attempt to gauge the true drift of company policy.

In 1956, 1957, and for most of 1958, Stehlik believed that company policy clearly required compliance with 20.5. But in the fall of 1958, Stehlik’s immediate superior, George E. Burens, told him that Paxton had told him (Burens) to have lunch with a competitor. Paxton later testified that he categorically told Burens not to discuss prices. But Stehlik got a different impression.

In Stehlik’s mind, this fact made an “impact.” He felt that company policy was now in favor of disobeying 20.5. So, late in 1958, when Burens told him to begin having price meetings with a competitor, he was not at all surprised. Stehlik complied.

Brooks next describes the communication problem from the point of view of superiors. Raymond W. Smith was general manager of G.E.’s transformer division, while Arthur F. Vinson was vice-president in charge G.E.’s apparatus group. Vinson ended up becoming Smith’s immediate boss.

Smith testified that Cordiner gave him the usual order on 20.5. But late in 1957, price competition for transformers was so intense that Smith decided on his own to start meeting with competitors to see if prices could be stabilized. Smith thought company policy and industry practice both supported his actions.

When Vinson became Smith’s boss, Smith felt he should let him know what he was doing. So on several occasions, Smith told Vinson, “I had a meeting with the clan this morning.”

Vinson, in his testimony, said he didn’t even recall Smith use the phrase, “meeting of the clan.” Vinson only recalled that Smith would say things like, “Well, I am going to take this new plan on transformers and show it to the boys.” Vinson testified that he thought Smith meant the G.E. district salespeople and the company’s customers. Vinson claimed to be shocked when he learned that Smith was referring to price-fixing meetings with competitors.

But Smith was sure that his communication had gotten through to Vinson. “I never got the impression that he misunderstood me,” Smith testified.

Senator Kefauver asked Vinson if he was so naive as to not know to whom “the boys” referred. Vinson replied, “I don’t think it is too naive. We have a lot of boys… I may be naive, but I am certainly telling the truth, and in this kind of thing I am sure I am naive.”

Kefauver pressed Vinson, asking how he could have become vice-president at $200,000 a year if he were naive. Vinson: “I think I could well get there by being naive in this area. It might help.”

Brooks asks:

Was Vinson really saying to Kefauver what he seemed to be saying – that naivete about antitrust violations might be a help to a man in getting and holding a $200,000-a-year job at General Electric? It seems unlikely. And yet what else could he have meant?

Vinson was also implicated in another part of the case. Four switchgear executives – Burens, Stehlik, Clarence E. Burke, and H. Frank Hentschel – testified before the grand jury (and later before the Subcommittee) that in mid-1958, Vinson had lunch with them in Dining Room B of G.E.’s switchgear works in Philadelphia, and that Vinson told them to hold price meetings with competitors.

This led the four switchgear executives to hold a series of meetings with competitors. But Vinson told prosecutors that the lunch never took place and that he had had no knowledge at all of the conspiracy until the case broke. Regarding the lunch, Burens, Stehlik, Burke, and Hentschel all had lie-detector tests, given by the F.B.I., and passed them.

Brooks writes:

Vinson refused to take a lie-detector test, at first explaining that he was acting on advice of counsel and against his personal inclination, and later, after hearing how the four other men had fared, arguing that if the machine had not pronounced them liars, it couldn’t be any good.

It was shown that there were only eight days in mid-1958 when Burens, Stehlik, Burke, and Hentschel all had been together at the Philadelphia plant and could have had lunch together. Vinson produced expense accounts showing that he had been elsewhere on each of those eight days. So the Justice Department dropped the case against Vinson.

The upper level of G.E. “came through unscathed.” Chairman Cordiner and President Paxton did seem to be clearly against price-fixing, and unaware of all the price-fixing that had been occurring. Paxton, during his testimony, said that he learned from his boss, Gerard Swope, that the ultimate goal of business was to produce more goods for people at lower cost. Paxton claimed to be deeply impacted by this philosophy, explaining why he was always strongly against price-fixing.

Brooks concludes:

Philosophy seems to have reached a high point at G.E., and communication a low one. If executives could just learn to understand one another, most of the witnesses said or implied, the problem of antitrust violations would be solved. But perhaps the problem is cultural as well as technical, and has something to do with a loss of personal identity that comes with working in a huge organization. The cartoonist Jules Feiffer, contemplating the communication problem in a nonindustrial context, has said, ‘Actually, the breakdown is between the person and himself. If you’re not able to communicate successfully between yourself and yourself, how are you supposed to make it with the strangers outside?’ Suppose, purely as a hypothesis, that the owner of a company who orders his subordinates to obey the antitrust laws has such poor communication with himself that he does not really know whether he wants the order to be complied with or not. If his order is disobeyed, the resulting price-fixing may benefit his company’s coffers; if it is obeyed, then he has done the right thing. In the first instance, he is not personally implicated in any wrongdoing, while in the second he is positively involved in right doing. What, after all, can he lose? It is perhaps reasonable to suppose that such an executive will communicate his uncertainty more forcefully than his order.

 

THE LAST GREAT CORNER

Piggly Wiggly Stores – a chain of retail self-service markets mostly in the South and West, and headquartered in Memphis – was first listed on the New York Stock Exchange in June, 1922. Clarence Saunders was the head of Piggly Wiggly. Brooks describes Saunders:

…a plump, neat, handsome man of forty-one who was already something of a legend in his home town, chiefly because of a house he was putting up there for himself. Called the Pink Palace, it was an enormous structure faced with pink Georgia marble and built around an awe-inspiring white-marble Roman atrium, and, according to Saunders, it would stand for a thousand years. Unfinished though it was, the Pink Palace was like nothing Memphis had ever seen before. Its grounds were to include a private golf course, since Saunders liked to do his golfing in seclusion.

Brooks continues:

The game of Corner – for in its heyday it was a game, a high-stakes gambling game, pure and simple, embodying a good many of the characteristics of poker – was one phase of the endless Wall Street contest between bulls, who want the price of a stock to go up, and bears, who want it to go down. When a game of Corner was underway, the bulls’ basic method of operation was, of course, to buy stock, and the bears’ was to sell it.

Since most bears didn’t own the stock, they would have to conduct a short sale. This means they borrow stock from a broker and sell it. But they must buy the stock back later in order to return it to the broker. If they buy the stock back at a lower price, then the difference between where they initially sold the stock short, and where they later buy it back, represents their profit. If, however, they buy the stock back at a higher price, then they suffer a loss.

There are two related risks that the short seller (the bear) faces. First, the short seller initially borrows the stock from the broker in order to sell it. If the broker is forced to demand the stock back from the short seller – either because the “floating supply” needs to be replenished, or because the short seller has insufficient equity (due to the stock price moving to high) – then the short seller can be forced to take a loss. Second, technically there is no limit to how much the short seller can lose because there is no limit to how high a stock can go.

The danger of potentially unlimited losses for a short seller can be exacerbated in a Corner. That’s because the bulls in a Corner can buy up so much of the stock that there is very little supply of it left. As the stock price skyrockets and the supply of stock shrinks, the short seller can be forced to buy the stock back – most likely from the bulls – at an extremely high price. This is precisely what the bulls are trying to accomplish in a Corner.

On the other hand, if the bulls end up owning most of the publicly available stock, and if the bears can ride out the Corner, then to whom can the bulls sell their stock? If there are virtually no buyers, then the bulls have no chance of selling most of their holding. In this case, the bulls can get stuck with a mountain of stock they can’t sell. The achievable value of this mountain can even approach zero in some extreme cases.

Brooks explains that true Corners could not happen after the new securities legislation in the 1930’s. Thus, Saunders was the last intentional player of the game.

Saunders was born to a poor family in Amherst County, Virginia, in 1881. He started out working for practically nothing for a local grocer. He then worked for a wholesale grocer in Clarksville, Tennessee, and then for another one in Memphis. Next, he organized a retail food chain, which he sold. Then he was a wholesale grocer before launching the retail self-service food chain he named Piggly Wiggly Stores.

By the fall of 1922, there were over 1,200 Piggly Wiggly Stores. 650 of these were owned outright by Saunders’ Piggly Wiggly Stores, Inc. The rest were owned independently, but still paid royalties to the parent company. For the first time, customers were allowed to go down any aisle and pick out whatever they wanted to buy. Then they paid on their way out of the store. Saunders didn’t know it, but he had invented the supermarket.

In November, 1922, several small companies operating Piggly Wiggly Stores in New York, New Jersey, and Connecticut went bankrupt. These were independently owned, having nothing to do with Piggly Wiggly Stores, Inc. Nonetheless, several stock-market operators saw what they believed was a golden opportunity for a bear raid. Brooks:

If individual Piggly Wiggly stores were failing, they reasoned, then rumors could be spread that would lead the uninformed public to believe that the parent firm was failing, too. To further this belief, they began briskly selling Piggly Wiggly short, in order to force the price down. The stock yielded readily to their pressure, and within a few weeks its price, which earlier in the year had hovered around fifty dollars a share, dropped to below forty.

Saunders promptly announced to the press that he was going to “beat the Wall Street professionals at their own game” through a buying campaign. At that point, Saunders had no experience at all with owning stock, Piggly Wiggly being the only stock he had ever owned. Moreover, there is no reason to think Saunders was going for a Corner at this juncture. He merely wanted to support his stock on behalf of himself and other stockholders.

Saunders borrowed $10 million dollars – about $140 million in 2019 dollars – from bankers in Memphis, Nashville, New Orleans, Chattanooga, and St. Louis. Brooks:

Legend has it that he stuffed his ten million-plus, in bills of large denomination, into a suitcase, boarded a train for New York, and, his pockets bulging with currency that wouldn’t fit in the suitcase, marched on Wall Street, ready to do battle.

Saunders later denied this, saying he conducted his campaign from Memphis. Brooks continues:

Wherever he was at the time, he did round up a corp of some twenty brokers, among them Jesse L. Livermore, who served as his chief of staff. Livermore, one of the most celebrated American speculators of this century, was then forty-five years old but was still occasionally, and derisively, referred to by the nickname he had earned a couple of decades earlier – the Boy Plunger of Wall Street. Since Saunders regarded Wall Streeters in general and speculators in particular as parasitic scoundrels intent only on battering down his stock, it seemed likely that his decision to make an ally of Livermore was a reluctant one, arrived at simply with the idea of getting the enemy chieftain into his own camp.

Within a week, Saunders had bought 105,000 shares – more than half of the 200,000 shares outstanding. By January 1923, the stock hit $60 a share, its highest level ever. Reports came from Chicago that the stock was cornered. The bears couldn’t find any available supply in order to cover their short positions by buying the stock back. The New York Stock Exchange immediately denied the rumor, saying ample amounts of Piggly Wiggly stock were still available.

Saunders then made a surprising but exceedingly crafty move. The stock was pushing $70, but Saunders ran advertisements offering to sell it for $55. Brooks explains:

One of the great hazards in Corner was always that even though a player might defeat his opponents, he would discover that he had won a Pyrrhic victory. Once the short sellers had been squeezed dry, that is, the cornerer might find that the reams of stock he had accumulated in the process were a dead weight around his neck; by pushing it all back into the market in one shove, he would drive its price down close to zero. And if, like Saunders, he had had to borrow heavily to get into the game in the first place, his creditors could be expected to close in on him and perhaps not only divest him of his gains but drive him into bankruptcy. Saunders apparently anticipated this hazard almost as soon as a corner was in sight, and accordingly made plans to unload some of his stock before winning instead of afterward. His problem was to keep the stock he sold from going right back into the floating supply, thus breaking his corner; and his solution was to sell his fifty-five-dollar shares on the installment plan.

Crucially, the buyers on the installment plan wouldn’t receive the certificates of ownership until they had paid their final installment. This meant they couldn’t sell their shares back into the floating supply until they had finished making all their installment payments.

By Monday, March 19, Saunders owned nearly all of the 200,000 shares of Piggly Wiggly stock. Livermore had already bowed out of the affair on March 12 because he was concerned about Saunders’ financial position. Nonetheless, Saunders asked Livermore to spring the bear trap. Livermore wouldn’t do it. So Saunders himself had to do it.

On Tuesday, March 20, Saunders called for delivery all of his Piggly Wiggly stock. By the rules of the Exchange, stock so called for had to be delivered by 2:15 the following afternoon. There were a few shares around owned in small amounts by private investors. Short sellers were frantically trying to find these folks. But on the whole, there were basically no shares available outside of what Saunders himself owned.

This meant that Piggly Wiggly shares had become very illiquid – there were hardly any shares trading. A nightmare, it seemed, for short sellers. Some short sellers bought at $90, some at $100, some at $110. Eventually the stock reached $124. But then a rumor reached the floor that the governors of the Exchange were considering a suspension of trading in Piggly Wiggly, as well as an extension of the deadline for short sellers. Piggly Wiggly stock fell to $82.

The Governing Committee of the Exchange did, in fact, made such an announcement. They claimed that they didn’t want to see a repeat of the Northern Pacific panic. However, many wondered whether the Exchange was just helping the short sellers, among whom were some members of the Exchange.

Saunders still hadn’t grasped the fundamental problem he now faced. He still seemed to have several million in profits. But only if he could actually sell his shares.

Next, the Stock Exchange announced a permanent suspension of trading in Piggly Wiggly stock and a full five day extension for short sellers to return their borrowed shares. Short sellers had until 2:15 the following Monday.

Meanwhile, Piggly Wiggly Stores, Inc., released its annual financial statement, which revealed that sales, profits, and assets had all sharply increased from the previous year. But everyone ignored the real value of the company. All that mattered at this point was the game.

The extension allowed short sellers the time to find shareholders in a variety of locations around the country. These shareholders were of course happy to dig out their stock certificates and sell them for $100 a share. In this way, the short sellers were able to completely cover their short positions by Friday evening. And instead of paying Saunders cash for some of his shares, the short sellers gave him more shares to settle their debt, which is the last thing Saunders wanted just then. (A few short sellers had to pay Saunders directly.)

The upshot was that all the short sellers were in the clear, whereas Saunders was stuck owning nearly every single share of Piggly Wiggly stock. Saunders, who had already started complaining loudly, repeated his charge that Wall Street had changed its own rule in order to let “a bunch of welchers” off the hook.

In response, the Stock Exchange issued a statement explaining its actions:

‘The enforcement simultaneously of all contracts for the return of stock would have forced the stock to any price that might be fixed by Mr. Saunders, and competitive bidding for the insufficient supply might have brought about conditions illustrated by other corners, notably the Northern Pacific corner in 1901.’

Furthermore, the Stock Exchange pointed out that its own rules allowed it to suspend trading in a stock, as well as to extend the deadline for the return of borrowed shares.

It is true that the Exchange had the right to suspend trading in a stock. But it is unclear, to say the least, about whether the Exchange had any right to postpone the deadline for the delivery of borrowed shares. In fact, two years after Saunders’ corner, in June, 1925, the Exchange felt bound to amend its constitution with an article stating that “whenever in the opinion of the Governing Committee a corner has been created in a security listed on the Exchange… the Governing Committee may postpone the time for deliveries on Exchange contracts therein.”

 

A SECOND SORT OF LIFE

According to Brooks, other than FDR himself, perhaps no one typified the New Deal better than David Eli Lilienthal. On a personal level, Wall Streeters found Lilienthal a reasonable fellow. But through his association with Tennessee Valley Authority from 1933 to 1946, Lilienthal “wore horns.” T.V.A. was a government-owned electric-power concern that was far larger than any private power corporation. As such, T.V.A. was widely viewed on Wall Street as the embodiment of “galloping Socialism.”

In 1946, Lilienthal became the first chairman of the United States Atomic Energy Commission, which he held until February, 1950.

Brooks was curious what Lilienthal had been up to since 1950, so he did some investigating. He found that Lilienthal was co-founder and chairman of Development & Resources Corporation. D. & R. helps governments set up programs similar to the T.V.A. Brooks also found that as of June, 1960, Lilienthal was a director and major shareholder of Minerals & Chemicals Corporation of America.

Lastly, Brooks discovered Lilienthal had published his third book in 1953, “Big Business: A New Era.” In the book, he argues that:

  • the productive superiority of the United States depends on big business;
  • we have adequate safeguards against abuses by big business;
  • big businesses tend to promote small businesses, not destroy them;
  • and big business promotes individualism, rather than harms it, by reducing poverty, disease, and physical insecurity.

Lilienthal later agreed with his family that he hadn’t spent enough time on the book, although its main points were correct. Also, he stressed that he had conceived of the book before he ever decided to transition from government to business.

In 1957, Lilienthal and his wife Helen Lamb Lilienthal had settled in a house in Princeton. It was a few years later, at this house, that Brooks went to interview Lilienthal. Brooks was curious to hear about how Lilienthal thought about his civic career as compared to his business career.

Lilienthal had started out as a lawyer in Chicago and he done quite well. But he didn’t want to practice the law. Then – in 1950 – his public career over, he was offered various professorship positions at Harvard. He didn’t want to be a professor. Then various law firms and businesses approached Lilienthal. He still had no interest in practicing law. He also rejected the business offers he received.

In May, 1950, Lilienthal took a job as a part-time consultant for Lazard Freres & Co., whose senior partner, Andre Meyer, he had met through Albert Lasker, a mutual friend. Through Lazard Freres and Meyer, Lilienthal became a consultant and then an executive of a small company, the Minerals Separation North American Corporation. Lazard Freres had a large interest in the concern.

The company was in trouble, and Meyer thought Lilienthal was the man to solve the case. Through a series of mergers, acquisitions, etc., the firm went through several name changes ending, in 1960, with the name, Minerals & Chemicals Philipp Corporation. Meanwhile, annual sales for the company went from $750,000 in 1952 to more than $274,000,000 in 1960. (In 2019 dollars, this would be a move from $6,750,000 to $2,466,000,000.) Brooks writes:

For Lilienthal, the acceptance of Meyer’s commission to look into the company’s affairs was the beginning of a four-year immersion in the day-to-day problems of managing a business; the experience, he said decisively, turned out to be one of his life’s richest, and by no means only in the literal sense of that word.

Minerals Separation North American, founded in 1916 as an offshoot from a British company, was a patent firm. It held patents on processes used to refine copper ore and other nonferrous minerals. In 1952, Lilienthal became the president of the company. In order to gain another source of revenue, Lilienthal arranged a merger between Minerals Separation and Attapulgus Clay Company, a producer of a rare clay used in purifying petroleum products and also a manufacturer of various household products.

The merger took place in December, 1952, thanks in part to Lilienthal’s work to gain agreement from the Attapulgus people. The profits and stock price of the new company went up from there. Lilienthal managed some of the day-to-day business. And he helped with new mergers. One in 1954, with Edgar Brothers, a leading producer of kaolin for paper coating. Two more in 1955, with limestone firms in Ohio and Virginia. Brooks notes that the company’s net profits quintupled between 1952 and 1955.

Lilienthal received stock options along the way. Because the stock went up a great deal, he exercised his options and by August, 1955, Lilienthal had 40,000 shares. Soon the stock hit $40 and was paying a $0.50 annual dividend. Lilienthal’s financial worries were over.

Brooks asked Lilienthal how all of this felt. Lilienthal:

‘I wanted an entrepreneurial experience. I found a great appeal in the idea of taking a small and quite crippled company and trying to make something of it. Building. That kind of building, I thought, is the central thing in American free enterprise, and something I’d missed in all my government work. I wanted to try my hand at it. Now, about how it felt. Well, it felt plenty exciting. It was full of intellectual stimulation, and a lot of my old ideas changed. I conceived a great new respect for financiers – men like Andre Meyer. There’s a correctness about them, a certain high sense of honor, that I’d never had any conception of. I found that business life is full of creative, original minds – along with the usual number of second-guessers, of course. Furthermore, I found it seductive. In fact, I was in danger of becoming a slave… I found that the things you read – for instance, that acquiring money for its own sake can become an addiction if you’re not careful – are literally true. Certain good friends helped keep me on track… Oh, I had my problems. I questioned myself at every step. It was exhausting.’

A friend of Lilienthal’s told Brooks that Lilienthal had a marvelous ability to immerse himself totally in the work. The work may not always be important. But Lilienthal becomes so immersed, it’s as if the work becomes important simply because he’s doing it.

On the matter of money, Lilienthal said it doesn’t make much difference as long as you have enough. Money was something he never really thought about.

Next Brooks describes Lilienthal’s experience at Development & Resources Corporation. The situation became ideal for Lilienthal because it combined helping the world directly with the possibility of also earning a profit.

In the spring of 1955, Lilienthal and Meyer had several conversations. Lilienthal told Meyer that he knew dozens of foreign dignitaries and technical personnel who had visited T.V.A. and shown strong interest. Many of them told Lilienthal that at least some of their own countries would be interested in starting similar programs.

The idea for D. & R. was to accomplish very specific projects and, incidentally, to make a profit. Meyer liked the idea – although he expected no profit – so they went forward, with Lazard Freres owning half the firm. The executive appointments for D.& R. included important alumni from T.V.A., people with deep experience and knowledge in management, engineering, dams, electric power, and related areas.

In September, 1955, Lilienthal was at a World Bank meeting in Istanbul and he ended up speaking with Abolhassan Ebtehaj, head of a 7-year development plan in Iran. Iran had considerable capital with which to pay for development projects, thanks to royalties from its nationalized oil industry. Moreover, what Iran badly needed was technical and professional guidance. Lilienthal and a colleague later visited Iran as guests of the Shah to see what could be done about Khuzistan.

Lilienthal didn’t know anything about the region at first. But he learned that Khuzistan was in the middle of the Old Testament Elamite kingdom and later of the Persian Empire. The ruins of Persepolis are close by. The ruins of Susa, where King Darius had a winter palace, are at the center of Khuzistan. Brooks quotes Lilienthal (in the 1960’s):

Nowadays, Khuzistan is one of the world’s richest oil fields – the famous Abadan refinery is at its southern tip – but the inhabitants, two and a half million of them, haven’t benefited from that. The rivers have flowed unused, the fabulously rich soil has lain fallow, and all but a tiny fraction of the people have continued to live in desperate poverty.

D. & R. signed a 5-year agreement with the Iranian government. Once the project got going, there were 700 people working on it – 100 Americans, 300 Iranians, and 300 others (mostly Europeans). In addition, 4,700 Iranian-laborers were on the various sites. The entire project called for 14 dams on 5 different rivers. After D. & R. completed its first 5-year contract, they signed a year-and-a-half extension including an option for an additional 5 years.

Brooks records:

While the Iranian project was proceeding, D. & R. was also busy lining up and carrying out its programs for Italy, Colombia, Ghana, the Ivory Coast, and Puerto Rico, as well as programs for private business groups in Chile and the Philippines. A job that D. & R. had just taken on from the United States Army Corps of Engineers excited Lilienthal enormously – an investigation of the economic impact of power from a proposed dam on the Alaskan sector of the Yukon, which he described as ‘the river with the greatest hydroelectric potential remaining on this continent.’ Meanwhile, Lazard Freres maintained its financial interest in the firm and now very happily collected its share of a substantial annual profit, and Lilienthal happily took to teasing Meyer about his former skepticism as to D. & R. financial prospects.

Lilienthal wrote in his journal about the extreme poverty in Ahwaz, Khuzistan:

…visiting villages and going into mud ‘homes’ quite unbelievable – and unforgettable forever and ever. As the Biblical oath has it: Let my right hand wither if I ever forget how some of the most attractive of my fellow human beings live – are living tonight, only a few kilometres from here, where we visited them this afternoon…

And yet I am as sure as I am writing these notes that the Ghebli area, of only 45,000 acres, swallowed in the vastness of Khuzistan, will become as well known as, say, the community of Tupelo… became, or New Harmony or Salt Lake City when it was founded by a handful of dedicated men in a pass of the great Rockies.

 

STOCKHOLDER SEASON

The owners of public businesses in the United States are the stockholders. But many stockholders don’t pay much attention to company affairs when things are going well. Also, many stockholders own small numbers of shares, making it not seem worthwhile to exercise their rights as owners of the corporations. Furthermore, many stockholders don’t understand or follow business, notes Brooks.

Brooks decided to attend several annual meetings in the spring of 1966.

What particularly commended the 1966 season to me was that it promised to be a particularly lively one. Various reports of a new “hard-line approach” by company managements to stockholders had appeared in the press. (I was charmed by the notion of a candidate for office announcing his new hard-line approach to voters right before an election.)

Brooks first attended the A. T. & T. annual meeting in Detroit. Chairman Kappel came on stage, followed by eighteen directors who sat behind him, and he called the meeting to order. Brooks:

From my reading and from annual meetings that I’d attended in past years, I knew that the meetings of the biggest companies are usually marked by the presence of so-called professional stockholders… and that the most celebrated members of this breed were Mrs. Wilma Soss, of New York, who heads an organization of women stockholders and votes the proxies of its members as well as her own shares, and Lewis D. Gilbert, also of New York, who represents his own holdings and those of his family – a considerable total.

Brooks learned that, apart from prepared comments by management, many big-company meetings are actually a dialogue between the chairman and a few professional stockholders. So professional stockholders can come to represent, in a way, many other shareholders who might otherwise not be represented, whether because they own few shares, don’t follow business, or other reasons.

Brooks notes that occasionally some professional stockholders get boorish, silly, on insulting. But not Mrs. Soss or Mr. Gilbert:

Mrs. Soss, a former public-relations woman who has been a tireless professional stockholder since 1947, is usually a good many cuts above this level. True, she is not beyond playing to the gallery by wearing bizarre costumes to meetings; she tries, with occasional success, to taunt recalcitrant chairmen into throwing her out; she is often scolding and occasionally abusive; and nobody could accuse her of being unduly concise. I confess that her customary tone and manner set my teeth on edge, but I can’t help recognizing that, because she does her homework, she usually has a point. Mr. Gilbert, who has been at it since 1933 and is the dean of them all, almost invariably has a point, and by comparison with his colleagues he is the soul of brevity and punctilio as well as of dedication and diligence.

At the A. T. & T. meeting, after the management-sponsored slate of directors had been duly nominated, Mrs. Soss got up to make a nomination of her own, Dr. Frances Arkin, a psychoanalyst. Mrs. Soss said A. T. & T. ought to have a woman on its board and, moreover, she thought some of the company’s executives would have benefited from periodic psychiatric examinations. (Brooks comments that things were put back into balance at another annual meeting when the chairman suggested that some of the firm’s stockholders should see a psychiatrist.) The nomination of Dr. Arkin was seconded by Mr. Gilbert, but only after Mrs. Soss nudged him forcefully in the ribs.

A professional stockholder named Evelyn Y. Davis complained about the meeting not being in New York, as it usually is. Brooks observed that Davis was the youngest and perhaps the best-looking, but “not the best-informed or the most temperate, serious-minded, or worldly-wise.” Davis’ complaint was met with boos from the largely local crowd in Detroit.

After a couple of hours, Mr. Kappel was getting testy. Soon thereafter, Mrs. Soss was complaining that while the business affiliations of the nominees for director were listed in the pamphlet handed out at the meeting, this information hadn’t been included in the material mailed to stockholders, contrary to custom. Mrs. Soss wanted to know why. Mrs. Soss adopted a scolding tone and Mr. Kappel an icy one, says Brooks. “I can’t hear you,” Mrs. Soss said at one point. “Well, if you’d just listen instead of talking…”, Mr. Kappel replied. Then Mrs. Soss said something (Brooks couldn’t hear it precisely) that successfully baited the chairman, who got upset and had the microphone in front of Mrs. Soss turned off. Mrs. Soss marched towards the platform and was directly facing Mr. Kappel. Mr. Kappel said he wasn’t going to throw her out of the meeting as she wanted. Mrs. Soss later returned to her seat and a measure of calm was restored.

Later, Brooks attended the annual meeting of Chas. Pfizer & Co., which was run by the chairman, John E. McKeen. After the company announced record highs on all of its operational metrics, and predicted more of the same going forward, “the most intransigent professional stockholder would have been hard put to it to mount much of a rebellion at this particular meeting,” observes Brooks.

John Gilbert, brother of Lewis Gilbert, may have been the only professional stockholder present. (Lewis Gilbert and Mrs. Davis were at the U.S. Steel meeting in Cleveland that day.)

John Gilbert is the sort of professional stockholder the Pfizer management deserves, or would like to think it does. With an easygoing manner and a habit of punctuating his words with self-deprecating little laughs, he is the most ingratiating gadly imaginable (or was on this occasion; I’m told he isn’t always), and as he ran through what seemed to be the standard Gilbert-family repertoire of questions – on the reliability of the firms’s auditors, the salaries of its officers, the fees of its directors – he seemed almost apologetic that duty called on him to commit the indelicacy of asking such things.

The annual meeting of Communications Satellite Corporation had elements of farce, recounts Brooks. (Brooks refers to Comsat as a “glamorous space-age communications company.”) Mrs. Davis, Mrs. Soss, and Lewis Gilbert were in attendance. The chairman of Comsat, who ran the meeting, was James McCormack, a West Point graduate, former Rhodes Scholar, and retired Air Force General.

Mrs. Soss made a speech which was inaudible because her microphone wasn’t working. Next, Mrs. Davis rose to complain that there was a special door to the meeting for “distinguished guests.” Mrs. Davis viewed this as undemocratic. Mr. McCormack responded, “We apologize, and when you go out, please go by any door you want.” But Mrs. Davis went on speaking. Brooks:

And now the mood of farce was heightened when it became clear that the Soss-Gilbert faction had decided to abandon all efforts to keep ranks closed with Mrs. Davis. Near the height of her oration, Mr. Gilbert, looking as outraged as a boy whose ball game is being spoiled by a player who doesn’t know the rules or care about the game, got up and began shouting, ‘Point of order! Point of order!’ But Mr. McCormack spurned this offer of parliamentary help; he ruled Mr. Gilbert’s point of order out of order, and bade Mrs. Davis proceed. I had no trouble deducing why he did this. There were unmistakable signs that he, unlike any other corporate chairman I had seen in action, was enjoying every minute of the goings on. Through most of the meeting, and especially when the professional stockholders had the floor, Mr. McCormack wore the dreamy smile of a wholly bemused spectator.

Mrs. Davis’ speech increased in volume and content, and she started making specific accusations against individual Comsat directors. Three security guards appeared on the scene and marched to a location near Mrs. Davis, who then suddenly ended her speech and sat down.

Brooks comments:

Once, when Mr. Gilbert said something that Mrs. Davis didn’t like and Mrs. Davis, without waiting to be recognized, began shouting her objection across the room, Mr. McCormack gave a short irrepressible giggle. That single falsetto syllable, magnificently amplified by the chairman’s microphone, was the motif of the Comsat meeting.

 

ONE FREE BITE

Brooks writes about Donald W. Wohlgemuth, a scientist for B. F. Goodrich Company in Akron, Ohio.

…he was the manager of Goodrich’s department of space-suit engineering, and over the past years, in the process of working his way up to that position, he had had a considerable part in the designing and construction of the suits worn by our Mercury astronauts on their orbital and suborbital flights.

Some time later, the International Latex Corporation, one of Goodrich’s three main competitors in the space-suit field, contacted Wohlgemuth.

…Latex had recently been awarded a subcontract, amounting to some three-quarters of a million dollars, to do research and development on space suits for the Apollo, or man-on-the-moon, project. As a matter of fact, Latex had won this contract in competition with Goodrich, among others, and was thus for the moment the hottest company in the space-suit field.

Moreover, Wohlgemuth was not particularly happy at Goodrich for a number of reasons. His salary was below average. His request for air-conditioning had been turned down.

Latex was located in Dover, Delaware. Wohlgemuth went there to meet with company representatives. He was given a tour of the company’s space-suit-development facilities. Overall, he was given “a real red-carpet treatment,” as he later desribed. Eventually he was offered the position of manager of engineering for the Industrial Products Division, which included space-suit development, at an annual salary of $13,700 (over $109,000 in 2019 dollars) – solidly above his current salary. Wohlgemuth accepted the offer.

The next morning,Wohlgemuth informed his boss at Goodrich, Carl Effler, who was not happy. The morning after that, Wohlgemuth told Wayne Galloway – with whom he had worked closely – of his decision.

Galloway replied that in making the move Wohlgemuth would be taking to Latex certain things that did not belong to him – specifically, knowledge of the processes that Goodrich used in making space suits.

Galloway got upset with Wohlgemuth. Later Effler called Wohlgemuth to his office and told him he should leave the Goodrich offices as soon as possible. Then Galloway called him and told him the legal department wanted to see him.

While he was not bound to Goodrich by the kind of contract, common in American industry, in which an employee agrees not to do similar work for any competing company for a stated period of time, he had, on his return from the Army, signed a routine paper agreeing ‘to keep confidential all information, records, and documents of the company of which I may have knowledge because of my employment’ – something Wohlgemuth had entirely forgotten until the Goodrich lawyer reminded him. Even if he had not made that agreement, the lawyer told him now, he would be prevented from going to work on space suits for Latex by established principles of trade-secrets law. Moreover, if he persisted in his plan, Goodrich might sue him.

To make matters worse, Effler told Wohlgemuth that if he stayed at Goodrich, this incident could not be forgotten and might well impact his future. Wohlgemuth then informed Latex that he would be unable to accept their offer.

That evening, Wohlgemuth’s dentist put him in touch with a lawyer. Wohlgemuth talked with the lawyer, who consulted another lawyer. They told Wohlgemuth that Goodrich was probably bluffing and wouldn’t sue him if he went to work for Latex.

The next morning – Thursday – officials of Latex called him back to assure him that their firm would bear his legal expenses in the event of a lawsuit, and, furthermore, would indemnify him against any salary losses.

Wohlgemuth decided to work for Latex, after all, and left the offices of Goodrich late that day, taking with him no documents.

The next day, R. G. Jeter, general counsel of Goodrich, called Emerson P. Barrett, director of industrial relations for Latex. Jeter outlined Goodrich’s concern for its trade secrets. Barrett replied that Latex was not interested in Goodrich trade secrets, but was only interested in Wohlgemuth’s “general professional abilities.”

That evening, at a farewell dinner given by forty or so friends, Wohlgemuth was called outside. The deputy sheriff of Summit County handed him two papers.

One was a summons to appear in the Court of Common Pleas on a date a week or so off. The other was a copy of a petition that had been filed in the same court that day by Goodrich, praying that Wohlgemuth be permanently enjoined from, among other things, disclosing to any unauthorized person any trade secrets belonging to Goodrich, and ‘performing any work for any corporation… other than plaintiff, relating to the design, manufacture and/or sale of high-altitude pressure suits, space suits and/or similar protective garments.’

For a variety of reasons, says Brooks, the trial attracted much attention.

On one side was the danger that discoveries made in the course of corporate research might become unprotectable – a situation that would eventually lead to the drying up of private research funds. On the other side was the danger that thousands of scientists might, through their very ability and ingenuity, find themselves permanently locked in a deplorable, and possibly unconstitutional, kind of intellectual servitude – they would be barred from changing jobs because they knew too much.

Judge Frank H. Harvey presided over the trial, which took place in Akron from November 26 to December 12. The seriousness with which Goodrich took this case is illustrated by the fact that Jeter himself, who hadn’t tried a case in 10 years, headed Goodrich’s legal team. The chief defense counsel was Richard A. Chenoweth, of Buckingham, Doolittle & Burroughs – an Akron law firm retained by Latex.

From the outset, the two sides recognized that if Goodrich was to prevail, it had to prove, first, that it possessed trade secrets; second, that Wohlgemuth also possessed them, and that a substantial peril of disclosure existed; and, third, that it would suffer irreparable injury if injunctive relief was not granted.

Goodrich attorneys tried to establish that Goodrich had a good number of space-suit secrets. Wohlgemuth, upon cross-examination from his counsel, sought to show that none of these processes were secrets at all. Both companies brought their space suits into the courtroom. Goodrich wanted to show what it had achieved through research. The Latex space suit was meant to show that Latex was already far ahead of Goodrich in space-suit development, and so wouldn’t have any interest in Goodrich secrets.

On the second point, that Wohlgemuth possessed Goodrich secrets, there wasn’t much debate. But Wohlgemuth’s lawyers did argue that he had taken no papers with him and that he was unlikely to remember the details of complex scientific processes, even if he wanted to.

On the third point, seeking injunctive relief to prevent irreparable injury, Jeter argued that Goodrich was the clear pioneer in space suits. It made the first full-pressure flying suit in 1934. Since then, it has invested huge amounts in space suit research and development. Jeter characterized Latex as a newcomer intent on profiting from Goodrich’s years of research by hiring Wohlgemuth.

Furthermore, even if Wohlgemuth and Latex had the best of intentions, Wohlgemuth would inevitably give away trade secrets. But good intentions hadn’t been demonstrated, since Latex deliberately sought Wohlgemuth, who in turn justified his decision in part on the increase in salary. The defense disagreed that trade secrets would be revealed or that anyone had bad intentions. The defense also got a statement in court from Wohlgemuth in which he pledged not to reveal any trade secrets of B. F. Goodrich Company.

Judge Harvey reserved the decision for a later date. Meanwhile, the lawyers for each side fought one another in briefs intended to sway Judge Harvey. Brooks:

…it became increasingly clear that the essence of the case was quite simple. For all practical purposes, there was no controversy over facts. What remained in controversy was the answer to two questions: First, should a man be formally restrained from revealing trade secrets when he has not yet committed any such act, and when it is not clear that he intends to? And, secondly, should a man be prevented from taking a job simply because the job presents him with unique temptations to break the law?

The defense referred to “Trade Secrets,” written by Ridsdale Ellis and published in 1953, which stated that usually it is not until there is evidence that the employee has not lived up to the contract, written or implied, that the former employer can take action. “Every dog has one free bite.”

On February 20, 1963, Judge Harvey delivered his decision in a 9-page essay. Goodrich did have trade secrets. And Wohlgemuth could give these secrets to Latex. Furthermore, there’s no doubt Latex was seeking to get Wohlgemuth for his specialized knowledge in space suits, which would be valuable for the Apollo contract. There’s no doubt, wrote the judge, that Wohlgemuth would be able to disclose confidential information.

However, the judge said, in keeping with the one-free-bite principle, an injunction against disclosure of trade secrets cannot be issued before such disclosure has occurred unless there is clear and substantial evidence of evil intent on the part of the defendant. In the view of the court, Wohlgemuth did not have evil intent in this case, therefore the injunction was denied.

On appeal, Judge Arthur W. Doyle partially reversed the decision. Judge Doyle granted an injunction against Wohlgemuth from disclosing to Latex any trade secrets of Goodrich. On the other hand, Wohlgemuth had the right to take a job in a competitive industry, and he could use his knowledge and experience – other than trade secrets – for the benefit of his employer. Wohlgemuth was therefore free to work on space suits for Latex, provided he didn’t reveal any trade secrets of Goodrich.

 

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: jb@boolefund.com

 

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

Bad Blood

July 27, 2025

Bad Blood: Secrets and Lies in a Silicon Valley Startup, by John Carreyrou, is hands-down one of the best business books I’ve ever read. (It’s up there withBusiness Adventures, by John Brooks, andShoe Dog, by Phil Knight.) The book tells the story of the rise and fall of Theranos.

In brief, here’s why it’s such a great book: Carreyrou was the investigative reporter who broke the Theranos story in 2015. Carreyrou interviewed 150 people and withstood enormous pressure from the company’s charismatic CEO and her attorneys–led by one of the best and most feared lawyers in the country. Other key whistle-blowers also withstood great pressure. Many of the facts of the story are unbelievable. And finally, Carreyrou does an outstanding job telling the story.

Theranos was a company founded by Stanford dropout Elizabeth Holmes when she was just 19 years old. She claimed that she had invented a semi-portable device that could do every kind of blood test using only a tiny drop of blood obtained by a pin prick to the end of a finger. Holmes declared that you could get the results in a few hours and at a much lower price than what other labs charged.

Had Theranos’s technology worked, it would have been revolutionary. The only problem: it never came close to working. There are different kinds of blood tests that require different laboratory instruments. If you do one kind of blood test on a tiny sample, there isn’t enough blood left to do the other kinds of blood tests.

But Holmes believed in her vision so much, and she was such a charismatic and brilliant saleswoman, that she raised close to $1 billion dollars from investors. This included $700 million in late 2013. How? See this CNN Business interview (Sept. 20, 2018):https://www.youtube.com/watch?v=BXfw-S62ISE

As Carreyrou explains to Julia Chatterley in the CNN Business interview: Holmes launched the purportedly innovative technology in Walgreens stores in California and Arizona. In addition, when seeking investors, she focused on the family offices of billionaires while avoiding investors with any sophistication related to next-gen diagnostics. When the less sophisticated investors learned that Theranos was giving blood tests in Walgreens stores, they assumed that its technology must be real.

Theranos offered 250 blood tests. Unbeknownst to investors and to Theranos’s business partners–Walgreens and Safeway–240 of these tests were actually done on Siemens machines. Theranos would collect tiny blood samples from finger pricks and then dilute them so that the Siemens machine could analyze them. (This also required modifications to the Siemens machines that Theranos engineers had figured out.)

Only 10 of the 250 blood tests offered by Theranos were done on the company’s machine, the Edison. Moreover, the Edison was shockingly unreliable. Ultimately, a million blood tests done by Edison machines were voided.

Here is the outline for this blog post. (The outline does not include the Prologue and the Epilogue, which I also touch on.)

    1. A Purposeful Life
    2. The Gluebot
    3. Apple Envy
    4. Goodbye East Paly
    5. The Childhood Neighbor
    6. Sunny
    7. Dr. J
    8. The miniLab
    9. The Wellness Play
    10. “Who is LTC Shoemaker?”
    11. Lighting a Fuisz
    12. Ian Gibbons
    13. Chiat/Day
    14. Going Live
    15. Unicorn
    16. The Grandson
    17. Fame
    18. The Hippocratic Oath
    19. The Tip
    20. The Ambush
    21. Trade Secrets
    22. La Mattanza
    23. Damage Control
    24. The Empress Has No Clothes

 

PROLOGUE

November 17, 2006. Henry Mosley, Theranos’s chief financial officer. Good news from Tim Kemp: Elizabeth Holmes, the twenty-two year old founder, had shown off the company’s system to executives at Novartis, a European drug giant. She had told Kemp, “It was perfect!”

Carreyrou writes:

This was a pivotal moment for Theranos. The three-year-old startup had progressed from an ambitious idea Holmes had dreamed up in her Stanford dorm room to an actual product a huge multinational corporation was interested in using.

Mosley was a veteran of Silicon Valley. Carreyrou again:

What had drawn Mosley to Theranos was the talent and experience gathered around Elizabeth. She might be young, but she was surrounded by an all-star cast. The chairman of her board was Donald L. Lucas, the venture capitalist who had groomed billionaire software entrepreneur Larry Ellison and helped him take Oracle Corporation public in the mid-1980s.Lucas and Ellison had both put some of their own money into Theranos.

Another board member with a sterling reputation was Channing Robertson, the associate dean of Stanford’s School of Engineering.Robertson was one of the stars of the Stanford faculty… Based on the few interactions Mosley had had with him, it was clear Robertson thought the world of Elizabeth.

Carreyrou says that Theranos also had a strong management team, which impressed Mosley. Furthermore, Mosley understood that the market Theranos was targeting was huge. Pharmaceutical companies spent tens of billions of dollars on clinical trials to test new drugs each year. If Theranos could make itself indispensable to them and capture a fraction of that spending, it could make a killing.

Carreyrou notes that Elizabeth had asked Mosley for some financial projections, which he provided. Elizabeth asked him to revise the projections upward. Mosley was a bit uncomfortable, but he knew it was a part of the game new tech startups played to attract VC money.

Something wasn’t right, though. Although Elizabeth was enthusiastic about the presentation to Novartis, some of her colleagues seemed downcast. With some digging, Mosley found out the problem from Shaunak, a fellow employee.Theranos’s blood-testing system was unreliable. This was the first Mosley heard about the issue.

Well, there was a reason it always seemed to work, Shaunak said. The image on the computer screen showing the blood and settling into he little wells was real. But you never knew whether you were going to get a result or not. So they’d recorded a result from one of the times it worked.It was that recorded result that was displayed at the end of each demo.

Mosley was stunned. He thought the result were extracted in real time from the blood inside the cartridge. That was certainly what the investors he brought by were led to believe. What Shaunak had just described sounded like a sham.It was OK to be optimistic and aspirational when you pitched investors, but there was a line not to cross. And this, in Mosley’s view, crossed.

Later, Mosley politely raised the issue with Elizabeth. Mosley said they couldn’t keep fooling investors. Elizabeth’s expression immediately became hostile. She told Mosley he wasn’t a team player and said he should leave immediately. Elizabeth had fired him.

 

A PURPOSEFUL LIFE

Elizabeth wanted to be an entrepreneur at a young age. Carreyrou:

When she was seven, she set out to design a time machine and filled up a notebook with detailed engineering drawings.

When she was nine or ten, one of her relatives asked her at a family gathering the question every boy and girl is asked sooner or later: “What do you want to do when you grow up?”

Without skipping a beat, Elizabeth replied, “I want to be a billionaire.”

These weren’t the idle words of a child. Elizabeth uttered them with the utmost seriousness and determination, according to a family member who witnessed the scene.

Carreyrou explains that Elizabeth’s parents encouraged her ambition based on a distinguished family history. She descended from Charles Louis Fleischmann on her father’s side. Fleischmann was a Hungarian immigrant who created the Fleischmann Yeast Company, which was remarkably successful. The Fleischmanns were one of the wealthiest families in America at the beginning of the twentieth century.

Bettie Fleischmann, Charles’s daughter, married her father’s Danish physician, Dr. Christian Holmes. He was Elizabeth’s great-great-grandfather.

Aided by the political and business connections of his wife’s wealthy family, Dr. Holmes established Cincinnati General Hospital and the University of Cincinnati’s medical school. So the case could be made–and it would in fact be made to the venture capitalists clustered on Sand Hill Road near the Stanford University campus–that Elizabeth didn’t just inherit entrepreneurial genes, but medical ones too.

Elizabeth’s mother, Noel, also had notable family background. Noel’s father was a West Point graduate who became a high-ranking Pentagon official who oversaw the shift from draft-based military to an all-volunteer force in the early 1970s. The Daoust line could be traced back to one of Napoleon’s top field generals.

Chris Holmes also made sure to teach his daughter about the failings of his father and grandfather. They had cycled through marriages and struggled with alcoholism while they squandered the family fortune. Elizabeth later explained that she learned about greatness, but also about what happens if you don’t have a high purpose–your character and qualify of life suffered.

When Elizabeth was a kid, she liked to play monopoly with her cousins and brother. She was intensely competitive. She got furious when she lost and at least a few times ran right through a screen on the front door of the condo owned by her aunt and uncle.

Elizabeth became a straight-A student in high school by working hard and sacrificing sleep. Stanford was the natural choice for someone interested in computers and science who wanted to be an entrepreneur. She was accepted to Stanford as a President’s Scholar in the spring of 2002.

Carreyrou explains how Elizabeth got interested in biotechnology:

Her father had drilled into her the notion that she should live a purposeful life. During his career in public service, Chris Holmes had overseen humanitarian efforts like the 1980 Mariel boatlift, in which more than one hundred thousand Cubans and Haitians migrated to the United States. There were pictures around the house of him provided disaster relief in war-torn countries. The message Elizabeth took away from them is that if she wanted to truly leave her mark on the world, she would need to accomplish something that furthered the greater good, not just become rich. Biotechnology offered the prospect of achieving both. She chose to study chemical engineering, a field that provided a natural gateway to the industry.

Elizabeth took Introduction to Chemical Engineering from star faculty member Channing Robertson. She also convinced him to let her work in his lab. She had a boyfriend for a time, but broke up telling him that she was starting a company and wouldn’t have any time to date.

After her freshman year, Elizabeth had a summer internship at the Genome Institute of Singapore. Earlier that year (2003), severe acute respiratory syndrome (SARS) had hit Asia. Elizabeth’s job was testing patient specimens gathered using low-tech methods like syringes. She thought there was a better way. Carreyrou:

When she got back home to Houston, she sat down at her computer for five straight days, sleeping one or two hours a night and eating from trays of food her mother brought her. Drawing from new technologies she had learned about during her internship and in Robertson’s classes, she wrote a patent application for an arm patch that would simultaneously diagnose medical conditions and treat them.

Robertson was impressed, saying:

“She had somehow been able to take and synthesis these pieces of science and engineering and technology that I had never thought of.”

Robertson urged Elizabeth to follow her dream. So she did: she launched a startup, tapping family connections to raise money. By the end of 2006, she had raised almost $6 million. Her first employee was Shaunak Roy, who had a Ph.D. in chemical engineering. Elizabeth had worked with Shaunak in Robertson’s lab.

Elizabeth and Shaunak dropped the patch idea and came up with a cartridge-and-reader system:

The patient would prick her finger to draw a small sample of blood and place it in a cartridge that looked like a thick credit card. The cartridge would slot into a bigger machine called a reader. Pumps inside the reader would push the blood through tiny channels in the cartridge and into little wells coated with proteins known as antibodies. On its way to the wells, a filter would separate the blood’s solid elements, its red and white blood cells, from the plasma and let only the plasma through. When the plasma came into contact with the antibodies, a chemical reaction would produce a signal that would be “read” by the reader and translated into a result.

Elizabeth envisioned placing the cartridges and readers in patient’s homes so that they could test their blood regularly. A cellular antenna on the reader would send the test results to the computer of a patient’s doctor by way of a central server.This would allow the doctor to make adjustments to the patient’s medication quickly, rather than waiting for the patient to go get his blood tested at a blood-draw center or during his next office visit.

By late 2005, eighteen months after he’d come on board, Shaunak was beginning to feel like they were making progress. The company had a prototype, dubbed the Theranos 1.0, and had grown to two dozen employees. It also had a business model it hoped would quickly generate revenues: it planned to license its blood-testing technology to pharmaceutical companies to help them catch adverse drug reactions during clinical trials.

 

THE GLUEBOT

Edmund Ku was a talented engineer with a reputation for fixing tough problems. When Ku interviewed with Elizabeth Holmes in early 2006, he felt inspired by her vision.

Elizabeth cited the fact that an estimated one hundred thousand Americans died each year from adverse drug reactions. Theranos would eliminate all those deaths, she said. It would quite literally save lives.

Ed’s job would be to turn the Theranos 1.0 prototype into a product that could be commercialized. It soon became clear to Ed that this would be the most difficult engineering challenge he had faced. The main challenge was that Elizabeth required that they use only a drop of blood pricked from the end of a finger.

Her obsession with miniaturization extended to the cartridge. She wanted it to fit in the palm of a hand, further complicating Ed’s task. He and his team spent months reengineering it, but they never reached a point where they could reliably reproduce the same test results from the same blood samples.

The quantity of blood they were allowed to work with was so small that it had to bediluted with a saline solution to create more volume. That made what would otherwise have been relatively routine chemistry work a lot more challenging.

Adding another level of complexity, blood and saline weren’t the only fluids that had to flow through the cartridge. The reactions that occurred when the blood reached the little wells required chemicals known as reagents. Those were stored in separate chambers.

All these fluids needed to flow through the cartridge in a meticulously choreographed sequence, so the cartridge contained little valves that opened and shut at precise intervals. Ed and his engineers tinkered with the design and the timing of the valves and the speed at which the various fluids were pumped through the cartridge.

Another problem was preventing all those fluids from leaking and contaminating one another.

Meanwhile, having burned through its first $6 million, Theranos raised another $9 million. A separate group of biochemists worked on the chemistry work. But Elizabeth kept the two groups from communicating with one another. She preferred to be the only one who could see the whole system. This was far from ideal. Ed couldn’t tell if problems they were trying to solve were caused by microfluidics, which was their focus, or chemistry, which the other group was responsible for.

One evening, Elizabeth told Ed that progress wasn’t fast enough. She wanted the engineering department to run twenty-four hours a day. Ed disagreed.

Ed noticed a quote cut out from an article sitting on Elizabeth’s desk. It was from Channing Robertson:

“You start to realize you are looking in the eyes of another Bill Gates, or Steve Jobs.”

Carreyrou:

That was a high bar to set for herself, Ed thought. Then again, if there was anyone who could clear it, it might just be this young woman. Ed had never encountered anyone as driven and relentless. She slept four hours a night and popped chocolate-coated coffee beans throughout the day to inject herself with caffeine. He tried to tell her to get more sleep and to live a healthier lifestyle, but she brushed him off.

Around that time, Elizabeth was meeting regularly with the venture capitalist Don Lucas and also (less regularly) with Larry Ellison. Lucas and Ellison had both invested in the recent Series B round that raised $9 million. Carreyrou comments:

Ellison might be one of the richest people in the world, with a net worth of some $25 billion, but he wasn’t necessarily the ideal role model. In Oracle’s early years, he had famously exaggerated his database software’s capabilities and shipped versions of it crawling with bugs. That’s not something you could do with a medical device.

Since Ed had refused to make his engineering group work 24/7, Elizabeth had cooled towards him. Soon she had hired a rival engineering group. Ed’s group was put in competition with this new group.

Elizabeth had persuaded Pfizer to try the Theranos system in a pilot project in Tennessee. The Theranos 1.0 devices would be put in people’s homes and they would test their blood every day. Results would be sent wirelessly to the Theranos’s office in California, where they would be analyzed and then sent to Pfizer. The bugs would have to be fixed before then. Ed accompanied Elizabeth to Tennessee to start training doctors and patients on how to use the system.

When they got to Tennessee, the cartridges and the readers they’d brought weren’t functioning properly, so Ed had to spend the night disassembling and reassembling them on his bed in his hotel room. He managed to get them working well enough by morning that they were able to draw blood samples from two patients and a half dozen doctors and nurses at a local oncology clinic.

Thepatients looked very sick. Ed learned that they were dying of cancer. They were taking drugs designed to slow the growth of their tumors, which might buy them a few more months to live.

Elizabeth declared the trip a success, but Ed thought it was too soon to use Theranos 1.0 in a patient study–especially on terminal cancer patients.

***

In August 2007, Elizabeth had everyone in the company gather. Standing next to Elizabeth was Michael Esquivel, a lawyer. Equivel announced that the company was suing three former employees–Michael O’Connell, Chris Todd, and John Howard–for stealing intellectual property. Current employees were not to have any contact with these individuals. And all documents and emails had to be preserved. Moreover, the FBI had been called for assistance.

O’Connell held a postdoctorate in nanotechnology from Stanford. He thought he had solved the microfluidic problems of the Theranos system. O’Connell convinced Todd to form a company with him–Avidnostics. O’Connell also spoke with Howard, who helped but decided not to join the company.

Elizabeth had always been very concerned about proprietary information getting out. She required employees–as well as any who entered the Theranos office or did business with it–to sign nondisclosure agreements.

Meanwhile, the engineering teams vied to be first to solve the problems with Theranos 1.0. Tony Nugent, an Irishman, was the head of the team competing with Ed’s team.

Tony decided that part of the Theranos value proposition should be to automate all the steps that bench chemists followed when they tested blood in a laboratory. In order to automate, Tony needed a robot. But he didn’t want to waste time building one from scratch, so he ordered a three-thousand-dollar glue-dispensing robot from a company in New Jersey called Fisnar. It became the heart of the new Theranos system.

Soon Tony and team had built a smaller version of the robot that fit inside an aluminum box slightly smaller than a desktop computer tower. Eventually they got the robot to follow the same steps a human chemist would.

First, it grabbed one of the two pipette tips and used it to aspirate the blood and mix it with diluents contained in the cartridge’s other tubes. Then it grabbed the other pipette tip and aspirated the diluted blood with it. This second tip was coated with antibodies, which attached themselves to the molecule of interest, creating a microscopic sandwich.

Therobot’s last step was to aspirate reagents from yet another tube in the cartridge. When the reagents came into contact with the microscopic sandwiches, a chemical reaction occurred that emitted a light signal. An instrument inside the reader called a photomultiplier tube then translated the light signal into an electric current.

The molecule’s concentration in the blood–what the test sought to measure–could be inferred from the power of the electrical current, which was proportional to the intensity of the light.

This blood-testing technique was known as chemiluminescent immunoassay. (In laboratory speak, the word “assay” is synonymous with “blood test.”) The technique was not new: it had been pioneered in the early 1980s by a professor at Cardiff University. But Tony had automated it inside a machine that, though bigger than the toaster-size Theranos 1.0, was still small enough to make Elizabeth’s vision of placing it in patients’ homes possible. And it only required about 50 microliters of blood. That was more than 10 microliters Elizabeth initially insisted upon, but it still amounted to just a drop.

Once they had a functioning prototype–it worked much better than the system Ed was working on–Elizabeth suggested they call it the Edison (since everything else had failed). Elizabeth decided to use the Edison instead of the microfluidic system. Carreyrou points out the irony of this decision, given that the company had just filed a lawsuit to protect the intellectual property associated with the microfluidic system. Soon thereafter, Ed and his team were let go.

Carreyrou continues:

Shaunak followed Ed out the door two weeks later, albeit on friendlier terms. The Edison was at its core a converted glue robot and that was a pretty big step down from the lofty vision Elizebeth had originally sold him on. He was also unsettled by the constant staff turnover and the lawsuit hysteria.

Although Elizabeth was excited about the Edison, it was a long way from a finished product.

 

APPLE ENVY

Elizabeth worshipped Steve Jobs and Apple. In the summer of 2007, she started recruiting employees of Apple. Ana Arriola, a product designer who worked on the iPhone, was one such recruit.

…Elizabeth told Ana she envisioned building a disease map of each person through Theranos’s blood tests. The company would then be able to reverse engineer illnesses like cancer with mathematical models that would crunch the blood data and predict the evolution of tumors.

Ana and (later) her wife Corrine were impressed enough that Ana decided to leave behind fifteen thousand Apple shares. She was hired as Theranos’s chief design officer. Elizabeth wanted a software touchscreen like the iPhone’s for the Edison. And she wanted a sleek outer case.

Since fans like Channing Robertson and Don Lucas were starting to compare Elizabeth to Steve Jobs, Ana thought she should look the part. Soon Elizabeth was wearing a black turtleneck and black slacks most of the time.

Elizebeth’s idealism seemed like a good thing. But there continued to be other aspects of working at Theranos that seemed stifling (to say the least). Different groups were prevented from sharing information and working together. Moreover, employees knew they were being spied on–including what they did on their computer and what they did on Facebook.

Also, one of Elizabeth’s assistants kept track of how many hours each employee worked. Elizabeth had dinner catered–it arrived at 8 or 8:30 each night–in order to encourage people to put in more hours.

Finally, people were constantly getting fired from Theranos.

One person Elizabeth recruited to Theranos was Avie Tevanian. Avie was one of Steve Job’s closest friends. Avie had worked with Jobs and NeXT, and then went with Jobs to Apple in 1997. Avie was the head of software engineering. After an arduous decade, Avie retired. Elizabeth convinced Avie to join the Theranos board. Avie invested $1.5 million into the company in the 2006 offering.

The first couple of board meetings Avie attended had been relatively uneventful, but, by the third one, he’d begun to notice a pattern. Elizabeth would present increasingly rosy projections based on the deals she said Theranos was negotiating with pharmaceutical companies, but the revenues wouldn’t materialize. It didn’t help that Henry Mosley, the chief financial officer, had been fired soon after Avie became a director. At the last board meeting he’d attended, Avie had asked more pointed questions about the pharmaceutical deals and been told they were held up in legal review. When he’d asked to see the contracts, Elizabeth had said she didn’t have any copies readily available.

There were also repeated delays with the product’s rollout and the explanation for what needed to be fixed kept changing. Avie didn’t pretend to understand the science of blood-testing; his expertise was software. But if the Theranos system was in the final stages of fine-tuning as he’d been told, how could a completely different technical issue be the new holdup every quarter? That didn’t sound to him like a product that was on the cusp of commercialization.

Avie started asking more questions at the board meetings. Soon thereafter, Don Lucas contacted Avie and informed him that Elizabeth was upset with his behavior and wanted him to leave the board. Avie was surprised because he was just doing his duty as a board member. Avie decided to look at all the material he’d been given over the previous year, including investment material.

As he read them over, he realized that everything about the company had changed in the space of a year, including Elizabeth’s entire executive team. Don needed to see these, he thought.

Ana Arriola was also growing concerned. One morning, Ana brought up a question to Elizabeth. Given that the technology wasn’t working, why not pause the Tennessee study in order to fix the bugs first? They could always restart the study later once the product was functional. Elizabeth replied that Pfizer and every other big pharma company wanted her blood-testing system and Theranos was going to be a great company. Then Elizabeth suggested to Ana that she might be happier elsewhere.

Ana knew it wasn’t right to use an unreliable blood-test system in the Tennessee study. Later that same day, she resigned.

When Avie showed the material he’d gathered to Don, Don suggested to Avie that he resign. Avie was surprised that Don didn’t seem interested in the material. But Avie realized that he’d retired from Apple for good reason (to spend more time with his family). He didn’t need extra aggravation. So he told Don he would resign.

Don then brought up one more thing to Avie. Shaunak Roy was leaving and was selling his shares to Elizabeth. She needed the board to waive the company’s rights to repurchase Shaunak’s stock. Avie didn’t think that was a good idea. Don then said he wanted Avie to waive his own right as a board member to purchase the stock.

Avie was starting to get upset. He told Don to have Theranos’s general, Michael Esquivel, to send him the information. After reading it, Avie thought it was clear that he could buy some of Shaunak’s stock. Avie decided to do so and informed Esquivel. That prompted an argument.

At 11:17 p.m. on Christmas Eve, Esquivel sent Avie an email accusing him of acting in “bad faith” and warned him that Theranos was giving serious consideration to suing him for breach of his fiduciary duties as a board member and for public disparagement of the company.

Avie was astonished. Not only had he done no such things, in all his years in Silicon Valley he had never come close to being threatened with a lawsuit. All over the Valley, he was known as a nice guy. A teddy bear. He didn’t have any enemies. What was going on here?

Avie spoke with a friend who was a lawyer, who asked Avie if, given what he now knew, he really wanted to buy more shares in the company. No, thought Avie. But he did write a parting letter to Don summarizing his concerns. The letter concluded:

“I do hope you will fully inform the rest of the Board as to what happened here. They deserve to know that by not going along 100% ‘with the program’ they risk retribution from the Company/Elizabeth.”

 

GOODBYE EAST PALY

In early 2008, Theranos moved to a new location on Hillview Avenue in Palo Alto. It was a drastic improvement over their previous location in East Palo Alto. That area–east of Highway 101 (Bayshore Freeway)–was much poorer and had once been the country’s murder capital.

Matt Bissel, head of IT, was in charge of the move. At 4 o’clock in the afternoon the day before the movers were scheduled to come, Matt was pulled into a conference room. Elizabeth was on the line from Switzerland. She told Matt she’d just learned that Theranos would be charged an extra month’s rent if they waited until tomorrow. She told Matt to call the moving company immediately to see if they could do it. No way. But Elizabeth kept pushing. Someone pointed out that the blood samples wouldn’t be kept at the right temperature if they were moved immediately. Elizabeth said they could put them in refrigerated trucks.

Finally, Matt got Elizabeth to slow down after pointing out that they would still have to do an inspection with state officials to prove that they had properly disposed of any hazardous materials. That meant no new tenant could move in until then.

Matt greatly admired Elizabeth as one of the smartest people he’d ever met, and as an energizing leader. But he was starting to grow worried about some aspects of the company.

One aspect of Matt’s job had become increasingly distasteful to him. Elizabeth demanded absolute loyalty from her employees and if she sensed that she no longer had it from someone, she could turn on them in a flash. In Matt’s two and a half years at Theranos, he had seen her fire some thirty people, not counting the twenty or so employees who lost their jobs at the same time as Ed Ku when the microfluidic platform was abandoned.

Every time Elizabeth fired someone, Matt had to assist with terminating the employee…In some instances, she asked him to build a dossier on the person that she could use for leverage.

Matt was bothered in particular about how John Howard was treated.

When Matt reviewed all the evidence assembled for the Michael O’Connell lawsuit, he didn’t see anything proving that Howard had done anything wrong. He’d had contact with O’Connell but he’d declined to join his company. Yet Elizabeth insisted on connecting the dots in a certain way and suing him too, even though Howard been one of the first people to help her when she dropped out of Stanford, letting her use the basement of his house in Saratoga for experiments in the company’s early days.

Matt decided it was a good time to launch his own IT company. When he informed Elizabeth, she couldn’t believe it. She offered him a raise and a promotion, but he turned her down. Then she grew very cold. She offered one of Matt’s colleagues, Ed Ruiz, Matt’s position if he would look through Matt’s files and emails. Ed was good friends with Matt and refused. (There was nothing to find anyway.) A few months after Matt left, Ed decided to work for Matt’s new company.

Meanwhile, Aaron Moore and Mike Bauerly wanted to test two ofthe Edison prototypes built by Tony Nugent and Dave Nelson. This was informal “human factors” research to see how people reacted.

Aaron took photos with his digital camera to document what they were doing. The Eve Behar cases weren’t ready yet, so the devices had a primitive look. Their temporary cases were made from gray aluminum plates bolted together. The front plate tilted upward like a cat door to let the cartridge in. A rudimentary software interface sat atop the cat door at an angle. Inside, the robotic arm made loud, grinding sounds. Sometimes, it would crash against the cartridge and the pipette tips would snap off. The overall impression was that of an eighth-grade science project.

Aaron and Mike visited their friends’ offices to do the tests.

As the day progressed, it became apparent that one pinprick often wasn’t enough to get the job done. Transferring the blood to the cartridge wasn’t the easiest of procedures. The person had to swab his finger with alcohol, prick it with the lancet, apply the transfer pen to the blood that bubbled up from the finger to aspirate it, and then press on the transfer pen’s plunger to expel the blood into the cartridge. Few people got it right on their first try. Aaron and Mike kept having to ask their test subjects to prick themselves multiple times. It got messy. There was blood everywhere.

This confirmed Aaron was worried about: A fifty-five-year-old patient in his or her home was going to have trouble. Aaron passed on his concerns to Tony and Elizabeth, but they didn’t think it was important. Aaron was getting disillusioned.

A bit later, Todd Surdey was hired to run sales and marketing. One of Todd’s two subordinates was on the East Coast: Susan DiGiaimo. Susan had accompanied Elizabeth on quite a few sales pitches to drug makers. Susan had been uncomfortable about Elizabeth’s very lofty promises.

Todd asked Susan about Elizabeth’s revenue projections. Susan replied that they were vastly overinflated.

Moreover, no significant revenues would materialize unless Theranos proved to each partner that its blood system worked. To that effect, each deal provided for an initial tryout, a so-called validation phase…

The 2007 study in Tennessee was the validation phase of the Pfizer contract. Its objective was to prove that Theranos could help Pfizer gauge cancer patients’ response to drugs by measuring the blood concentration of three proteins the body produces in excess when tumors grow. If Theranos failed to establish any correlation between the patients’ protein levels and the drugs, Pfizer could end their partnership and any revenue forecast Elizabeth had extrapolated from the deal would turn out to be fiction.

Susan also shared with Todd that she had never seen any validation data. And when she went on demonstrations with Elizabeth, the devices often malfunctioned. A case in point was the one they’d just conducted at Novartis. After the first Novartis demo in late 2006 during which Tim Kemp had beamed a fabricated result from California to Switzerland, Elizabeth had continued to court the drug maker and had arranged a second visit to its headquarters in January 2008.

The night before that second meeting, Susan and Elizabeth had pricked their fingers for two hours in a hotel in Zurich to try to establish some consistency in the test results they were getting, to no avail.When they showed up at Novartis’s Basel offices the next morning, it got worse: all three Edison readers produced error messages in front of a room full of Swiss executives. Susan was mortified, but Elizabeth kept her composure and blamed a minor technical glitch.

Based on the intel he was getting from Susan and from other employees in Palo Alto, Todd became convinced that Theranos’s board was being misled about the company’s finances and the state of its technology.

Todd brought his concerns to Michael Esquivel, the company’s general counsel. Michael had been harboring his own suspicions. In March 2008, Todd and Michael approached Tom Brodeen, a Theranos board member. Since he was relatively new, he said they should raise their concerns with Don Lucas, the board’s chairman. So they did.

This time, Don Lucas had to take the matter seriously.

Lucas convened an emergency meeting of the board in his office on Sand Hill Road. Elizabeth was asked to wait outside the door while the other directors–Lucas, Brodeen, Channing Robertson, and Peter Thomas, the founder of an early stage venture capital firm called ATAventures–conferred inside.

After some discussion, the four men reached a consensus: they would remove Elizabeth as CEO. She had proven herself too young and inexperienced for the job. Tom Brodeen would step in to lead the company for a temporary period until a more permanent replacement could be found. They called in Elizabeth to confront her with what they had learned and inform her of their decision.

But then something extraordinary happened.

Over the course of the next two hours, Elizabeth convinced them to change their minds. She told them she recognized there were issues with her management and promised to change. She would be more transparent and responsive going forward. It wouldn’t happen again.

A few weeks later, Elizabeth fired Todd and Michael. Soon thereafter, Justin Maxwell, a friend of Aaron and Mike’s, decided to resign. His resignation email included this:

believe in the people who disagree with you… Lying is a disgusting habit, and it flows through the conversations here like its our own currency. The cultural disease here is what we should be curing… I mean no ill will towards you, since you believe in what I was doing and hoped I would succeed at Theranos.

A few months later, Aaron Moore and Mike Bauerly resigned.

 

THE CHILDHOOD NEIGHBOR

Richard Fuisz was a medical inventor and entrepreneur. He was following what Elizabeth was doing at Theranos. The Fuisz and Holmes families had been friends for two decades.

Elizabeth’s mother, Noel, and Richard’s wife, Lorraine, had developed a close friendship. But the husbands weren’t as close. This may have been because Chris Holmes was on a government salary, while Richard Fuisz was a successful businessman who liked to flaunt it.

Money was indeed a sore point in the Holmes household. Chris’s grandfather, Christian Holmes II, had depleted his share of the Fleischmann fortune by living a lavish and hedonistic lifestyle on an island in Hawaii, and Chris’s father, Christian III, had frittered away what was left during an unsuccessful career in the oil business.

Carreyrou later explains:

Richard Fuisz was a vain and prideful man. The thought that the daughter of longtime friends and former neighbors would launch a company in his area of expertise and that they wouldn’t ask for his help or even consult him deeply offended him.

Carreyrou again:

Fuisz had a history of taking slights personally and bearing grudges. The lengths he was willing to go to get even with people he perceived to have crossed him is best illustrated by his long and protracted feud with Vernon Loucks, the CEO of hospital supplies maker Baxter International.

Fuisz traveled frequently to the Middle East in the 1970s and early 1980s because it was the biggest market for his medical film business, Medcom. On one of these trips, he ran into Loucks. Over dinner, Loucks offered to buy Medcom for $53 million. Fuisz agreed.

Fuisz was supposed to be head of the new Baxter subsidiary for three years, but Loucks dismissed him after the acquisition closed. Fuisz sued Baxter for wrongful termination, asserting that Loucks fired him for refusing to pay a $2.2 million bribe to a Saudi firm to remove Baxter from an Arab blacklist of companies doing business with Israel. Carreyrou:

The two sides reached a settlement in 1986, under which Baxter agreed to pay Fuisz $800,000. That wasn’t the end of it, however. When Fuisz flew to Baxter’s Deerfield, Illinois, headquarters to sign the settlement, Loucks refused to shake his hand, angering Fuisz and putting him back on the warpath.

In 1989, Baxter was taken off the Arab boycott list, giving Fuisz an opening to seek his revenge. He was leading a double life as an undercover CIA agent by then, having volunteered his services to the agency a few years earlier after coming across one of its ads in the classified pages of the Washington Post.

Fuisz’s work for the CIA involved setting up dummy corporations throughout the Middle East that employed agency assets, giving them a non-embassy cover to operate outside the scrutiny of local intelligence services. One of the companies supplied oil-rig operators to the national oil company of Syria, where he was particularly well-connected.

Fuisz suspected Baxter had gotten itself back in Arab countries’ good graces through chicanery and set out to prove it using his Syrian connections.He sent a female operative he’d recruited to obtain a memorandum kept on file in the offices of the Arab League committee in Damascus that was in charge of enforcing the boycott. It showed that Baxter had provided the committee detailed documentation about its recent sale of an Israeli plant and promised it wouldn’t make new investments in Israel or sell the country new technologies. This put Baxter in violation of a U.S. anti-boycott law, enacted in 1977, that forbade American companies from participating in any foreign boycott or supplying blacklist officials any information that demonstrated cooperation with the boycott.

Fuisz sent a copy of the memo to Baxter’s board of directors and another copy to the Wall Street Journal. The Journal published a front-page story. Fuisz then was able to get copies of letters Baxter’s general counsel had written to a general in the Syrian army. These letters confirmed the memo.

The revelations led the Justice Department to open an investigation. In March 1993, Baxter was forced to plead guilty to a felony charge of violating the anti-boycott law and to pay $6.6 million in civil and criminal fines. The company was suspended from new federal contracts for four months and barred from doing business in Syria and Saudi Arabia for two years. The reputational damage also cost it a $50 million contract with a big hospital group.

Fuisz was upset, however, that Loucks still remained CEO. So he came up with another attack. Loucks was a Yale alumnus and served as trustee of Yale Corporation, the university’s governing body. He also chaired the university’s fund-raising campaign. Commencement ceremonies were coming up that May.

Through his son Joe, who had graduated from Yale the year before, Fuisz got in touch with a student named Ben Gordon, who was the president of Yale Friends of Israel association. Together, they organized a graduation day protest featuring “Loucks Is Bad for Yale” signs and leaflets. The crowning flourish was a turboprop plane Fuisz hired to fly over the campus trailing a banner that read, “Resign Loucks.”

Three months later, Loucks stepped down as Yale trustee.

All of that said, Fuisz’s initial interest in Theranos’s technology came more from opportunism than any desire for revenge. Fuisz had made quite a bit of money by patenting inventions he thought other companies would want at some point. Carreyrou:

One of his most lucrative plays involved repurposing a cotton candy spinner to turn drugs into fast-dissolving capsules. The idea came to him when he took his daughter to a country fair in Pennsylvania in the early 1990s. He later sold the public corporation he formed to house the technology to a Canadian pharmaceutical company for $154 million and personally pocketed $30 million from the deal.

Fuisz listened to an interview Elizabeth did for NPR’s “Biotech Nation,” in May 2005. In that interview, Elizabeth explained how her blood-test system could be used for at-home monitoring of adverse reactions to drugs.

…But as a trained physician, he also spotted a potential weakness he could exploit. If patients were going to test their blood at home with the Theranos device to monitor how they were tolerating the drugs they were taking, there needed to be a built-in mechanism that would alert their doctors when the results came back abnormal.

He saw a chance to patent that missing element, figuring there was money to be made down the road, whether from Theranos or someone else. His thirty-five years of experience patenting medical inventions told him such a patent might eventually command up to $4 million for an exclusive license.

Fuisz filed a fourteen-page patent application with he U.S. Patent and Trademark office on April 24, 2006.It didn’t claim to invent new technology, but to combine existing technologies–wireless data transmission, computer chips, and bar codes–into a physician alert mechanism that could be part of at-home blood-testing devices. The application said clearly that it was targeting the company Theranos.

Meanwhile, for other reasons, the Fuisz and Holmes families grew apart. By the time Elizabeth became aware of Richard Fuisz’s patent, the two families were no longer on speaking terms.

 

SUNNY

Chelsea Burkett and Elizabeth had been friends at Stanford. Elizabeth recruited Chelsea to Theranos. Chelsea found Elizabeth to be very persuasive:

She had this intense way of looking at you while she spoke that made you believe in her and want to follow her.

About the same time Chelsea joined Theranos, Ramesh “Sunny” Balwani came on board as a senior Theranos executive. All that Chelsea knew was that Sunny was Elizabeth’s boyfriend and that they were living together in a Palo Alto apartment. Sunny immediately asserted himself and seemed omnipresent.

Sunny was a force of nature, and not in a good way. Though only about five foot five and portly, he made up for his diminutive stature with an aggressive, in-your-face management style. His thick eyebrows and almost-shaped eyes, set above a mouth that drooped at the edges and a square chin, projected an air of menace. He was haughty and demeaning towards employees, barking orders and dressing people down.

Chelsea took an immediate dislike to him even though he made an effort to be nicer to her in deference to her friendship with Elizabeth. She didn’t understand what her friend saw in this man, who was nearly two decades older than she was and lacking in the most basic grace and manners. All her instincts told her Sunny was bad news, but Elizabeth seemed to have the utmost confidence in him.

Elizabeth and Sunny had met in Beijing when Elizabeth was in her third year of a Stanford program that taught students Mandarin. Apparently, Elizabeth had been bullied by some of the students and Sunny came to her defense.

Sunny was born and raised in Pakistan. He pursued his undergraduate studies in the U.S. Then he worked for a decade as a software engineer for Lotus and Microsoft. In 1999, Sunny joined CommerceBid.com, which was developing software that would have suppliers bid against one another in an auction. The goal was to achieve economies of scale and lower prices.

In November 1999, a few months after Sunny joined CommerceBid as president and chief technology officer, the company was acquired for $232 million in cash and stock. Carreyrou:

It was a breathtaking price for a company that had just three clients testing its software and barely any revenues. As the company’s second-highest-ranking executive, Sunny pocketed more than $40 million. His timing was perfect. Five months later, the dot-com bubble popped and the stock market came crashing down.Commerce One [the company that acquired CommerceBid] eventually filed for bankruptcy.

Yet Sunny didn’t see himself as lucky. In his mind, he was a gifted businessman and the Commerce One windfall was a validation of his talent. When Elizabeth met him a few years later, she had no reason to question that. She was an impressionable eighteen-year-old girl who saw in Sunny what she wanted to become: a successful and wealthy entrepreneur. He became her mentor, the person who would teach her about business in Silicon Valley.

In 2004, the IRS forced Sunny to pay millions in back taxes after he had tried to use a tax shelter. Sunny liked to flaunt his wealth. He drove a black Lamborghini Gallardo and a black Porsche 911. Carreyrou writes:

He wore white designer shirts with puffy sleaves, acid-washed jeans, and blue Gucci loafers. His shirts’ top three buttons were always undone, causing his chest hair to spill out and revealing a thin gold chain around his neck. A pungent scent of cologne emanated from him at all times. Combined with the flashy cars, the overall impression was of someone heading out to a nightclub rather than to the office.

Sunny was supposed to be an expert in software. He even bragged that he’d written a million lines of code. Some employees thought that was an absurd claim. (Microsoft software engineers had written the Windows operating system at a rate of one thousand lines of code per year, notes Carreyrou.)

Carreyrou adds:

There was also the murky question of what she told the board about their relationship. When Elizabeth informed Tony that Sunny was joining the company, Tony asked her point-blank whether they were still a couple. She responded that the relationship was over. Going forward, it was strictly business, she said. But that would prove not to be true.

Carreyrou continues:

When Elizabeth pitched pharmaceutical executives now, she told them that Theranos would forecast how patients would react to the drugs they were taking. Patients’ test results would be input into a proprietary computer program the company had developed. As more results got fed into the program, its ability to predict how markers in the blood were likely to change during treatment would become better and better, she said.

It sounded cutting-edge, but there was a catch: the blood-test results had to be reliable for the computer program’s predictions to have any value… Theranos was supposed to help Centocor [in Antwerp, Belgium] to assess how patients were responding to an asthma drug by measuring a biomarker in their blood called allergen-specific immunoglobulin E, or IgE, but the Theranos devices seemed very buggy to Chelsea. There were frequent mechanical failures. The cartridges either wouldn’t slot into the readers properly or something inside the readers would malfunction. Even when the devices didn’t break down, it could be a challenge coaxing any kind of output from them.

Sunny always blamed the wireless connection. That was true sometimes, but there were other things that could interfere. Nearly all blood tests require some dilution, but too much dilution made it harder for Theranos to get accurate results.

The amount of dilution the Theranos system required was greater than usual because of the small size of the blood samples Elizabeth insisted on.

Furthermore, to function properly, the Edisons required the ambient temperature to be exactly 34 degrees Celsius. Two 11-volt heaters built into the reader tried to maintain that temperature during a blood test. But in colder settings, including some hospitals in Europe, the temperature couldn’t be maintained.

Meanwhile, Pfizer had ended its collaboration with Theranos because it was not impressed by the results of the Tennessee validation study.

The study had failed to show any clear link between drops in the patients’ protein levels and the administration of the antitumor drugs. And the report had copped to some of the same snafus Chelsea was now witnessing in Belgium, such as mechanical failures and wireless transmission errors.

When Chelsea returned from her three-week trip to Europe, she found that Elizabeth and Sunny were now focused on Mexico, where a swine flu epidemic had been raging. Seth Michelson, Theranos’ chief scientific officer, had suggested an idea to Elizabeth.

Seth had told Elizabeth about a math model called SEIR (Susceptible, Exposed, Infected, and Resolved) that he thought could be adapted to predict where the swine flu virus would spread next. For it to work, Theranos would need to test recently infected patients and input their blood-test results into the model. That meant getting the Edison readers and cartridges to Mexico.Elizabeth envisioned putting them in the beds of pickup trucks and driving them to the Mexican villages on the front lines of the outbreak.

Because Chelsea was fluent in Spanish, she and Sunny were sent. Elizabeth used her family connections in order to get authorization to use the experimental medical device in Mexico.

Once again, things did not go smoothly. Frequently, the readers flashed error messages, or the result that came back from Palo Alto was negative for the virus when it should have been positive. Some of the readers didn’t work at all. And Sunny continued to blame the wireless transmission.

Chelsea grew frustrated and miserable. She questioned what she was even doing there. Gary Frenzel and some of the other Theranos scientists had told her that the best way to diagnose H1N1, as the swine flu virus was called, was with a nasal swab and that testing for it in blood was a questionable utility. She’d raised this point with Elizabeth before leaving, but Elizabeth had brushed it off.”Don’t listen to them,” she’d said of the scientists. “They’re always complaining.”

At the time, Theranos was struggling financially:

The $15 million Theranos had raised in its first two funding rounds was long gone and the company had already burned through the $32 million Henry Mosley had been instrumental in bringing in during its Series C round in late 2006. The company was being kept afloat by a loan Sunny had personally guaranteed.

Meanwhile, Sunny was also traveling to Thailand to set up another swine flu testing outpost. The epidemic had spread to Asia, and the country was one of the region’s hardest hit with tens of thousands of cases and more than two hundred deaths. But unlike in Mexico, it wasn’t clear that Theranos’s activities in Thailand were sanctioned by local authorities. Rumors were circulating among employees that Sunny’s connections there were shady and that he was paying bribes to obtain blood samples from infected patients. When a colleague of Chelsea’s in the client solutions group named Stefan Hristu quit immediately upon returning from a trip to Thailand with Sunny in January 2010, many took it to mean the rumors were true.

On the whole, Sunny had created a culture of fear with his bullying behavior. The high rate of firings continued, and Sunny had taken charge of it. Remaining employees started to say, “Sunny disappeared him” whenever Sunny fired someone.

The scientists, especially, were afraid of Sunny.One of the only ones who stood up to him was Seth Michelson. A few days before Christmas, Seth had gone out and purchased polo shirts for his group.Their color matched the green of the company logo and they had the words “Theranos Biomath” emblazoned on them.Seth thought it was a nice team-building gesture and paid for it out of his own pocket.

When Sunny saw the polos, he got angry. He didn’t like that he hadn’t been consulted and he argued that Seth’s gift to his team made the other managers look bad. Earlier in his career, Seth had worked at Roche, the big Swiss drug maker, where he’d been in charge of seventy people and an annual budget of $25 million. He decided he wasn’t going to let Sunny lecture him about management. He pushed back and they got into a yelling match.

Soon thereafter, Seth found another job at Genomic Health in Redwood City. When he went to give his resignation letter to Elizabeth, Sunny was there. He read the letter and threw it in Seth’s face, shouting, “I won’t accept this!”

Seth shouted back: “I have news for you, sir: in 1863, President Lincoln freed the slaves!”

Sunny’s response was to throw him out of the building.It was weeks before Seth was able to retrieve his math books, scientific journals, and the pictures of his wife on his desk. He had to enlist the company’s new lawyer, Jodi Sutton, and a security guard to help him pack his things late on a weeknight when Sunny wasn’t around.

Sunny also got into a yelling match with Tony Nugent. Chelsea attempted to get through to Elizabeth about Sunny, but she was unable to.

Chelsea wanted to quit, but still wasn’t sure. Then one day the Stanford student with the family connections to Mexico stopped by with his father, who was dealing with a cancer scare of some sort. Elizabeth and Sunny persuaded him to allow Theranos to test his blood for cancer biomarkers.

Chelsea was appalled. The validation study in Belgium and the experiments in Mexico and Thailand were one thing. Those were supposed to be for research purposes only and to have no bearing on the way patients were treated. But by encouraging someone to rely on a Theranos blood test to make an important medical decision was something else altogether. Chelsea found it reckless and irresponsible.

She became further alarmed when not long afterward Sunny and Elizabeth began circulating copies of the requisition forms doctors used to order blood tests from laboratories and speaking excitedly about the great opportunities that lay in consumer testing.

I’m done, Chelsea thought to herself. This has crossed too many lines.

[…]

Chelsea also worried about Elizabeth. In her relentless drive to be a successful startup founder, she had built a bubble around herself that was cutting her off from reality. And the only person she was letting inside was a terrible influence. How could her friend not see that?

 

DR. J

Dr. J was Jay Rosen’s nickname. Rosen is a doctor who is a member of Walgreens’s innovation team, whose goal is to find ideas and technologies that could create growth.

In January 2010, Theranos approached Walgreens with an email stating that it had developed small devices capable of running any blood test from a few drops pricked from a finger in real time and for less than half the cost of traditional laboratories. Two months later, Elizabeth and Sunny traveled to Walgreens’s headquarters in the Chicago suburb of Deerfield, Illinois, and gave a presentation to a group of Walgreens executives. Dr. J, who flew up from Pennsylvania for the meeting, instantly recognized the potential for the Theranos technology. Bringing the startup’s machines inside Walgreens stores could open up a big new revenue stream for the retailer and be the game changer it had been looking for, he believed.

…The picture Elizabeth presented at the meeting of making blood tests less painful and more widely available so they could become an early warning system against disease deeply resonated with him.

On August 24, 2010, a Walgreens delegation arrived at the Theranos office in Palo Alto for a two-day meeting. Kevin Hunter was the leader of a small lab consulting firm Colaborate. Walgreens had hired him to evaluate and launch a partnership it was setting up with the startup. Hunter’s father, grandfather, and great-grandfather had all been pharmacists.

Walgreens and Theranos had signed a preliminary contract. Walgreens would prepurchase up to $50 million worth of Theranos cartridges and loan the startup $25 million. If the pilot went well, the companies would expand their partnership nationwide.

Hunter asked to see the lab, but Elizabeth said later if there was time. Hunter asked again. Elizabeth pulled Dr. J aside. Then Dr. J informed Hunter that they wouldn’t see the lab yet.

Theranos had told Walgreens it had a commercially ready laboratory and had provided it with a list of 192 different blood tests it said its proprietary devices could handle. In reality, although there was a lab downstairs, it was just an R&D lab where Gary Frenzel and his team of biochemists conducted their research.Moreover, half of the tests on the list couldn’t be performed as chemiluminescent immunoassays, the testing technique the Edison system relied on. These required different testing methods beyond the Edison’s scope.

Carreyrou writes:

Hunter was beginning to grow suspicious. With her black turtleneck, her deep voice, and the green kale shakes she sipped on all day, Elizabeth was going to great lengths to emulate Steve Jobs, but she didn’t seem to have a solid understanding of what distinguished different types of blood tests. Theranos had also failed to deliver on his two basic requests: to let him see its lab and to demonstrate a live vitamin D test on its device.Hunter’s plan had been to have Theranos test his and Dr. J’s blood, then get retested at Stanford Hospital that evening and compare results. He’d even arranged for a pathologist to be on standby at the hospital to write the order and draw their blood. But Elizabeth claimed she’d been given too little notice even though he’d made the request two weeks ago.

Despite Hunter’s suspicions, Dr. J and the Walgreens CFO, Wade Miquelon, continued to be big fans of Elizabeth.

In September 2010, Elizabeth and Sunny met with Walgreens executives at the company’s headquarters in Deerfield. Elizabeth and Sunny suggested they do blood tests on the executives. Hunter wasn’t at the meeting, but he heard about the blood tests later. He thought it was a good opportunity to see how the technology performed.

Hunter asked about the blood-test results a few days later on the weekly video conference call the companies were using as their primary mode of communication. Elizabeth responded that Theranos could only release the results to a doctor. Dr J…reminded everyone that he was a trained physician, so why didn’t Theranos go ahead and send him the results? They agreed that Sunny would follow up separately with him.

A month passed and still no results.

There was another issue, too.Theranos had suddenly changed its regulatory strategy. Initially Theranos said the blood tests would qualify as “waived” under the Clinical Laboratory Improvement Amendments, a 1988 federal law that covered laboratories.

CLIA-waved tests usually involved simple laboratory procedures that the Food and Drug Administration had cleared for home use.

Now, Theranos was changing its tune and saying the tests it would be offering in Walgreens stores were “laboratory-developed tests.” It was a big difference: laboratory-developed tests lay in a gray zone between the FDA and another federal health regulator, the Centers for Medicare and Medicaid Services. CMS, as the latter agency was known, exercised oversight of clinical laboratories under CLIA, while the FDA regulated the diagnostic equipment that laboratories bought and used for their testing. But no one closely regulated tests that labs fashioned with their own methods. Elizabeth and Sunny had a testy exchange with Hunter over the significance of the change. They maintained that all the big laboratory companies mostly used laboratory-developed tests, which Hunter knew not to be true.

Hunter argued that it was now even more important to make sure Theranos’s tests were accurate. He suggested a fifty-patient study, which he could easily arrange. Hunter noticed that Elizabeth became defensive immediately. She said they didn’t want to do it “at this time,” and she quickly changed the subject.

After they hung up, Hunter took aside Renaat Van den Hooff, who was in charge of the pilot on the Walgreens side, and told him something just wasn’t right. The red flags were piling up. First, Elizabeth had denied him access to their lab. Then she’d rejected his proposal to embed someone with them in Palo Alto. And now she was refusing to do a simple comparison study. To top it all off, Theranos had drawn the blood of the president of Walgreen’s pharmacy business, one of the company’s most senior executives, and failed to give him a test result!

Van den Hooff told Hunter:

“We can’t not pursue this. We can’t risk a scenario where CVS has a deal with them in six months and it ends up being real.”

Almost everything Walgreens did was done with its rival CVS in mind.

Theranos had cleverly played on this insecurity. As a result, Walgreens suffered from a severe case of FoMO–the fear of missing out.

There were two more things Theranos claimed were proof that its technology works. First, there was clinical trial work Theranos had done with pharmaceutical companies. Hunter had called the pharmaceutical companies, but hadn’t been able to reach anyone who could verify Theranos’s claims. Second, Dr. J had commissioned Johns Hopkins University’s medical school to do a review of Theranos’s technology.

Hunter asked to see the Johns Hopkins review. It was a two-page document.

When Hunter was done reading it, he almost laughed.It was a letter dated April 27, 2010, summarizing a meeting Elizabeth and Sunny had had with Dr. J and five university representatives on the Hopkins campus in Baltimore. It stated that they had shown the Hopkins team “proprietary data on test performance” and that Hopkins had deemed the technology “novel and sound.” But it also made clear that the university had conducted no independent verification of its own. In fact, the letter included a disclaimer at the bottom of the second page: “The materials provided in no way signify an endorsement by Johns Hopkins Medicine to any product or service.”

In addition to Walgreens, Theranos also tried to get Safeway as a partner. Elizabeth convinced Safeway’s CEO, Steve Burd, to do a deal. Safeway loaned Theranos $30 million. Safeway also committed to a massive renovation project of its stores, creating new clinics where customers could have their blood tested on Theranos devices. Burd saw Elizabeth as a genius.

In early 2011, Hunter was informed that Elizabeth and Sunny no longer wanted him on the calls or in meetings between Theranos and Walgreens. Hunter asked: Why Walgreens was paying him $25,000 a month to look out for its interests if he couldn’t do his job, which includes asking tough questions?

 

THE MINILAB

Elizabeth had told Walgreens and Safeway that Theranos’s technology could perform hundreds of tests on small blood samples.

The truth was that the Edison system could only do immunoassays, a type of test that uses antibodies to measure substances in the blood. Immunoassays included some commonly ordered lab tests such as tests to measure vitamin D or to detect prostrate cancer. But many other routine blood tests, ranging from cholesterol to blood sugar, required completely different laboratory techniques.

Elizabeth needed a new device, one that could perform more than just one class of test. In November 2010, she hired a young engineer named Kent Frankovich and put him in charge of designing it.

Kent had just earned a master’s degree in mechanical engineering from Stanford. Prior to that, he’d worked for two years at NASA’s Jet Propulsion Laboratory in Pasadena, where he’d helped construct Curiosity, the Mars rover. Kent recruited a friend–Greg Baney–from NASA to Theranos.

Carreyrou notes that for several months, Kent and Greg were Elizabeth’s favorite employees. She joined their brainstorming sessions and offered some suggestions about what robotic systems they should consider. Elizabeth called the new system the “miniLab.”

Because the miniLab would be in people’s homes, it had to be small.

This posed engineering challenges because, in order to run all the tests she wanted, the miniLab would need to have many more components than the Edison. In addition to Edison’s photomultiplier tube, the new device would need to cram three other laboratory instruments in one small space: a spectrophotometer, a cytometer, and an isothermal amplifier.

None of these were new inventions…

Laboratories all over the world had been using these instruments for decades. In other words, Theranos wasn’t pioneering any new ways to test blood. Rather, the miniLab’s value would lie in the miniaturization of existing lab technology. While that might not amount to groundbreaking science, it made sense in the context of Elizabeth’s vision of taking blood testing out of central laboratories and bringing it to drugstores, supermarkets, and, eventually, people’s homes.

To be sure, there were already portable blood analyzers on the market. One of them, a device that looked like a small ATM called the Piccolo Express, could perform thirty-one different blood tests and produce results in as little as twelve minutes. It required only three or four drops of blood for a panel of a half dozen commonly ordered tests. However, neither the Piccolo nor other existing portable analyzers could do the entire range of laboratory tests. In Elizabeth’s mind, that was going to be the miniLab’s selling point.

Greg thought they should take off-the-shelf components and get the overall system working first before miniaturizing it. Trying to miniaturize before having a working prototype didn’t make sense. But Elizabeth wouldn’t hear of it.

In the spring of 2011, Elizabeth hired her younger brother, Christian. Although two years out of college–Duke University–and with no clear qualifications to work at a blood diagnostics company, what mattered to Elizabeth was that she could trust her brother. Christian soon recruited five fraternity brothers: Jeff Blickman, Nick Menchel, Dan Edlin, Sani Hadziahmetovic, and Max Fosque. The became known inside Theranosas “the Frat Pack.”

Like Christian, none of the other Duke boys had any experience or training relevant to blood testing or medical devices, but their friendship with Elizabeth’s brother vaulted them above most other employees in the company hierarchy.

Meanwhile, Greg had brought several of his own friends, Jordan Carr, Ted Pasco, and Trey Howard.

Jordan, Trey, and Ted were all assigned to the product management group with Christian and his friends, but they weren’t granted the same level of access to sensitive information. Many of the hush-hush meetings Elizabeth and Sunny held to strategize about the Walgreens and Safeway partnerships were off limits to them, whereas Christian and his fraternity brothers were invited in.

At the holiday party in December 2011, Elizabeth gave a speech which included the following:

“The miniLab is the most important thing humanity has ever built. If you don’t believe this is the case, you should leave now. Everyone needs to work as hard as humanly possible to deliver it.”

By this point, Greg had decided to leave Theranos in two months. He had become disillusioned:

The miniLab Greg was helping build with a prototype, nothing more. It needed to be tested thoroughly and fine-tuned, which would require time. A lot of time. Most companies went through three cycles of prototyping before they went to market with a product. But Sunny was already placing orders for components to build one hundred miniLabs, based on a first, untested prototype. It was as if Boeing built one plane and, without doing a single flight test, told airline passengers, “Hop aboard.”

One problem that would require a great deal of testing was thermal. Packing many instruments together in a small space led to unpredicted variations in temperature.

 

THE WELLNESS PLAY

Safeway’s business was struggling. On an earnings call, CEO Steve Burd was asked why the company was buying back stock in order to boost earnings per share. Burd responded that the company was about to do well, so buying back shares was the right move. Burd elaborated by saying that the company was planning a significant “wellness play.” Analysts inferred that Safeway had a secret plan to ignite growth.

Burd had high hopes for the venture. He’d ordered the remodeling of more than half of Safeway’s seventeen hundred stores to make room for upscale clinics with deluxe carpeting, custom wood cabinetry, granite countertops, and flat-screen TVs. Per Theranos’s instructions, they were to be called wellness centers and had to look “better than a spa.” Although Safeway was shouldering the entire cost of the $350 million renovation on its own, Burd expected it to more than pay for itself once the new clinics started offering the startup’s novel blood tests.

…[Burd] was starry-eyed about the young Stanford dropout and her revolutionary technology, which fit so perfectly with his passion for preventative healthcare.

Elizabeth had a direct line to Burd and answered only to him… He usually held his deputies and the company’s business partners to firm deadlines, but he allowed Elizabeth to miss one after the other.

In early 2012, the companies had agreed that Theranos would be in charge of blood testing at a Safeway employee health clinic on its corporate campus in Pleasanton.

Safeway’s first chief medical officer was Kent Bradley. Bradley attended West Point and then the armed forces’ medical school in Bethesda, Maryland. Then he served the U.S. Army for seventeen years before Safeway hired him. Bradley looked forward to seeing the Theranos system in action.

However, he was surprised to learn that Theranos wasn’t planning on putting any of its devices in the Pleasanton clinic. Instead, it had stationed two phlebotomists there to draw blood, and the samples they collected were couriered across San Francisco Bay to Palo Alto for testing. He also noticed that the phlebotomists were drawing blood from every employee twice, once with a lancet applied to the index finger and a second time the old-fashioned way with a hypodermic needle inserted in the arm. Why the need for venipunctures–the medical term for needle draws–if the Theranos finger-stick technology was fully developed and ready to be rolled out to consumers, he wondered.

Bradley’s suspicions were further aroused by the amount of time it took to get results back. His understanding had been that the tests were supposed to be quasi-instantaneous, but some Safeway employees were having to wait as long as two weeks to receive their results. And not every test was performed by Theranos itself. Even though the startup had not said anything about outsourcing some of the testing, Bradley discovered that it was farming out some tests to a big reference laboratory in Salt Lake City called ARUP.

What really set off Bradley’s alarm bells, though, was when some otherwise healthy employees started coming to him with concerns about abnormal test results. As a precaution, he sent them to get retested at a Quest or LabCorp location. Each time, the new set of tests came back normal, suggesting the Theranos results were off…

Bradley put together a detailed analysis of the discrepancies. Some of the differences between the Theranos values and the values from the other labs were disturbingly large. When the Theranos values did match those of the other labs, they tended to be for tests performed by ARUP.

Bradley ended up taking his concerns to Burd, but Burd assured the doctor that Theranos’s technology had been tested and was reliable.

Theranos had a temporary lab in East Meadow Circle in Palo Alto. The lab had gotten a certificate saying it was in compliance with CLIA–the federal law that governed clinical laboratories. But such certificates were easy to obtain.

Although the ultimate enforcer of CLIA was the Centers for Medicare and Medicaid Services, the federal agency delegated most routine lab inspections to states. In California, they were handled by the state department of health’s Laboratory Field Services division, which an audit had shown to be badly underfunded and struggling to fulfill its oversight responsibilities.

The East Meadows Circle lab didn’t contain a single Theranos proprietary device. The miniLab was still being developed and was a long way from being ready for patient testing. Instead, the lab had more than a dozen commercial blood and body-fluid analyzers made by companies such as Chicago-based Abbott Laboratories, Germany’s Siemens, and Italy’s DiaSorin. Arne Gelb, a pathologist, ran the lab. A handful of clinical laboratory scientists (CLSs) helped Arne.

One CLS named Kosal Lim was poorly trained and sloppy. An experienced colleague, Diana Dupuy, believed Lim was harming the accuracy of the test results.

To Dupuy, Lim’s blunders were inexcusable.They included ignoring manufacturers’ instructions for how to handle reagents; putting expired reagents in the same refrigerator as current ones; running patient tests on lab equipment that hadn’t been calibrated; improperly performing quality-control runs on an analyzer; doing tasks he hadn’t been trained to do; and contaminating a bottle of Wright’s stain, a mixture of dyes used to differentiate blood cell types.

Dupuy documented Lim’s mistakes in regular emails to Arne and to Sunny, often including photos.

Dupuy also had concerns about the competence of the two phlebotomists Theranos had stationed in Pleasanton. Blood is typically spun down in a centrifuge before it’s tested to separate its plasma from the patient’s blood cells. The phlebotomists hadn’t been trained to use the centrifuge they’d been given and they didn’t know how long or at what speed to spin down patients’ blood. When they arrived in Palo Alto, the plasma samples were often polluted with particulate matter. She also discovered that many of the blood-drawing tubes Theranos was using were expired, making the anticoagulant in them ineffective and compromising the integrity of the specimens.

Dupuy was sent to Delaware to train on a new Siemens analyzer Theranos bought. When she got back to the lab, it was spotless.

Sunny, who appeared to have been waiting for her, summoned her into a meeting room. In an intimidating tone, he informed her that he had taken a tour of the lab in her absence and found not a single one of her complaints to be justified.

Sunny promptly fired her. He rehired her based on Arne’s recommendation. Then Sunny fired Dupuy again several weeks later. She was immediately escorted from the building without a chance to grab her personal belongings. Dupuy sent an email to Sunny–and copied Elizabeth–which included the following:

“I was warned by more than 5 people that you are a loose cannon and it all depends on your mood as to what will trigger you to explode. I was also told that anytime someone deals with you it’s never a good outcome for that person.

The CLIA lab is in trouble with Kosal running the show and no one watching him or Arne. You have a mediocre Lab Director taking up for a sub-par CLS for whatever reason. I fully guarantee that Kosal will certainly make a huge mistake one day in the lab that will adversely affect patient results.I actually think he has already done this on several accounts but has put the blame on the reagents. Just as you stated everything he touches is a disaster!

I only hope that somehow I bring awareness to you that you have created a work environment where people hide things from you out of fear. You cannot run a company through fear and intimidation… it will only work for a period of time before it collapses.”

As for the Safeway partnership, Theranos kept pushing back the date for the launch. Burd had to keep telling analysts and investors on each quarterly earnings call that the new program was just about to launch, only to have it be delayed again. Safeway’s finance department forecast revenues of $250 million, which was aggressive. The revenues hadn’t materialized, however, and Safeway had spent $350 million just to build the wellness centers. Safeway’s board was starting to get upset. Although Burd had done an excellent job during his first decade as CEO, the second decade hadn’t been very good. The costs and delays associated with the wellness centers prompted the board to ask Burd to retire. He agreed.

Safeway then had to contact Sunny or the Frat Pack if they wanted to communicate with Theranos. Sunny always acted upset as if his time was too valuable, as if Theranos’s technology was a massive innovation requiring a huge time commitment. Safeway executives were very upset about Sunny’s attitude. But they still worried that they might miss out, so they didn’t walk away from the partnership.

 

“WHO IS LTC SHOEMAKER?”

Lieutenant Colonel David Shoemaker was part of a small military delegation meeting in Palo Alto in November 2011 to bless Theranos’s deploying its devices in the Afghan war theatre. Only, instead of blessing the proposal, LTC Shoemaker told Elizabeth that there were various regulations her approach would fail to meet.

The idea of using Theranos devices on the battlefield had germinated the previous August when Elizabeth had met James Mattis, head of the U.S. Central Command, at the Marines’ Memorial Club in San Francisco. Elizabeth’s impromptu pitch about how her novel way of testing blood from just a finger prick could help diagnose and treat wounded soldiers faster, and potentially save lives, had found a receptive audience in the four-star general. Jim “Mad Dog” Mattis was fiercely protective of his troops, which made him one of the most popular commanders in the U.S. military. The hard-charging general was open to pursuing any technology that might keep his men safer as they fought the Taliban in the interminable, atrocity-marred war in Afghanistan.

This type of request had to go through the army’s medical department. Shoemaker’s job was to makes sure the army followed all laws and regulations when it tested medical devices. With regard to Theranos, the company would have to get approval from the FDA at a minimum.

Elizabeth disagreed forcefully, citing advice Theranos received from its lawyers. She was so defensive and obstinate that Shoemaker quickly realized that prolonging the argument would be a waste of time. She clearly didn’t want to hear anything that contradicted her point of view. As he looked around the table, he noted that she had brought no regulatory affairs expert to the meeting. He suspected the company didn’t even employ one. If he was right about that, it was an incredibly na¯ve way of operating. Health care was the most highly regulated industry in the country, and for good reason: the lives of patients were at stake.

Soon thereafter, in response to an email from Shoemaker complaining to the FDA, Gary Yamamoto, a veteran field inspector in CMS’s regional office in San Francisco, was sent to exam Theranos’s lab.

[Elizabeth] and Sunny professed not to know what Shoemaker had been talking about in his email. Yes, Elizabeth had met with the army officer, but she had never told him Theranos intended to deploy its blood-testing machines far and wide under the cover of a single CLIA certificate.

Yamamoto asked why Theranos had applied for a CLIA certificate.

Sunny responded that the company wanted to learn about how labs worked and what better way to do that than to operate one itself? Yamamoto found that answer fishy and borderline nonsensical. He asked to see their lab.

Carreyrou continues:

It looked like any other lab. No sign of any special or novel blood-testing technology. When he pointed this out, Sunny said the Theranos devices were still under development and the company had no plans to deploy them without FDA clearance–flatly contradicting what Elizabeth had told Shoemaker on not one but two occasions. Yamamoto wasn’t sure what to believe. Why would the army officer have made all that stuff up?

…If Theranos intended to eventually roll its devices out to other locations, those places would need CLIA certificates too.Either that or, better yet, the devices themselves would need to be approved by the FDA.

Elizabeth immediately sent an email to General Mattis accusing Shoemaker of giving “blatantly false information” to the FDA and CMS about Theranos. Mattis was furious and wanted to get to the bottom of things ASAP. A colleague of Shoemaker’s forwarded the emails, including Mattis’s responses, to Shoemaker. Shoemaker got worried about what Mattis would do.

Shoemaker met with Mattis to answer the general’s questions. Once Mattis learned more about the rules and regulations governing the situation–the medical devices couldn’t be tested on human subjects without FDA approval except under very strict conditions–he was reasonable. In the meantime, they could conduct a “limited objective experiment” using leftover de-identified blood samples from soldiers.

Although Theranos had the green light to run the “limited objective experiment,” for some reason it never proceeded to do so.

 

LIGHTING A FUISZ

On October 29, 2011, Richard Fuisz was served a set of papers. It was a lawsuit filed by Theranos in federal court in San Francisco alleging that Fuisz had conspired with his sons from his first marriage, Joe and John Fuisz, to steal confidential patent information to develop a rival patent. The suit alleged that the theft had been done by John Fuisz while he was employed at Theranos’s former patent counsel, McDermott Will & Emery.

Fuisz and his sons were angered by the suit, but they weren’t overly worried about it at first. They were confident in the knowledge that its allegations were false.

Carreyrou writes:

John had no reason to wish Elizabeth or her family ill; on the contrary. When he was in his early twenties, Chris Holmes had written him a letter of recommendation that helped him gain admission to Catholic University’s law school. Later, John’s first wife had gotten to know Noel Holmes through Lorraine Fuisz and become friendly with her. Noel had even dropped by their house when John’s first son was born to bring the baby a gift.

Moreover, Richard and John Fuisz weren’t close. John thought his father was an overbearing megalomaniac and tried to keep their interactions to a bare minimum. In 2004, he’d even dropped him as a McDermott client because he was being difficult and slow to pay his bills. The notion that John had willingly jeopardized his legal career to steal information for his father betrayed a fundamental misunderstanding of their frosty relationship.

But Elizabeth was understandably furious at Richard Fuisz. The patent application he had filed in April 2006 had matured into U.S. Patent 7,824,612 in November 2010 and now stood in the way of her vision of putting the Theranos device in people’s homes. If that vision was someday realized, she would have to license the bar code mechanism Fuisz had thought up to alert doctors to patients’ abnormal blood-test results. Fuisz had rubbed that fact in her face the day his patent was issued by sending a Fuisz pharma press release to info@theranos.com, the email address the company provided on its website for general queries. Rather than give in to what she saw as blackmail, Elizabeth had decided to steamroll her old neighbor by hiring one of the country’s best and most feared attorneys to go after him.

The Justice Department had hired David Boies to handle its antitrust suit against Microsoft. Boies won a resounding victory in that case, which helped him rise to national prominence. Just before Theranos sued, all three Fuiszes–Richard, John, and Joe–could tell that they were under surveillance by private investigators.

Boies’s use of private investigators wasn’t an intimidation tactic, it was the product of a singular paranoia that shaped Elizabeth and Sunny’s view of the world. That paranoia centered on the belief that the lab industry’s two dominant players, Quest Diagnostics and Laboratory Corporation of America, would stop at nothing to undermine Theranos and its technology. When Boies had first been approached about representing Theranos by Larry Ellison and another investor, it was that overarching concern that had been communicated to him. In other words, Boies’s assignment wasn’t just to sue Fuisz, it was to investigate whether he was in league with Quest and LabCorp. The reality was that Theranos was on neither company’s radar at that stage and that, as colorful and filled with intrigue as Fuisz’s life had been, he had no connection to them whatsoever.

Boies had zero evidence that John Fuisz had done what Theranos alleged. Nonetheless, Boies intended to use several things from John’s past to create doubt in a judge or jury. Potentially the most damaging thing Boies wanted to use was that McDermott had made John resign in 2009 after he had an argument with the firm’s other partners. John insisted the firm discontinue its reliance on a forged document in a case before the International Trade Commission in which McDermott was representing a Chinese state-owned company against the U.S. government’s Office of Unfair Import Investigations. McDermott leaders agreed to withdraw the document, but that decision significantly weakened the Chinese client’s defense. Senior partners got upset about it. They argued that there had been several incidents when John didn’t behave as a partner should. One incident was a complaint a client had made–this was Elizabeth’s September 2008 complaint about Richard Fuisz’s patent.

Eventually John was beyond furious. He had launched his own practice after leaving McDermott. The Theranos allegations had caused him to lose several clients. Moreover, opposing counsel mentioned the allegations in order to tar John. Finally, his wife had been diagnosed with vasa previa–a pregnancy complication where the fetus’s blood vessels are dangerously exposed. This added to John’s stress.

John always had a short fuse. During the deposition by Boies’s partners, John was combative and ornery. He used foul language while threatening to harass Elizabeth “till she dies, absolutely.”

In the meantime, Richard and Joe Fuisz were worrying about how expensive the litigation was getting. Also, they knew they were up against one of the most expensive lawyers in the world: David Boies, who was reported to make $10 million a year. But they didn’t know that Boies had agreed to accept stock in Theranos in place of his usual fees. Partly out of concern for his investment, Boies began attending all of the company’s board meetings in early 2013.

Richard Fuisz examined Theranos’s patents. He noticed that the name Ian Gibbons often appeared. Gibbons was British and had a Ph.D. in biochemistry from Cambridge. Fuisz suspected that Gibbons and other Theranos employees with advanced degrees had done most of the technical work related to Theranos’s patents.

 

IAN GIBBONS

Elizabeth hired Ian Gibbons on the recommendation of her Stanford mentor, Channing Robertson.

Ian fit the stereotype of the nerdy scientists to a T. He wore a beard and glasses and hiked his pants way above his waist. He could spend hours on end analyzing data and took copious notes documenting everything he did at work. This meticulousness carried over to his leisure time: he was an avid reader and kept a list of every single book he’d read. It included Marcel Proust’s seven-volume opus, Remembrance of Things Past, which he reread more than once.

Ian met his wife Rochelle at Berkeley in the 1970s. He was doing a postdoctorate fellowship in molecular biology, while Rochelle was doing graduate research. They didn’t have children. But they loved their dogs Chloe and Lucy, and their cat Livia, named after the wife of the Roman emperor Augustus. Ian also enjoyed going to the opera and photography. He altered photos for fun.

Ian’s specialty was immunoassays. He was passionate about the science of bloodtesting. He also enjoyed teaching it. Early on at Theranos, he would give small lectures to the rest of the staff.

Ian insisted that the blood tests they designed be as accurate in Theranos devices as they were on the lab bench. Because this was rarely the case, Ian was quite frustrated.

He and Tony Nugent butted heads over this issue during the development of the Edison.As admirable as Ian’s exacting standards were, Tony felt that all he did was complain and that he never offered any solutions.

Ian also had issues with Elizabeth’s management, especially the way she siloed the groups off from one another and discouraged them from communicating. The reason she and Sunny invoked for this way of operating was that Theranos was “in stealth mode,” but it made no sense to Ian. At the other diagnostics companies where he had worked, there had always been cross-functional teams with representatives from the chemistry, engineering, manufacturing, quality control, and regulatory departments working toward a common objective. That was how you got everyone on the same page, solved problems, and met deadlines.

Elizabeth’s loose relationship with the truth was another point of contention. Ian had heard her tell outright lies more than once and, after five years of working with her, he no longer trusted anything she said, especially when she made representations to employees or outsiders about the readiness of the company’s technology.

Ian complained confidentially to his friend Channing Robertson. But Robertson turned around and told Elizabeth all that Ian said. Elizabeth fired him. Sunny called the next day because several colleagues urged Elizabeth to reconsider. Ian was brought back but he was no longer head of general chemistry. Instead, he was a technical consultant.

Ian wasn’t the only employee being sidelined at that point. It seemed that the old guard was being mothballed in favor of new recruits. Nonetheless, Ian took it hard.

One day, Tony and Ian–who’d both been marginalized–got to talking. Tony suggested that perhaps the company was merely a vehicle for Elizabeth and Sunny’s romance and that none of the work they didn’t actually mattered. Ian agreed, saying, “It’s a folie a deux.” Tony looked up the definition of that expression, which seemed accurate to him: “The presence of the same or similar delusional ideas in two persons closely associated with one another.”

Ian kept working closely with Paul Patel, who had replaced Ian. Paul had enormous respect for Ian and continued treating him as an equal, consulting him on everything. However, Paul avoided conflict and was more willing than Ian to compromise with the engineers while building the miniLab. Ian wouldn’t compromise and got upset. Paul frequently had to calm him down over the phone at night.Ian told Paul to abide by his convictions and never lose sight of concern for the patient.

Sunny put Samartha Anekal, who had a Ph.D. in chemical engineering, in charge of integrating the parts of the miniLab. Sam struck some as a yes-man who simply did what Sunny told him to do.

As these things were unfolding, Ian had gotten clinically depressed–except he hadn’t been diagnosed as such. He started drinking heavily in the evenings. Rochelle was grieving for her mother, who had just passed away, and didn’t notice how depressed Ian was getting.

Theranos told Ian he’d been subpoenaed to testify in the Fuisz case. Because Rochelle had done work as a patent attorney, Ian asked her to look the Theranos’s patents.

While doing so, she noticed that Elizabreth’s name was on all the company’s patents, often in first place in the list of inventors. When Ian told her that Elizabeth’s scientific contribution had been negligible, Rochelle warned him that the patents could be invalidated if this was ever exposed. That only served to make him more agitated.

On May 15, he called to set up a meeting with Elizabeth. After an appointment was set for the next day, Ian started worrying that Elizabeth would fire him. The same day, the Theranos lawyer David Doyle told Ian that Fuizs’s lawyers–after trying for weeks to get the Boies Schiller attorneys to propose a date for Ian’s deposition–required Ian to appear at their offices in Campbell, California, on May 17.

The morning of May 16, Ian’s wife discovered that he’d taken enough acetaminophen to kill a horse. He was pronounced dead on May 23. Theranos had virtually no response.

Although Tony Nugent and Ian had fought all the time, Tony felt bad about the lack of empathy for someone who had given a decade of his life to the company. Tony downloaded a list of Ian’s patents and created an email, including a photo of Ian, which Tony sent to two dozen colleagues who’d worked with him.

 

CHIAT/DAY

Chiat/Day was working on a secret marketing campaign for Theranos. Patrick O’Neill, the creative director of the company’s Los Angeles office, was in charge.

Elizabeth had chosen Chiat/Day because it was the agency that represented Apple for many years, creating its iconic 1984 Macintosh ad and later its “Think Different” campaign in the late 1990s. She’d even tried to convince Lee Clow, the creative genius behind those ads, to come out of retirement to work for her. Clow politely referred her back to the agency, where she had immediately connected with Patrick.

Patrick was drawn in by Elizabeth’s extreme determination to do something great. The Theranos mission to give people pain-free, low-cost health care was inspiring. Advertisers don’t often get a chance to work on something that can make the world better, observes Carreyrou.

Part of the campaign included pictures of patients–played by models–of all different ages, genders, and ethnicities.

The message was that Theranos’s blood-testing technology would help everyone.

Carreyrou again:

Real blood tended to turn purple after awhile when it was exposed to air, so they filled one of the nanotainters with fake Halloween blood and took pictures of it against a white background. Patrick then made a photo montage showing it balancing on the tip of a finger. As he’d anticipated, it made for an arresting visual. Mike Yagi tried out different slogans to go with it, eventually settling on two that Elizabeth really liked: “One tiny drop changes everything” and “The lab test, reinvented.”…

Patrick also worked with Elizabeth on a new company logo. Elizabeth believed in the Flower of Life, a geometric pattern of intersecting circles within a larger circle that pagans once considered the visual expression of the life that runs through all sentient beings.

Although Patrick was enthused, his colleague Stan Fiorito was more circumspect. He thought something about Sunny was strange. He kept using software engineering jargon in weekly meetings even though it had zero applicability to the marketing discussions. Also, Theranos was paying Chiat/Day $6 million a year. Where was it getting the money for this? Elizabeth stated several times that the army was using Theranos technology on the battlefield in Afghanistan. She claimed it was saving soldiers’ lives. Perhaps Theranos was funded by the Pentagon, thought Stan. At least that would help explain the extreme secrecy the company insisted upon.

Besides Mike Yagi, Stan supervised Kate Wolff and Mike Pedito. Kate and Mike were no-nonsense people and they began to wonder about Theranos.

Elizabeth wanted the website and all the various marketing materials to feature bold, affirmative statements. One was that Theranos could run “over 800 tests”on a drop of blood. Another was that its technology was more accurate than traditional lab testing. She also wanted to say that Theranos test results were ready in less than thirty minutes and that its tests were “approved by FDA” and “endorsed by key medical centers” such as the Mayo Clinic and the University of California, San Francisco’s medical school, using the FDA, Mayo Clinic, and UCSF logos.

When she inquired about the basis for the claim about Theranos’s superior accuracy, Kate learned that it was extrapolated from a study that had concluded that 93 percent of lab mistakes were due to human error. Theranos argued that, since its testing process was fully automated inside its device, that was grounds enough to say that it was more accurate than other labs. Kate thought that was a big leap in logic and said so. After all, there were laws against misleading advertising.

Mike agreed with Kate.

Elizabeth had mentioned a report several hundred pages long supporting Theranos’s scientific claims. Kate and Mike repeatedly asked to see it, but Theranos wouldn’t produce it. Instead, the company sent them a password-protected file containing what it said were excerpts from the report. It stated that the Johns Hopkins University School of Medicine had conducted due diligence on the Theranos technology and found it “novel and sound” and capable of “accurately” running “a wide range of routine and special assays.”

Those quotes weren’t from any lengthy report, however. They were from the two-page summary of Elizabeth and Sunny’s meeting with five Hopkins officials in April 2010. As it had done with Walgreens, Theranos was again using that meeting to claim that its system had been independently evaluated. But that simply wasn’t true. Bill Clarke, the director of clinical toxicology at the Johns Hopkins Hospital and one of three university scientists who attended the 2010 meeting, had asked Elizabeth to ship one of her devices to his lab so he could put it through its paces and compare its performance to the equipment he normally used. She had indicated she would but had never followed through. Kate and Mike didn’t know any of this, but the fact that Theranos refused to show them the full report made them suspicious.

To learn how to market to doctors, Chiat/Day suggested doing focus group interviews with a few physicians. Theranos agreed as long as it was very secret. Kate asked her wife, Tracy, chief resident at Los Angeles County General, to participate. Tracy agreed. During a phone interview, Tracy asked a few questions that no one at Theranos seemed to be able to answer. Tracy told Kate that she doubted the company had any new technology. She also doubted you could get enough blood from a finger to run tests accurately.

The evening before the marketing campaign was going to launch, Elizabeth set up an emergency conference call. She systematically dialed back the language that would be used. “Welcome to a revolution in lab testing” was changed to “Welcome to Theranos.” “Faster results. Faster answers.” became “Fast results. Fast answers.” “A tiny drop is all it takes” was now “A few drops is all it takes.” “Goodbye, big bad needle” (which referred only to finger-stick draws) was replaced with “Instead of a huge needle, we can use a tiny finger stick or collect a micro-sample from a venous draw.”

Not everyone at Chiat/Day was skeptical, however. Patrick thought Theranos could become his own big legacy, just as Apple had been for Lee Clow.

 

GOING LIVE

Alan Beam decided to become a doctor because his conservative Jewish parents thought that only law, medicine, or business was an appropriate career choice. While attending Mount Sinai’s School of Medicine, he didn’t like the crazy hours or the sights and smells of the hospital ward. Instead, he got interested in laboratory science. He pursued postdoctoral studies in virology and a residency in clinical pathology at Brigham and Women’s Hospital in Boston.

In the summer of 2012, having recently read Walter Isaacson’s biography of Steve Jobs–which greatly inspired Alan–he wanted to move to the San Francisco Bay Area. He ended up being hired as laboratory directory as Theranos. He didn’t start until April 2013 because it took eight months before he got his California medical license.

After starting, Alan became concerned about low morale in the lab:

Its members were downright despondent. During Alan’s first week on the job, Sunny summarily fired one of the CLSs. The poor fellow was frog-marched out by security in front of everyone. Alan got the distinct impression it wasn’t the first time something like that had happened. No wonder people’s spirits were low, he thought.

The lab Alan inherited was divided into two parts: a room on the building’s second floor that was filled with commercial diagnostic equipment, and a second room beneath it where research was being conducted. The upstairs room was the CLIA-certified part of the lab, the one Alan was responsible for. Sunny and Elizabeth viewed its conventional machines as dinosaurs that would soon be rendered extinct by Theranos’s revolutionary technology, so they called it “Jurassic Park.” They called the downstairs room “Normandy” in reference to the D-day landings during during World War II. The proprietary Theranos devices it contained would take the lab industry by storm, like the Allied troops who braved hails of machine-gun fire on Normandy’s beaches to liberate Europe from Nazi occupation.

Alan liked the bravado at first. But then he learned from Paul Patel–the biochemist leading the development of blood tests for Theranos’s new device (now called the “4S” instead of the miniLab)–that he and his team were still developing its assays on lab plates on the bench. Alan asked Paul about it and Paul said the new Theranos box wasn’t working.

By the summer of 2013, the 4S had been under development for more than two and a half years. But it still had a long list of problems. Carreyrou writes:

The biggest problem of all was the dysfunctional corporate culture in which it was being developed. Elizabeth and Sunny regarded anyone who raised a concern or an objection as a cynic and a naysayer. Employees who persisted in doing so were usually marginalized or fired, while sycophants were promoted. Sunny had elevated a group of ingratiating Indians to key positions…

For the dozens of Indians Theranos employed, the fear of being fired was more than just the dread of losing a paycheck. Most were on H-1B visas and dependent on their continued employment at the company to remain in the country. With a despotic boss like Sunny holding their fates in his hands, it was akin to indentured servitude. Sunny, in fact, had the master-servant mentality common among an older generation of Indian businessmen. Employees were his minions. He expected them to be at his disposal at all hours of the day or night and on weekends. He checked the security logs every morning to see when they badged in and out…

With time, some employees grew less afraid of him and devised ways to manage him, as it dawned on them that they were dealing with an erratic man-child of limited intellect and an even more limited attention span.

Some of the problems were because Elizabeth was fixated on certain things. For instance, she thought the 4S–aka the miniLab–was a consumer device like an iPhone, and therefore it had to be small and pretty. She still hoped these devices would be in people’s homes someday.

Another difficulty stemmed from Elizabeth’s insistence that the miniLab be capable of performing the four major classes of blood tests: immunoassays, general chemistry assays, hematology assays, and assays that relied on the amplification of DNA. The only known approach that would permit combining all of them in one desktop machine was to use robots wielding pipettes. But this approach had an inherent flaw: overtime, a pipette’s accuracy drifts… While pipette drift was something that ailed all blood analyzers that relied on pipetting systems, the phenomenon was particularly pronounced on the miniLab. Its pipettes had to be recalibrated every two to three months, and the recalibration process put the device out of commission for five days.

Another serious weakness of the miniLab was that it could process only one blood sample at a time. Commercial machines–which were bulky–could process hundreds of samples at the same time.

If the Theranos wellness centers attracted a lot of patients, the miniLab’s low throughput would cause long wait times, which was clearly inconsistent with the company’s promise of fast test results.

Someone suggested putting six miniLabs on top of one another–sharing one cytometer. They adopted a computer term to name it: the”six-blade.” But they overlooked a basic issue: temperature. Some types of blood test require a very specific temperature.Because heat rises, the miniLabs near the top wouldn’t function.

There were other problems, too. Many of them were fixable but would require a relatively long time. Carreyrou explains:

Less than three years was not a lot of time to develop and perfect a complex medical device… The company was still several years away from having a viable product that could be used on patients.

However, as Elizabeth saw it, she didn’t have several years. Twelve months earlier, on June 5, 2012, she’d designed a new contract with Walgreens that committed Theranos to launch its blood-testing services in some of the chain’s stores by February 1, 2013, in exchange for a $100 million “innovation fee” and an additional $40 million loan.

Theranos had missed that deadline–another postponement in what from Walgreens’s perspective had been three years of delays. With Steve Burd’s retirement, the Safeway partnership was already falling apart, and if she waited much longer, Elizabeth risked losing Walgreens too. She was determined to launch in Walgreens stores by September, come hell or high water.

Since the miniLab was in no state to be deployed, Elizabeth and Sunny decided to dust off the Edison and launch with the older device. That, in turn, led to another fateful decision–the decision to cheat.

Daniel Young, head of Theranos’s biomath team, and Xinwei Gong (who went by Sam), told Alan Beam that he and Sam were going to tinker with the ADVIA, one of the lab’s commercial analyzers. It weighed 1,320 pounds and was made by Siemens Healthcare. Since the Edison could only do immunoassays, Alan grasped why Daniel and Sam were going to try to use the ADVIA, which specialized in general chemistry assays. As Carreyrou describes it:

One of the panels of blood tests most commonly ordered by physicians was known as the “chem 18” panel. Its components, which ranged from tests to measure electrolytes sodium, potassium, and chloride to tests used to monitor patients’ kidney and liver function, were all general chemistry assays. Launching in Walgreens stores with a menu of blood tests that didn’t include these tests would have been pointless. They accounted for about two-thirds of doctors’ orders.

But the ADVIA was designed to handle a larger quantity of blood than you could obtain by pricking a finger. So Daniel and Sam thought up a series of steps to adapt the Siemens analyzer to smaller samples. Chief among these was the use of a big robotic liquid handler called the Tecan to dilute the little blood samples collected in the nanotainters with a saline solution. Another was to transfer the diluted blood into custom-designed cups half the size of the ones that normally went into the ADVIA.

Because they were working with small blood samples, Daniel and Sam concluded that they would have to dilute the blood not once, but twice. Alan knew this was a bad idea:

Any lab director worth his salt knew that the more you tampered with a blood sample, the more room you introduced for error.

Moreover, this double dilution lowered the concentration of the analytes in the blood samples to levels that were below the ADVIA’s FDA-sanctioned analytic measurement range. In other words, it meant using the machine in a way that neither the manufacturer nor its regulator approved of. To get the final patient result, one had to multiply the diluted result by the same factor the blood had been diluted by, not knowing whether the diluted result was even reliable. Daniel and Sam were nonetheless proud of what they’d accomplished. At heart, both were engineers for whom patient care was an abstract concept. If their tinkering turned out to have adverse consequences, they weren’t the ones who would be held personally responsible. It was Alan’s name, not theirs, that was on the CLIA certificate.

Anjali Laghari was in charge of the immunoassay group. She’d worked with Ian Gibbons for a decade. Anjali had spent years trying to get the Edison working, but the device still had a high error rate.

When Anjali started hearing that Theranos was “going live,” she grew very concerned. She emailed Elizabeth and Daniel Young to remind them about the high error rates for some blood tests run on the Edison.

Neither Elizabeth nor Daniel acknowledged her email. After eight years at the company, Anjali felt she was at an ethical crossroads. To still be working out the kinks in the product was one thing when you were in R&D mode and testing blood volunteered by employees and their family members, but going live in Walgreens stores meant exposing the general population to what was essentially a big unauthorized research experiment. That was something she couldn’t live with. She decided to resign.

Elizabeth wanted to persuade Anjali to stay. Anjali asked Elizabeth: Why should they rush to launch before their technology was ready?

“Because when I promise something to a customer, I deliver.”

Anjali questioned this line of thought. The customers who really mattered were the patients who ordered blood tests, believing that the tests were a reliable basis for medical decisions.

After Anjali resigned, her deputy Tina Noyes resigned.

The resignations infuriated Elizabeth and Sunny. The following day they summoned the staff for an all-hands meeting in the cafeteria… Still visibly angry, Elizabeth told the gathered employees that she was building a religion. If there were any among them who didn’t believe, they should leave. Sunny put it more blatantly: anyone not prepared to show complete devotion and unmitigated loyalty to the company should “get the fuck out.”

 

UNICORN

Elizabeth had met the great statesman George Shultz a couple of years before 2013. She impressed him and won his support. Based on this connection, Elizabeth had been able to engineer a very favorable piece in the Wall Street Journal. The article was published September 7, 2013, just as Theranos was going to launch its blood-testing services. Carreyrou says of the article:

Drawing blood the traditional way with a needle in the arm was likened to vampirism… Theranos’s processes, by contrast,were described as requiring “only microscopic blood volumes” and as “faster, cheaper, and more accurate than the conventional methods.” The brilliant young Stanford dropout behind the breakthrough invention was anointed “the next Steve Jobs or Bill Gates” by no less than former secretary of state George Shultz, the man many credited with winning the cold war, in a quote at the end of the article.

Elizabeth planned to use the misleading article and the Walgreens launch as a basis for a new fundraising campaign.

Donald A. Lucas, son of legendary venture capitalist Donald L. Lucas, called Mike Barsanti. Don and Mike had been friendly since they attended Santa Clara University in the 1980s. Don proceeded to pitch Mike on Theranos.

Mike had first heard about Elizabeth seven years earlier. Mike had been interested then, but Don hadn’t been.

[Back in 2006, Mike] asked Don why the firm wasn’t taking a flyer on [Elizabeth] like his father had. Don had replied that after careful consideration he’s decided against it. Elizabeth was all over the place, she wasn’t focused, his father couldn’t control her even though he chaired her board, and Don didn’t like or trust her, Mike recalled his friend telling him.

In 2013, Mike asked Don what had changed.

Don explained excitedly that Theranos had come a long way since then. The company was about to announce the launch of its innovative finger-stick tests in one of the country’s largest retail chains. And that wasn’t all, he said. The Theranos devices were also being used by the U.S. military.

“Did you know they’re in the back of Humvees in Iraq?” he asked Mike.

[…]

If all this were true, they were impressive developments, Mike thought.

…Intent on seizing what he saw as a great opportunity, the Lucas Venture Group was raising money for two new funds, Don told Mike. One of them was a traditional venture fund that would invest in several companies, including Theranos. The second would be exclusively devoted to Theranos. Did Mike want in? If so, time was short.

Mike got an email on September 9, 2013, discussing the “Theranos-time sensitive” opportunity. The Lucas Venture group would get a discounted price, which valued the firm at $6 billion. Don mentioned that Theranos had “signed contracts and partnerships with very large retailers and drug stores as well as various pharmaceutical companies, HMO’s, insurance agencies, hospitals, clinics, and various government agencies.” Don also said that the company had been “cash flow positive since 2006.”

Theranos seemed to be another “unicorn.” Unicorns like Uber had been able to raise massive amounts of money while still remaining private companies, allowing them to avoid the pressures and scrutiny of going public.

Christopher James and Brian Grossman ran the hedge fund Partner Fund Management, which had $4 billion under management. James and Grossman saw the Wall Street Journal article about Theranos and were interested. They reached out to Elizabeth and went to meet with her on December 15, 2013.

During that first meeting, Elizabeth and Sunny told their guests that Theranos’s proprietary finger-stick technology could perform blood tests covering 1,000 of the 1,300 codes laboratories used to bill Medicare and private health insurers, according to a lawsuit Partner Fund later filed against the company. (Many blood tests involve several billing codes, so the actual number of tests represented by those thousand codes was in the low hundreds.)

At a second meeting three weeks later, they showed them a Powerpoint presentation containing scatter plots purporting to compare test data from Theranos’s proprietary analyzers to data from conventional lab machines. Each plot showed data points tightly clustered around a straight line that rose up diagonally from the horizontal x-axis. This indicated that Theranos’s tests results were almost perfectly correlated with those of the conventional machines. In other words, its technology was as accurate as traditional testing. The rub was that much of the data in the charts wasn’t from the miniLab or even from the Edison. It was from other commercial blood analyzers Theranos had purchased, including one manufactured by a company located an hour north of Palo Alto called Bio-Rad.

Sunny also told James and Grossman that Theranos had developed about three hundred different blood tests, ranging from commonly ordered tests to measure glucose, electrolytes, and kidney function to more esoteric cancer-detection tests. He boasted that Theranos could perform 98 percent of them on tiny blood samples pricked from a finger and that, within six months, it would be able to do all of them that way. These three hundred tests represented 99 to 99.9 percent of all laboratory requests, and Theranos had submitted every single one of them to the FDA for approval, he said.

Sunny and Elizabeth’s boldest claim was that the Theranos system was capable of running seventy different blood tests simultaneously on a single finger-stick sample and that it would soon be able to run even more. The ability to perform so many tests on just a drop or two of blood was something of a Holy Grail in the field of microfluidics.

There were some basic problems with trying to run many tests on small samples of blood. If you used a micro blood sample to do an immunoassay, then there usually wasn’t enough blood for the different set of lab techniques a general chemistry or hematology assay required. Another fundamental problem was that in transferring a small sample to a microfluidic chip, some blood was lost. This doesn’t matter for large blood samples, but it can be a crucial problem for small blood samples. Yet Elizabeth and Sunny implied that they had solved these and other difficulties.

James and Grossman not only liked the presentations by Elizabeth and Sunny; they also were impressed by Theranos’s board of directors. In addition to Shultz and General Mattis, the board now had Henry Kissinger, William Perry (former secretary of defense), Sam Nunn, and former navy admiral Gary Roughead. Like Shultz, all of these board members were fellows at the Hoover Institution at Stanford.

Sunny sent the hedge fund managers a spreadsheet with financial projections.

It forecast gross profits of $165 million on revenues of $261 million in 2014 and gross profits of $1.08 billion on revenues of $1.68 billion in 2015. Little did they know that Sunny had fabricated these numbers from whole cloth. Theranos hadn’t had a real chief financial officer since Elizabeth had fired Henry Mosley in 2006.

Partner Fund invested $96 million. This valued Theranos at $9 billion, which put Elizabeth’s net worth at almost $5 billion.

 

THE GRANDSON

Carreyrou writes this chapter about Tyler Shultz, the grandon of George Shultz:

Tyler had first met Elizabeth in late 2011 when he’d dropped by his grandfather George’s house near the Stanford campus. He was a junior then, majoring in mechanical engineering. Elizabeth’s vision of instant and painless tests run on drops of blood collected from fingertips had struck an immediate chord with him. After interning at Theranos that summer, he’d changed his major to biology and applied for a full-time position at the company.

Tyler became friends with Erika Cheung.

Their job on the immunoassay team was to help run experiments to verify the accuracy of blood tests on Theranos’s Edison devices before they were deployed in the lab for use on patients. This verification process was known as “assay validation.”

[…]

One type of experiment he and Erika were tasked with doing involved retesting blood samples on the Edisons over and over to measure how much their results varied. The data collected were used to calculate each Edison’s blood test’s coefficient of variation, or CV. A test is generally considered precise if its CV is less than 10 percent. To Tyler’s dismay, data runs that didn’t achieve low enough CVs were simply discarded and the experiments repeated until the desired number was reached. It was as if you flipped a coin enough times to get ten heads in a row and then declared that the coin always returned heads. Even with the “good” data runs, Tyler and Erika noticed that some values were deemed outliers and deleted. When Erika asked the group’s more senior scientists how they defined an outlier, no one could give her a straight answer. Erika and Tyler might be young and inexperienced, but they both knew that cherry-picking data wasn’t good science. Nor were they the only ones who had concerns about these practices.

Tyler and colleagues tested 247 blood samples on Edison for syphilis, 66 of which were known to be positive. The devices correctly identified only 65 percent of the sample on the first run, and 80 percent on the second run.

Yet, in its validation report, Theranos stated that its syphilis test had a sensitivity of 95 percent.

There were other tests where Tyler and Erika thought Theranos was being misleading. For instance, a blood sample would be tested for vitamin D on an analyzer made by the Italian company DiaSorin. It might show a vitamin D concentration of 20 nanograms per milliliter–a normal result for a healthy patient. When Erika tested the sample on the Edison, the result was 10 or 20 nanograms per milliliter–indicating a vitamin D deficiency. Nonetheless, the Edison was cleared for use in the clinical lab on live patient samples, writes Carreyrou.

In November 2013, while working in the clinical lab, Erika received a patient order from the Walgreens store in Palo Alto. As was standard practice, first she did a quality-control check. That involves testing a sample where you already know the concentration of the analyte.

If the result obtained is two standard deviations higher or lower than the known value, the quality-control check is usually deemed to have failed.

Erik’a first quality-control check failed. She ran it again and that one failed as well. Because it was during Thanksgiving, no one Erika normally reported to was around. Erika sent an email to the company’s emergency help line.

Sam Anekal, Suraj Saksena, and Daniel Young responded to her email with various suggestions, but nothing they proposed worked. After awhile an employee named Uyen Do from the research-and-development side came down and took a look at the quality-control readings.

Twelve values had been generated, six during each quality-control test.

Without bothering to explain her rationale to Erika, Do deleted two of those twelve values, declaring them outliers. She then went ahead and tested the patient sample and sent out a result.

This wasn’t how you were supposed to handle repeat quality-control failures. Normally, two such failures in a row would have been cause to take the devices off-line and recalibrate them. Moreover, Do wasn’t even authorized to be in the clinical lab. Unlike Erika, she didn’t have a CLS license and had no standing to process patient samples. The episode left Erika shaken.

Tyler Shultz moved to the production team in early 2014. This put him back near Erika and other colleagues from the clinical lab.

Tyler learned from Erika and others that the Edisons were frequently flunking quality-control checks and that Sunny was pressuring lab personnel to ignore the failures and to test patient samples on the devices anyway.

Tyler asked Elizabeth about validation reports, and she suggested he speak with Daniel Young. Tyler asked Daniel about CV values: Why were so many data runs discarded when the resulting CV was too high? Daniel told him that he was making the mistake of taking into account all six values generated by the Edison during a test. Young said that only the median value mattered. It was obvious to Tyler that if the Edison’s results were accurate, such data contortions–and the associated dishonesty–wouldn’t be needed in the first place.

Furthermore, all clinical laboratories undergo “proficiency testing” three times a year.

During its first two years of operation, the Theranos lab had always tested proficiency-testing samples on commercial analyzers. But since it was now using the Edisons for some patient tests, Alan Beam and his new lab codirector had been curious to see how the devices fared in the exercise. Beam and the new codirector, Mark Pandori, had ordered Erika and other lab associates to split the proficiency-testing samples and run one part on the Edisons and the other part on the lab’s Siemens and DiaSorin analyzers for comparison. The Edison results had differed markedly from the Siemens and DiaSorin ones, especially for vitamin D.

When Sunny had learned of their little experiment, he’d hit the roof. Not only had he put an immediate end to it, he had made them report only the Siemens and DiaSorin results. There was a lot of chatter in the lab that the Edison results should have been the ones reported. Tyler had looked up the CLIA regulations and they seemed to bear that out…

Tyler told Daniel he didn’t see how what Theranos had done could be legal. Daniel’s response followed a tortuous logic. He said a laboratory’s proficiency-testing results were assessed by comparing them to its peers’ results, which wasn’t possible in Theranos’s case because its technology was unique and had no peer group. As a result, the only way to do an apples-to-apples comparison was by using the same conventional methods as other laboratories. Besides, proficiency-testing rules were extremely complicated, he argued. Tyler could rest assured that no laws had been broken. Tyler didn’t buy it.

In March 2014, using an alias, Tyler emailed the New York health department because it ran one of the proficiency-testing programs in which Theranos had participated. Without revealing the name of the company in question, he asked about Theranos’s approach. He got confirmation that Theranos’s practices were “a form of PT cheating” and were “in violation of the state and federal requirements.” Tyler was given a choice: reveal the name of the company or file an anonymous complaint with New York State’s Laboratory Investigative Unit. He chose the second option.

Tyler told his famous grandfather George about his concerns. He said, moreover, that he was going to resign. George asked him to give Elizabeth a chance to respond. Tyler agreed. Elizabeth was too busy to meet in person, so Tyler sent her a detailed email. He didn’t hear anything for a few days.

When the response finally arrived, it didn’t come from Elizabeth. It came from Sunny. And it was withering. In a point-by-point rebuttal that was longer than Tyler’s original email, Sunny belittled everything from his grasp of statistics to his knowledge of laboratory science.

On the topic of proficiency testing, Sunny wrote:

“That reckless comment and accusation about the integrity of our company, its leadership and its core team members based on absolute ignorance is so insulting to me that had any other person made these statements, we would have held them accountable in the strongest way. The only reason I have taken so much time away from work to address this personally is because you are Mr. Shultz’s grandson…

I have now spent an extraordinary amount of time postponing critical business matters to investigate your assertions–the only email on this topic I want to see from you going forward is an apology that I’ll pass on to other people including Daniel here.”

Tyler replied to Sunny with a one-sentence email saying he was resigning. Before he even got to his car, Tyler’s mother called and blurted, “Stop whatever you’re about to do!” Tyler explained that he had already resigned.

“That’s not what I mean. I just got off the phone with your grandfather. He said Elizabeth called him and told him that if you insist on carrying out your vendetta against her, you will lose.”

Tyler was dumbfounded. Elizabeth was threatening him through his family, using his grandfather to deliver the message.

Tyler went to the Hoover Institution to meet with his grandfather.George listened to what Tyler had to say. Finally, George told his grandson that he thought he was wrong in this case.

In the meantime, a patient order for a hepatitis C test had reached the lab and Erika refused to run it on the Edisons, writes Carreyrou. The reagents for the hepatitis C test were expired. Also, the Edisons hadn’t been recalibrated in awhile. Erika and a coworker decided to use commercially available hepatitis kits called OraQuick HCV. That had worked until the lab had run out of them. They tried to order more, but Sunny had gotten upset and tried to block it. Sunny also learned that it was Erika who had given Tyler the proficiency-testing results. Sunny asked Erika to meet with him and then told her, “You need to tell me if you want to work here or not.”

Erika went to meet Tyler, who suggested that she join him for dinner at his grandfather’s house. Perhaps having two people with similar experiences would be more persuasive. Unfortunately, while Charlotte, George’s wife, seemed receptive and incredulous, George wasn’t buying it.

Tyler had noticed how much he doted on Elizabeth. His relationship with her seemed closer than their own. Tyler also knew that his grandfather was passionate about science. Scientific progress would make the world a better place and save it from such perils as pandemics and climate change, he often told his grandson. This passion seemed to make him unable to let go of the promise of Theranos.

George said a top surgeon in New York had told him the company was gong to revolutionize the field of surgery and this was someone his good friend Henry Kissinger considered to be the smartest man alive. And according to Elizabeth, Theranos’s devices were already being used in medevac helicopters and hospital operating rooms, so they must be working.

Tyler and Erika tried to tell him that couldn’t possibly be true given that the devices were barely working within the walls of Theranos. But it was clear they weren’t making any headway. George urged them to put the company behind them and to move on with their lives.

The next morning Erika quit Theranos.

 

FAME

After Theranos sued Richard Fuisz, Richard and Joe Fuisz resolved to fight it to the very end. However, after they’d spent more than $2 million on their defense and after they realized how outgunned they were by Theranos’s lawyers–led by David Boies–they decided it would be better to settle.

It amounted to a complete capitulation on the Fuiszes’ part. Elizabeth had won.

At a meeting with Boies, the two sides drafted the settlement agreement.Then Richard and Joe signed.

…Richard Fuisz looked utterly defeated. The proud and pugnacious former CIA agent broke down and sobbed.

Roger Parloff, Fortune magazine’s legal correspondent, saw an article about the case involving Theranos and the Fuiszes. Parloff called Dawn Schneider, Boies’s long-term public relations representative. She offered to meet Parloff at his office. On the walk across Midtown, Schneider thought that a better story to write about was Theranos and its brilliant young founder. When she arrived at Parloff’s office, she told him about Theranos and said, “this is the greatest company you’ve never heard of.”

Parloff went to Palo Alto do meet with Elizabeth.

…what Elizabeth told Parloff she’d achieved seemed genuinely innovative and impressive. As she and Sunny had stated to Partner fund, she told him the Theranos analyzer could perform as many as seventy different blood tests from one tiny finger-stick draw and she led him to believe that the more than two hundred tests on its menu were all finger-stick tests done with proprietary technology. Since he didn’t have the expertise to vet her scientific claims, Parloff interviewed the prominent members of her board of directors and effectively relied on them as character witnesses… All of them vouched for Elizabeth emphatically. Shultz and Mattis were particularly effusive.

“Everywhere you look with this young lady, there’s a purity of motivation,” Shultz told him. “I mean she is really trying to make the world better, and this is her way of doing it.”

Mattis went out his way to praise her integrity. “She has probably one of the most mature and well-honed sense of ethics–personal ethics, managerial ethics, business ethics, medical ethics that I’ve ever heard articulated,” the retired general gushed.

Parloff’s cover story for Fortune magazine was published June 12, 2014. Elizabeth instantly became a star. Forbes then ran its own piece.

Two months later she graced one of the covers of the magazine’s annual Forbes 400 issue on the richest people in America. More fawning stories followed in USA Today, Inc., Fast Company, and Glamour, along with segments on NPR, Fox Business, CNBC, CNN, and CBS News. With the explosion of media coverage came invitations to numerous conferences and a cascade of accolades. Elizabeth became the youngest person to win the Horatio Alger award. Time magazine named her one of the one hundred most influential people in the world. President Obama appointed her a U.S. ambassador for global entrepreneurship, and Harvard Medical School invited her to join its prestigious board of fellows.

Carreyrou continues:

As much as she courted the attention, Elizabeth’s sudden fame wasn’t entirely her doing… In Elizabeth Holmes, the Valley had its first female billionaire tech founder.

Still, there was something unusual in the way Elizabeth embraced the limelight.She behaved more like a movie star than an entrepreneur, basking in the public adulation she was receiving. Each week brought a new media interview or conference appearance. Other well-known startup founders gave interviews and made public appearances too but with nowhere near the same frequency. The image of the reclusive, ascetic young woman Parloff had been sold on had overnight given way to that of the ubiquitous celebrity.

Elizabeth excelled at delivering a heartwarming message that Theranos’s convenient blood tests could be used to catch diseases early so that no one would have to say goodbye to loved ones too soon, notes Carreyrou. She soon started adding a new personal detail to her interviews and presentations: her uncle had died of cancer.

It was true that Elizabeth’s uncle, Ron Dietz, had died eighteen months earlier from skin cancer that had metastasized and spread to his brain. But what she omitted to disclose was that she had never been close to him. To family members who knew the reality of their relationship, using his death to promote her company felt phony and exploitative.

Of course, at that time, most people who heard Elizabeth in an interview or presentation didn’t know about the lies she was telling. But she was a great salesperson. Elizabeth told one story about a little girl who got stuck repeatedly because the nurse couldn’t find the vein. Another story was about cancer patients depressed because of how much blood they had to give.

Patrick O’Neill, from TBWA/Chiat/Day, was Theranos’s chief creative officer. He was raising Elizabeth’s profile and perfecting her image.

To Patrick, making Elizabeth the face of Theranos made perfect sense. She was the company’s most powerful marketing tool. Her story was intoxicating. Everyone wanted to believe in it, including the numerous young girls who were sending her letters and emails. It wasn’t a cynical calculus on his part: Patrick was one of her biggest believers. He had no knowledge of the shenanigans in the lab and didn’t pretend to understand the science of blood testing. As far as he was concerned, the fairy tale was real.

With over five hundred employees, Theranos had to move to a new location. Patrick designed Elizabeth’s new office:

Elizabeth’s new corner office was designed to look like the Oval Office. Patrick ordered a custom-made desk that was as deep as the president’s at its center but had rounded edges. In front of it, he arranged two sofas and two armchairs around a table, replicating the White House layout. At Elizabeth’s insistence, the office’s big windows were made of bulletproof glass.

 

THE HIPPOCRATIC OATH

Alan Beam had become disillusioned:

For his first few months as laboratory director, he’s clung to the belief that the company was going to transform with its technology. But the past year’s events had shattered any illusion of that. He now felt like a pawn in a dangerous game played with patients, investors, and regulators. At one point, he’d had to talk Sunny and Elizabeth out of running HIV tests on diluted finger-stick samples. Unreliable potassium and cholesterol results were bad enough. False HIV results would have been disastrous.

Two of Alan’s colleagues had recently resigned out of disagreement with what they viewed as blatantly dishonest company policies.

One day Alan was talking with Curtis Schneider, one of the smartest people at Theranos, with a Ph.D. in inorganic chemistry and having spent four years as a postdoctoral scholar at Caltech.

He told Curtis about the lab’s quality-control data and how it was being kept from him. And he confided something else: the company was cheating on its proficiency testing. In case Curtis hadn’t registered the implication of what he’d just said, he spelled it out: Theranos was breaking the law.

A few weeks later, Christian Holmes contacted Alan.

Christian wanted Alan to handle yet another doctor’s complaint. Alan had fielded dozens of them since the company had gone live with its tests the previous fall. Time and time again, he’d been asked to convince physicians that blood-test results he had no confidence in were sound and accurate. He decided he couldn’t do it anymore. His conscience wouldn’t allow him to.

He told Christian no and emailed Sunny and Elizabeth to inform them that he was resigning and to ask them to immediately take his name off the lab’s CLIA license.

December 15, 2014, there another article about Theranos in the New Yorker. Adam Clapper, a pathologist in Columbia Missouri, who writes a blog about the industry Pathology Blawg, noticed the article. He was very skeptical about Theranos. Joe Fuisz noticed the article and told his father about it. Richard read the article and got in touch with Adam. Adam felt initially that he would need more proof.

A few days later, Richard noticed that someone named Alan Beam had looked at his LinkedIn profile. Richard saw that Alan had been laboratory director at Theranos. So he sent him an InMail, thinking it was worth a shot. Alan got back to him.

Alan called and said to Richard, “You and I took the Hippocratic Oath, which is to first do no harm. Theranos is putting people in harm’s way.” Alan filled him in on all the details.

Richard told Adam about what he’d learned from Alan. Adam agreed that the information changed everything. However, he was worried about the legal liability of going against a $9 billion Silicon Valley company with a litigious history and represented by David Boies. That said, Adam knew an investigative reporter at the Wall Street Journal. John Carreyrou.

 

THE TIP

Adam called John Carreyrou at the Wall Street Journal. Carreyrou says that even though nine times out of ten, tips don’t work out, he always listened because you never knew. Also, he happened to have just finished a year-long investigation in Medicare fraud and he was looking for his next story.

February 26, 2015, Carreyrou reached Alan Beam. Alan agreed to talk as long as his identity was kept confidential.

…the Theranos devices didn’t work. They were called Edisons, he said, and they were error-prone. They constantly failed quality-control. Furthermore, Theranos used them for only a small number of tests. It performed most of its tests on commercially available instruments and diluted the blood samples.

…Theranos didn’t want people to know its technology was limited, so it had contrived a way of running small finger-stick samples on conventional machines. This involved diluting the finger-stick samples to make them bigger. The problem, he said, was that when you diluted the samples, you lowered the concentration of analytes in the blood to a level the conventional machines could no longer measure accurately.

He said he had tried to delay the launch of Theranos’s blood tests in Walgreens stores and had warned Holmes that the lab’s sodium and potassium results were completely unreliable… I was barely getting my head around these revelations when Alan mentioned something called proficiency testing. He was adamant that Theranos was breaking federal proficiency-testing rules.

There was more:

Alan also said that Holmes was evangelical about revolutionizing blood testing but that her knowledge base on science and medicine was poor, confirming my instincts. He said she wasn’t the one running Theranos day-to-day. A man named Sunny Balwani was. Alan didn’t mince his words about Balwani: he was a dishonest bully who managed through intimidation. Then he dropped another bombshell: Holmes and Balwani were romantically involved.

It’s not that there were rules against such a romantic involvement in the Silicon Valley startup world.Rather, it’s that Elizabeth was hiding the relationship from her board. What other information might she be keeping from her board?

Alan told Carreyrou how he had brought up his concerns with Holmes and Balwani a number of times, but Balwani would either rebuff him or put him off, writes Carreyrou.

Alan was most worried about potential harm to patients:

He described the two nightmare scenarios false blood-test results could lead to. A false positive might cause a patient to have an unnecessary medical procedure. But a false negative was worse: a patient with a serious condition that went undiagnosed could die.

Carreyrou experienced the familiar rush of a big reporting breakthrough, but he knew that he needed to get corroboration. He proceeded to speak with others who had been associated with Theranos and who were willing to talk–some on the condition of anonymity. A good start. However, getting documentary evidence was “the gold standard for these types of stories.” This would be harder.

Carreyrou spoke with Alan again.

Our conversation shifted to proficiency testing. Alan explained how Theranos was gaming it and he told me which commercial analyzers it used for the majority of its blood tests. Both were made by Siemens… He revealed something else that hadn’t come up in our first call: Theranos’s lab was divided into two parts. One contained the commercial analyzers and the other the Edison devices. During her inspection of the lab, a state inspector had been shown only the part with the commercial analyzers. Alan felt she’d been deceived.

He also mentioned that Theranos was working on a newer-generation device code-named 4S that was supposed to supplant the Edison and do a broader variety of blood tests, but it didn’t work at all and was never deployed in the lab. Diluting finger-stick samples and running them on Siemens machines was supposed to be a temporary solution, but it had become a permanent one because the 4S had turned into a fiasco.

It was all beginning to make sense: Holmes and her company had overpromised and then cut corners when they couldn’t deliver.It was one thing to do that with software or a smartphone app, but doing it with a medical product that people relied on to make important health decisions was unconscionable.

Carreyrou reached out to twenty former and current Theranos employees. Many didn’t respond. Those Carreyrou got on the phone said they’d signed strict confidentiality agreements.They were worried about being sued.

Carreyrou’s initial conversations with Alan and two others had been “on deep background,” which meant Carreyrou could use what they said but had to keep their identities confidential. Subsequently, he spoke with a former high-ranking employee “off the record.” This meant that Carreyrou couldn’t make use of any information from that conversation. But Carreyrou did learn corroborating information even though it was off the record. This further bolstered his confidence.

Carreyrou knew he needed proof that Theranos was delivering inaccurate blood-test results. He discovered a doctor, Nicole Sundene, who had made a complaint about a Theranos blood test on Yelp. Carreyrou met with Dr. Sundene, who told him about the experience of one of her patients, Maureen Glunz.

The lab report she’d received from Theranos had shown abnormally elevated results for calcium, protein, glucose, and three liver enzymes… Dr. Sundene had worried she might be on the cusp of a stroke and sent her straight to the hospital. Glunz had spent four hours in the emergency room on the eve of Thanksgiving while doctors ran a battery of tests on her, including a CT scan. She’d been discharged after a new set of blood tests performed by the hospital’s lab came back normal. That hadn’t been the end of it, however. As a precaution, she’d undergone two MRIs during the ensuing week…

When I met with Dr. Sundene at her office, I learned that Glunz wasn’t the only patient whose results she found suspect. She told me more than a dozen of her patients had tested suspiciously high for potassium and calcium and she doubted the accuracy of those results as well. She had written Theranos a letter to complain but the company hadn’t even acknowledged it.

Carreyrou met a Dr. Adrienne Stewart, who told him about two of her patients who’d gotten incorrect results from Theranos. One patient had to delay a long-planned trip to Ireland because an incorrect result from Theranos suggested she could have deep vein thrombosis. A second set of tests from another lab turned out to be normal. Also, ultrasound of the patient’s legs didn’t reveal anything.

Another of Dr. Stewart’s patients had gotten a test result from Theranos indicating a high TSH value.

The patient was already on thyroid medication and the result suggested that he dose needed to be raised. Before she did anything, Dr. Stewart sent the patient to get retested at Sonora Quest, a joint venture of Quest and the hospital system Banner Health. The Sonora Quest result came back normal. Had she trusted the Theranos result and increased the patient’s medication dosage, the outcome could have been disastrous, Dr. Stewart said. The patient was pregnant. Increasing her dosage would have made her levels of thyroid hormone too high and put her pregnancy at risk.

Carreyrou also met with Dr. Gary Betz. He had a patient on medication to reduce blood pressure. High potassium was one potential side effect of the medication, so Dr. Betz monitored it. A Theranos test showed that his patient had an almost critical level of potassium. A nurse sent Dr. Betz’s patient back to get retested. But the phlebotomist was unable to complete the test despite three attempts to draw blood. Dr. Betz was very upset because if the initial test was accurate, an immediate change in the patient’s treatment was crucial. He sent his patient to get tested as Sonora Quest. The result came back normal.

As an experiment, Carreyrou and Dr. Sundene had each gotten their blood tested by Theranos and by another lab. Carreyrou:

Theranos had flagged three of my values as abnormally high and one as abnormally low. Yet on LabCorp’s report, all four of those values showed up as normal.Meanwhile, LabCorp had flagged both my total cholesterol and LDL cholesterol as high, while the Theranos described the first as “desirable” and the second as “near optimal.”

Those differences were mild compared to a whopper Dr. Sundene had found in her results. According to Theranos, the amount of cortisol in her blood was less than one microgram per deciliter. A value that low was usually associated with Addison’s disease, a dangerous condition characterized by extreme fatigue and low blood pressure that could result in death if it went untreated. Her LabCorp report, however, showed a cortisol level of 18.8 micrograms per deciliter, which was within the normal range for healthy patients. Dr. Sundene had no doubt which of the two values was the correct one.

Carreyrou mentions a “No surprise” rule they have at the Wall Street Journal.

We never went to press with a story without informing the story subject of every single piece of information we had gathered in our reporting and giving them ample time and opportunity to address and rebut everything.

Carreyrou met with Erica Cheung.

She said Theranos should never have gone live testing patient samples. The company routinely ignored quality-control failures and test errors and showed a complete disregard for the well-being of patients, she said. In the end, she had resigned because she was sickened by what she had become a party to, she told me.

Carreyrou also met with Tyler Shultz, who gave him a detailed account of his experiences with Theranos. Finally, Carreyrou met with Rochelle Gibbons, the widow of Ian Gibbons.

I flew back to New York the next day confident that I’d reached a critical mass in my reporting and that it wouldn’t be too long before I could publish. But that was underestimating whom I was up against.

 

THE AMBUSH

On May 27, 2015, Tyler went to his parents’ house for dinner, as he tried to do every two weeks. His father, looking worried, asked Tyler if he’d spoken with an investigative journalist from the Wall Street Journal. Yes, said Tyler. His father: “Are you kidding me? How stupid could you be? Well, they know.”

His father told him that his grandfather George had called. George said if Tyler wanted to get out of a “world of trouble,” he would have to meet with Theranos’s lawyers the next day and sign something. Tyler called his grandfather and arranged to meet him later that night.

Carreyrou had sent a list of seven areas he wanted to discuss with Elizabeth to Matthew Traub, a representative of Theranos. Included in one section was the coefficient of variation for one of the blood tests. It happened to be a number that Tyler had calculated. It was because of that number that Elizabeth had been able to tie Tyler to the investigative reporter.

However, the number Elizabeth tied to Tyler could have come from anyone. When Tyler met with his grandfather, he categorically denied speaking with any reporter. George told Tyler: “We’re doing this for you. Elizabeth says your career will be over if the article is published.”

Tyler summarized all the issues he had raised earlier regarding Theranos. But his grandfather still didn’t agree with Tyler’s views. George told his grandson that there was a one-page document Theranos wanted him to sign swearing confidentiality going forward. Theranos argued that the Wall Street Journal article would include trade secrets of the company. Tyler said he would consider signing the document if the company would stop bothering him.George then told Tyler that there were two Theranos lawyers upstairs.

Tyler felt betrayed because he had specifically asked to meet his grandfather with no lawyers. His grandmother Charlotte told Tyler that she was questioning whether Theranos had a functioning product and that Henry Kissinger was also skeptical and wanted out.

The two lawyers, Mike Brill and Meredith Dearborn, were partners at Boies, Schiller & Flexner.Brille told Tyler he had identified him as a source for the Journal article.

He handed him three documents: a temporary restraining order, a notice to appear in court two days later, and a letter stating Theranos had reason to believe Tyler had violated his confidentiality obligations and was prepared to file suit against him.

Brille pressed Tyler to admit that he had spoken with a reporter. Tyler kept denying it. Brille kept pushing and pushing and pushing. Finally, Tyler said the conversation needed to end. His grandfather jumped in and defended Tyler and escorted the lawyers out of the house.

[George] called Holmes and told her this was not what they had agreed upon. She had sent over a prosecutor rather than someone who was willing to have a civilized conversation. Tyler was ready to go to court the next day, he warned her.

George and Elizabeth reached a compromise. George and Tyler would meet again at George’s house the following morning. Tyler would look at the one-page document. George asked Elizabeth to send a different lawyer.

The next morning, Tyler wasn’t surprised to see Brille again. Brille had new documents.

One of them was an affidavit stating that Tyler had never spoken to any third parties about Theranos and that he pledged to give the names of every current and former employee who he knew had talked to the Journal. Brille asked Tyler to sign the affidavit. Tyler refused.

George asked Tyler what it would take for him to sign it. Tyler said Theranos would have to agree not to sue him. George wrote the requirement on the affidavit. Then he and Brille went into another room to talk.

In the interim, Tyler decided he wasn’t going to sign anything. After speaking with two lawyers soon thereafter, Tyler stuck with his decision. Brille had been threatening to sue immediately, but then told Tyler’s lawyer that they were going to delay the lawsuit in order to try to reach some agreement.

Tyler–through his lawyer–began exchanging drafts of the affidavit with Brille. Tyler tried to make concessions in order to reach some agreement. For instance, he agreed to be called a junior employee who couldn’t have known what he was talking about when it come to proficiency testing, assay validation, and lab operations. But Theranos kept pushing Tyler to name the Journal‘s other sources. He refused.

As the stalemate dragged on, Boies Schiller resorted to the bare-knuckle tactics it had become notorious for. Brille let it be known that if Tyler didn’t sign the affidavit and name the Journal‘s sources, the firm would make sure to bankrupt his entire family when it took him to court. Tyler also received a tip that he was being surveilled by private investigators.

Tyler got a lawyer for his parents. That way Tyler and his parents could communicate through attorneys and those conversations would be protected by attorney-client privilege.

This led to an incident that rattled both Tyler and his parents. Hours after his parents’ new lawyer met with them for the first time, her car was broken into and her briefcase containing her notes from the meeting was stolen.

 

TRADE SECRETS

A Theranos delegation met Carreyrou at the offices of the Journal. David Boies came with Mike Brille, Meredith Dearborn, and Heather King, who was now general counsel for Theranos. Matthew Traub was there. The only Theranos executive was Daniel Young.

Carreyrou brought along Mike Siconolfi, head of the Journal‘s investigations team, and Jay Conti, the deputy general counsel of the Journal’s parent company.

Carreyrou had sent eighty questions, at Traub’s request, as a basis for the discussion. King began the meeting by saying they were going to refute the “false premises” assumed by the questions. The lawyers tried to intimidate Carreyrou. King warned:

“We do not consent to your publication of our trade secrets.”

Carreyrou wasn’t going to be intimidated. He retorted:

“We do not consent to waiving our journalistic privileges.”

King became more conciliatory as they agreed to start going through the questions one at a time. Daniel Young was the only one there who could answer them.

After Young acknowledged that Theranos owned commercial blood analyzers, which he claimed the company used only for comparison purposes, rather than for delivering patient results, I asked if one of them was the Siemens ADVIA. He declined to comment, citing trade secrets. I then asked whether Theranos ran small finger-stick samples on the Siemens ADVIA with a special dilution protocol. He again invoked trade secrets to avoid answering the question but argued that diluting blood samples was common in the lab industry.

Carreyrou pointed out that if they weren’t prepared to answer such basic questions that were at the heart of his story, what was the point of meeting? Eventually Boies got angry and criticized Carreyrou’s reporting methods, saying he asked loaded questions to doctors. Much more back-and-forth ensued between members of the Theranos delegation and Carreyrou, Siconolfi, and Conti.

How could anything involving a commercial analyzer manufactured by a third party possibly be deemed a Theranos trade secret? I asked. Brille replied unconvincingly that the distinction wasn’t as simple as I made it out to be.

Turning to the Edison, Carreyrou asked how many blood tests it performs. The answer was that it was a trade secret.

I felt like I was watching a live performance of the Theater of the Absurd.

…It was frustrating but also a sign that I was on the right track.They wouldn’t be stonewalling if they had nothing to hide.

For four more hours, the meeting went on like this. Young did answer a few questions.

He acknowledged problems with Theranos’s potassium test but claimed they had quickly been solved and none of the faulty results had been released to any patients. Alan Beam had told me otherwise, so I suspected Young was lying about that.Young also confirmed that Theranos conducted proficiency testing differently than most laboratories but argued this was justified by the uniqueness of its technology.

A few days later, Theranos threatened Erika Cheung with a lawsuit and also started started threatening Alan Beam again. However, Alan had consulted a lawyer and felt less vulnerable to Theranos’s intimidation tactics.

Boies sent a twenty-three page letter to the Journal threatening a lawsuit if the paper published a story that defamed Theranos or revealed any of its trade secrets. Boies attacked Carreyrou’s journalistic integrity.

His main evidence to back up that argument was signed statements Theranos had obtained from two of the other doctors I had spoken to claiming I had mischaracterized what they had told me and hadn’t made clear to them that I might use the information in a published article. The doctors were Lauren Beardsley and Saman Rezaie…

The truth was that I hadn’t planned on using the patient case Dr. Beardsley and Rezaie had told me about because it was a secondhand account. The patient in question was being treated by another doctor in their practice who had declined to speak to me. But, while their signed statements in no way weakened my story, the likelihood that they had caved to the company’s pressure worried me.

Meanwhile, Dr. Stewart reassured Carreyrou that she was standing up for patients and for the integrity of lab testing. She wouldn’t be pressured. Balwani later told her that if the Journal article was published with Dr. Stewart in the story, her name would be dragged through the mud. When Carreyrou spoke with Dr. Stewart, she asked him please not to use her name in the story.

 

LA MATTANZA

Roger Parloff of Fortunestill believed in Theranos. During an interview with Elizabeth for a second article he was working on, he asked about an Ebola test Theranos had been developing.

Given that an Ebola epidemic had been raging in West Africa for more than a year, Parloff thought a rapid finger-stick test to detect the deadly virus could be of great use to public health authorities and had been interested in writing about it. Holmes said she expected to obtain emergency-use authorization for the test shortly and invited him to come see a live demonstration of it at Boies Schiller’s Manhattan offices.

Parloff arrived at the offices, and they told him they wanted to do two tests, one for Ebola and the other to measure potassium. They pricked his finger twice.

Parloff wondered fleetingly why one of the devices couldn’t simultaneously perform both tests from a single blood sample but decided not to press the issue.

For some reason, the results of the tests were delayed. An indicator of the machine’s progress seemed to be moving very slowly.

Balwani had tasked a Theranos software engineer named Michael Craig to write an application for the miniLab’s software that masked test malfunctions. When something went wrong insider the machine, the app kicked in and prevented an error message from appearing on the digital display. Instead, the screen showed the test’s progress slowing to a crawl.

[…]

In the absence of real validation data, Holmes used these demos to convince board members, prospective investors, and journalists that the miniLab was a finished working product. Michael Craig’s app wasn’t the only subterfuge used to maintain the illusion.During demos at headquarters, employees would make a show of placing the finger-stick sample of a visiting VIP in the miniLab, wait until the visitor had left the room, and then take the sample out and bring it to a lab associate, who would run it on one of the modified commercial analyzers.

Parloff had no idea he’d been duped.

Back in California, Holmes had invited Vice President Joe Biden to visit the company’s facilities.

Holmes and Balwani wanted to impress the vice president with a vision of a cutting-edge, completely automated laboratory.So instead of showing him the actual lab, they created a fake one.

Carreyrou writes:

A few days later, on July 28, I opened that morning’s edition of the Journal and nearly spit out my coffee: as I was leafing through the paper’s first section, I stumbled across an op-ed written by Elizabeth Holmes crowing about Theranos’s herpes-test approval and calling for all lab tests to be reviewed by the FDA.She’d been denying me an interview for months, her lawyers had been stonewalling and threatening my sources, and here she was using my own newspaper’s opinion pages to perpetuate the myth that she was regulators’ best friend.

Of course, because of the firewall between the Journal‘s news and editorial side, Paul Gigot and his staff had no idea what Carreyrou was working on. Nonetheless, Carreyrou was annoyed because it seemed like Holmes was trying to make it more difficult for the paper to publish Carreyrou’s investigation.

Carreyrou went to speak with his editor, Mike Siconolfi, hoping they could speed up the publication of his Theranos article. But Mike, who was Italian American, urged patience and then asked Carreyrou, “Did I ever tell you about la mattanza?” La mattanza was an ancient Sicilian ritual in which fishermen waded into the Mediterranean Sea with clubs and spears. Then they stood perfectly still for hours until the fish no longer noticed them. Someone would give the signal and the fishermen would strike.

 

DAMAGE CONTROL

Soon after Carreyrou started investigating Theranos, the company completed another round of fund-raising. They raised $430 million, $125 million of which came from Rupert Murdoch, who controlled News Corporation, the parent company of the Journal.

He was won over by Holmes’s charisma and vision but also by the financial projections she gave him. The investment packet she sent forecast $330 million in profits on revenues of $1 billion in 2015 and $505 million in profits on revenues of $2 billion in 2016. These numbers made what was now a $10 billion valuation seem cheap.

Murdoch also derived comfort from some of the other reputable investors he heard Theranos had lined up. They included Cox Enterprises, the Atlanta-based, family-owned conglomerate whose chairman, Jim Kennedy, he was friendly with, and the Waltons of Walmart fame. Other big-name investors he didn’t know about ranged from Bob Kraft, owner of the New England Patriots, to Mexican billionaire Carlos Slim and John Elkann, the Italian industrialist who controlled Fiat Chrystler Automobiles.

On two separate occasions when Holmes met with Murdoch, she brought up Carreyrou’s story, saying it was false and would damage Theranos. Both times, Murdoch maintained that he trusted the Journal‘s editors to handle the matter fairly.

Meanwhile, Theranos continued to try to intimidate Carreyrou’s sources. For instance, two patients who had appointments with Dr. Sundene fabricated negative stories and posted them on Yelp. Dr. Sundene had to hire an attorney to get Yelp to remove the bad reviews.

The Journal finally published Carreyrou’s story on the front page on Thursday, October 15, 2015.

The headline,”A Prized Startup Struggles,” was understated but the article itself was devastating. In addition to revealing that Theranos ran all but a small fraction of its tests on conventional machines and laying bare its proficiency-testing shenanigans and its dilution of finger-stick samples, it raised serious questions about the accuracy of its own devices. It ended with a quote from Maureen Glunz saying that “trial and error on people” was “not OK,” bringing home what I felt was the most important point: the medical danger to which the company had exposed patients.

The story sparked a firestorm…

Other news organization picked up the story and produced critical pieces. In Silicon Valley, everyone was talking about the Theranos story. Some, including venture capitalist Marc Andreesen, defended Theranos. Others revealed that they had had their doubts for some time:

Why had Holmes always been so secretive about her technology? Why had she never recruited a board member with even basic knowledge of blood science? And why hadn’t a single venture capital firm with expertise in health care put money into the company?

Many others didn’t know what to believe.

Carreyrou writes:

We knew that the battle was far from over and that Theranos and Boies would be coming at us hard in the coming days and weeks. Whether my reporting stood up to their attacks would largely depend on what actions, if any, regulators took.

Carreyrou was trying to speak with his source at the FDA and finally reached him:

On deep background, he confirmed to me that the FDA had recently conducted a surprise inspection of Theranos’s facilities in Newark and Palo Alto. Dealing a severe blow to the company, the agency had declared its nanotainter an uncleared medical device and forbid it from continuing to use it, he said.

He explained that the FDA had targeted the little tube because, as a medical device, it clearly fell under its jurisdiction and gave it the most solid legal cover to take action against the company. But the underlying reason for the inspection had been the poor clinical data Theranos had submitted to the agency in an effort to get it to approve its tests. When the inspectors failed to find any better data on-site, the decision had been made to shut down the company’s finger-stick testing by taking away the nanotainter, he said. That wasn’t all: he said the Centers for Medicare and Medicaid Services had also just launched its own inspection of Theranos.

Holmes tried to jump ahead of the story by stating that the nanotainter withdrawal was a voluntary decision.

We quickly published my follow-up piece online. Setting the record straight, it revealed that the FDA had forced the company to stop testing blood drawn from patients’ fingers and declared its nanotainter an “unapproved medical device.” The story made the front page of the paper’s print edition the next morning, providing more fuel to what was now a full-blown scandal.

Holmes called a meeting of all company employees.

Striking a defiant tone, she told the assembled staff that the two articles the Journalhad published were filled with falsehoods seeded by disgruntled former employees and competitors. This sort of thing was bound to happen when you were working to disrupt a huge industry with powerful incumbents who wanted to see you fail, she said. Calling the Journal a “tabloid,” she vowed to take the fight to the paper.

A senior hardware engineer asked Balwani to lead them in a chant. A few months earlier, they’d done a certain chant directed at Quest and LabCorp. Everyone remember this chant.

Balwani was glad to lead the chant again. Several hundred employees chanted:

“Fuck you, Carrey-rou! Fuck you, Carrey-rou!”

The following week, the Journal was hosting the WSJ D.Live conference at which Holmes was scheduled to be interviewed.

Holmes came out swinging from the start. That was no surprise: we had expected her to be combative. What we hadn’t fully anticipated was her willingness to tell bald-faced lies in a public forum. Not just once, but again and again during the half-hour interview. In addition to continuing to insist that the nanotainter withdrawal had been voluntary, she said the Edison devices referred to in my stories were an old technology that Theranos hadn’t used in years. She also denied that the company had ever used commercial lab equipment for finger-stick tests. And she claimed that the way Theranos conducted proficiency-testing was not only perfectly legal, it has the express blessing of regulators.

The biggest lie, to my mind, was her categorical denial that Theranos diluted finger-stick samples before running them on commercial machines.

By this point, several prominent Silicon Valley figures were publicly criticizing the company. John-Louis Gassee published a blog post in which he mentioned pointedly different blood-test results he received from Theranos and Stanford Hospital. He wrote Holmes asking about the discrepancy, but never got a reply.

Shultz, Kissinger, Sam Nunn, and other ex-statesmen left the Theranos board and instead formed a board of counselors. David Boies joined the Theranos board.

Within days, the Journalreceived a letter from Heather King demanding a retraction of the main points of the two articles, calling them “libelous assertions.” David Boies stated that a defamation suit was likely. The Journal received another letter demanding that it retain all documents concerning Theranos.

But if Theranos thought this saber rattling would make us stand down, it was mistaken. Over the next three weeks, we published four more articles. They revealed that Walgreens had halted a planned nationwide expansion of Theranos wellness centers, that Theranos had tried to sell more shares at a higher valuation days before my first story was published, that its lab was operating without a real director, and that Safeway had walked away from their previously undisclosed partnership over concerns about its testing.

In an interview with Bloomberg Businessweek, Holmes said she was the victim of sexism.

In the same story, her old Stanford professor, Channing Robertson, dismissed questions about he accuracy of Theranos’s testing as absurd, saying the company would have to be “certifiable” to go to market with a product that people’s lives depended on knowing that it was unreliable. He also maintained that Holmes was a once-in-a-generation genius, comparing her to Newton, Einstein, Mozart, and Leonardo da Vinci.

Carreyrou comments:

There was only one way the charade would end and that was if CMS, the chief regulatory of clinical laboratories, took strong action against the company. I needed to find out what had come of that second regulatory inspection.

 

THE EMPRESS HAS NO CLOTHES

Based on a complaint from Erika Cheung, a veteran CMS field inspector, Gary Yamamoto and his colleague Sarah Bennett made a surprise inspection of Theranos’s lab. Yamamoto and Bennett planned to spend two days, but there were so many issues that they asked for more time. Balwani asked if they could return in two months and they agreed.

In late 2015 and early 2016, Carreyrou tried to find out about the second inspection conducted by Yamamoto and Bennett. Finally he learned that the CMS inspectors had found “serious deficiencies.”

How serious became clear a few days later when the agency released a letter it had sent the company saying they posed “immediate jeopardy to patient health and safety.” The letter gave the company ten days to come up with a credible correction plan and warned that failing to come back into compliance quickly could cause the lab to lose its federal certification.

This was major. The overseer of clinical laboratories in the United States had not only confirmed that there were significant problems with Theranos’s blood tests, it had deemed the problems grave enough to put patients in immediate danger. Suddenly, Heather King’s written retraction demands, which had been arriving like clockwork after each story we published, stopped.

However, Theranos continued to minimize the seriousness of the situation. In a statement, it claimed to have already addressed many of the deficiencies and that the inspection findings didn’t reflect the current state of the Newark lab. It also claimed that the problems were confined to the way the lab was run and had no bearing on the soundness of its proprietary technology. It was impossible to disprove these claims without access to the inspection report. CMS usually made such documents public a few weeks after sending them to the offending laboratory, but Theranos was invoking trade secrets to demand that it be kept confidential…

Carreyrou filed a Freedom of Information Act request to try to force CMS to release the inspection report.

But Heather King continued to urge the agency not to make the report public without extensive redactions, claiming that doing so would expose valuable trade secrets. It was the first time the owner of a laboratory under the threat of sanctions had demanded redactions to an inspection report, and CMS seemed unsure how to proceed.

Carreyrou finally got his hands on a copy of the CMS report.

For one thing, it proved that Holmes had lied at the Journal’s tech conference the previous fall: the proprietary devices Theranos used in the lab were indeed called “Edison,” and the report showed it had used them for only twelve of the 250 tests on its menu. Every other test had been run on commercial analyzers.

More important, the inspection report showed, citing the lab’s own data, that the Edisons produced wildly erratic results. During one month, they had failed quality-control checks nearly a third of the time. One of the blood tests run on the Edisons, a test to measure a hormone that affects testosterone levels, had failed quality control an astounding 87 percent of the time. Another test, to help detect prostrate cancer, had failed 22 percent of its quality-control checks. In comparison runs using the same blood samples, the Edisons had produced results that differed from those of conventional machines by as much as 146 percent. And just as Tyler Shultz had contended, the devices couldn’t reproduce their own results. An Edison test to measure vitamin B12 had a coefficient of variation that ranged from 34 to 48 percent, far exceeding the 2 or 3 percent common for the test at most labs.

As for the lab itself, it was a mess: the company had allowed unqualified personnel to handle patient samples, it had stored blood at the wrong temperatures, it had let reagents expire, and it had failed to inform patients of flawed test results, among many other lapses.

[…]

The coup de grace came a few days later when we obtained a new letter CMS had sent to Theranos. It said the company had failed to correct forty-three of the forty-five deficiencies the inspectors had cited it for and threatened to ban Holmes from the blood-testing business for two years.

Carreyrou met up with Tyler Shultz. Carreyrou points out that Tyler never buckled even though he was under enormous pressure. Moreover, his parents spent over $400,000 on legal fees. Were it not for Tyler’s courage, Carreyrou acknowledges that he might never have gotten his first Theranos article published. In addition, Tyler continued to be estranged from his grandfather, who continued to believe Elizabeth and not Tyler.

Not long after this meeting between Tyler and Carreyrou, Theranos contacted Tyler’s lawyers and said they knew about the meeting. Because neither Tyler nor Carreyrou had told anyone about the meeting, they realized they were under surveillance and being followed. (Alan Beam and Erika Cheung were probably also under surveillance.) At this juncture, Tyler wasn’t too worried, joking that next time he might take a selfie of himself and Carreyrou and sent it to Holmes “to save her the trouble of hiring PIs.”

Soon thereafter, there was more bad news for Theranos. Carreyrou:

…we reported that Theranos had voided tens of thousands of blood-test results, including two years’ worth of Edison tests, in an effort to come back into compliance and avoid the CMS ban. In other words, it had effectively admitted to the agency that not a single one of the blood tests run on its proprietary devices could be relied upon. Once again, Holmes had hoped to keep the voided tests secret, but I found out about them from my new source, the one who had leaked to me CMS’s letter threatening to ban Holmes from the lab industry. In Chicago, executives at Walgreens were astonished to learn of the scale of the test voidings. The pharmacy chain had been trying to get answers from Theranos about the impact on its customers for months. On June 12, 2016, it terminated the companies’partnership and shut down all the wellness centers located in its stores.

In another crippling blow, CMS followed through on its threat to ban Holmes and her company from the lab business in early July. More ominously, Theranos was now the subject of a criminal investigation by the U.S. Attorney’s Office in San Francisco and of a parallel civil probe by the Securities and Exchange Commission.

Many investors in Theranos were fed up:

Partner Fund, the San Francisco hedge fund that had invested close to $100 million in the company in early 2014, sued Holmes, Balwani, and the company in Delaware’s Court of Chancery, alleging that they had deceived it with “a series of lies, material misstatements, and omissions.” Another set of investors led by the retired banker Robert Coleman filed a separate lawsuit in federal court in San Francisco. It also alleged securities fraud and sought class-action status.

Most of the other investors opted against litigation, settling instead for a grant of extra shares in exchange for a promise not to sue. One notable exception was Rupert Murdoch. The media mogul sold his stock back to Theranos for one dollar so he could claim a big tax write-off on his other earnings. With a fortune estimated at $12 billion, Murdoch could afford to lose more than a $100 million on a bad investment.

[…]

Walgreens, which had sunk a total of $140 million into Theranos, filed its own lawsuit against the company, accusing it of failing to meet the “most basic quality standards and legal requirements” of the companies’ contract. “The fundamental premise of the parties’contract–like any endeavor involving human health–was to help people, and not to harm them,” the drugstore chain wrote in its complaint.

Carreyrou concludes the chapter:

The number of test results Theranos voided or corrected in California and Arizona eventually reached nearly 1 million. The harm done to patients from all those faulty tests is hard to determine. Ten patients have filed lawsuits alleging consumer fraud and medical battery. One of them alleges that Theranos’s blood tests failed to detect his heart disease, leading him to suffer a preventable heart attack. The suits have been consolidated into a putative class action in federal court in Arizona. Whether the plaintiffs are able to prove injury in court remains to be seen.

One thing is certain: the chances that people would have died from missed diagnoses or wrong medical treatments would have risen expontentially if the company had expanded its blood-testing services to Walgreen’s 8,134 other U.S. stores as it was on the cusp of doing when Pathology Blawg’s Adam Clapper reached out to me.

 

EPILOGUE

Theranos settled the Partners Fund case for $43 million, and it settled the Walgreens lawsuit for more than $25 million. On March 14, 2018, the Securities and Exchange Commission charged Theranos, Holmes, and Balwani with conducting “an elaborate, years-long fraud.”

To resolve the agency’s civil charges, Holmes was forced to relinquish her voting control over the company, give back a big chunk of her stock, and pay a $500,000 penalty. She also agreed to be barred from being an officer or director in a public company for ten years. Unable to reach a settlement with Balwani, the SEC sued him in federal court in California. In the meantime, the criminal investigation continued to gather steam. As of this writing, criminal indictments of both Holmes and Balwani on charges of lying to investors and federal officials seem a distinct possibility.

It’s one thing for a software or hardware company to overhype the arrival of its technology years before the product was ready. The term “vaporware” describes this kind of software or hardware. Microsoft, Apple,and Oracle were all accused of this at one point, observes Carreyrou.

But it’s crucial to bear in mind that Theranos wasn’t a tech company in the traditional sense. It was first and foremost a health-care company. Its product wasn’t software but a medical device that analyzed people’s blood. As Holmes herself liked to point out in media interviews and public appearances at the height of her fame, doctors base 70 percent of their treatment decisions on lab results. They rely on lab equipment to work as advertised. Otherwise, patient health is jeopardized.

So how was Holmes able to rationalize gambling with people’s lives?

Carreyrou ends the book:

A sociopath is often described as someone with little or no conscience. I’ll leave it to the psychologists to decide whether Holmes fits the clinical profile, but there’s no question that her moral compass was badly askew. I’m fairly certain she didn’t initially set out to defraud investors and put patients in harm’s way when she dropped out of Stanford fifteen years ago. By all accounts, she had a vision that she genuinely believed in and threw herself into realizing. But in her all-consuming quest to be the second coming of Steve Jobs amid the gold rush of the “unicorn” boom, there came a point when she stopped listening to sound advice and began to cut corners. Her ambition was voracious and it brooked no interference. If there was collateral damage on her way to riches and fame, so be it.

 

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My e-mail: jb@boolefund.com

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

The Signal and the Noise

July 20, 2025

I recently re-read Nate Silver’s book, The Signal and the Noise (The Penguin Press, 2012).

From a value investing point of view, it’s crucialto bear in mind that trying to forecast the stock market will typically cause you to make less money than you otherwise would. It’s far more reliable and profitable over the long term to stay focused on individual businesses without ever trying to predict the market or the economy.

Yet it’s worth reviewing Silver’s book because it discusses Bayes’ rule, which is essential for anyone trying to make predictions.

Most of us, even many scientists, do a poor job when it comes to making predictions and when it comes to updating our beliefs. To understand why we make these errors so often, it helps to recall that we have two different mental systems:

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

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

Usually we rely on System 1 to make predictions. Most of the time, these predictions are accurate because they deal with areas of life with very high predictability, like the fact that there is gravity.

But when we encounter complex phenomena where only the careful use of proper statistical thinking can help us make good decisions, System 1 nearly always makes mistakes. In these situations, we have to slow down and consciously activate our System 2.

Once we’ve learned to activate System 2 when it is required, there are two separate steps we need to learn:

  • First, we must train ourselves to make good predictions on the basis of all available evidence.
  • Second, we must train ourselves to test our predictions and to update our hypotheses on the basis of new information. This is where Bayes’ rule comes in.

Here is an outline for this blog:

  • Ignore Macro Forecasting; Focus on Individual Businesses
  • Scientific Progress
  • Out of Sample Events
  • Foxes vs. Hedgehogs
  • Thinking Very Big and Very Small
  • Chaos Theory
  • Earthquakes
  • Economic Forecasting
  • Bayes’ Rule
  • The Problem of False Positives
  • Conclusion

Note: Bayes’ rule is in the running as the most important formula in artificial intelligence. Although a market-beating AI value investor may be 10-20 years away, it’s interesting to follow some of the developments.

 

IGNORE MACRO FORECASTING; FOCUS ON INDIVIDUAL BUSINESSES

No one has ever been able to predict the stock market with any sort of reliability. Ben Graham, the father of value investing, had about a 200 IQ. Buffett calls Graham “the smartest man I ever knew.” Here is what Graham said about market forecasting:

… 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.

If you’re a value investor buying individual businesses when their stocks are cheap, then macroeconomic variables generally aren’t relevant. Furthermore, most investors and businesspeople that pay attention to political and economic forecasts end up worse off as a result. Here are a few good quotes from Buffett on forecasting:

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.

If we find a company we like, the level of the market will not really impact our decisions. We will decide company by company. We spend essentially no time thinking about macroeconomic factors. In other words, if somebody handed us a prediction by the most revered intellectual on the subject, with figures for unemployment or interest rates or whatever it might be for the next two years, we would not pay any attention to it. We simply try to focus on businesses that we think we understand and where we like the price and management.

The great economist John Maynard Keynes developed a similar investment philosophy to that held by Buffett and Munger. Though Keynes was a true genius, he failed twice trying to invest based on macro predictions. Finally, he realized that a concentrated value investment approach was far more effective.

Keynes did very well over decades as a focused value investor. His best advice:

  • Buy shares when they are cheap in relation to probable intrinsic value;
  • Ignore macro and market predictions, and stay focused on a few individual businesses that you understand and whose management you believe in;
  • Hold those businesses for many years as long as the investment theses are intact;
  • Try to have negatively correlated investments (for example, the stock of a gold miner, says Keynes).

 

SCIENTIFIC PROGRESS

One of Silver’s chief points in the book is that we have more data than ever before, but the signal is often overwhelmed by the noise. Says Silver:

Data-driven predictions can succeed – and they can fail. It is when we deny our role in the process that the odds of failure rise. Before we demand more of our data, we need to demand more of ourselves.

When it comes to demanding more of ourselves, what Philip Tetlock and Barbara Mellers are doing with The Good Judgment Project is very worthwhile: http://www.goodjudgment.com/

Silver points out that if the underlying incidence of true hypotheses is low, then it’s quite likely we will have many false positives. John Ioannidis has already shown this – with respect to medical research – in his 2005 paper, ‘Why Most Published Research Findings Are False.’ Silver spoke with Ioannidis, who said:

I’m not saying that we haven’t made any progress. Taking into account that there are a couple of million papers, it would be a shame if there wasn’t. But there are obviously not a couple of million discoveries. Most are not really contributing much to generating knowledge.

 

OUT OF SAMPLE EVENTS

There were many failures of prediction related to the 2008 financial crisis. Silver observes that there is a common thread to these failures:

  • The confidence that homeowners had about housing prices may have stemmed from the fact that there had not been a substantial decline in U.S. housing prices in the recent past. However, there had never before been such a widespread increase in U.S. housing prices like the one that preceded the collapse.
  • The confidence that the banks had in Moody’s and S&P’s ability to rate mortgage-backed securities may have been based on the fact that the agencies had generally performed competently in rating other types of financial assets. However, the ratings agencies had never before rated securities as novel and complex as credit default options.
  • The confidence that economists had in the ability of the financial system to withstand a housing crisis may have arisen because housing price fluctuations had generally not had large effects on the financial system in the past. However, the financial system had probably never been so highly leveraged, and it had certainly never made so many side bets on housing before.
  • The confidence that policy makers had in the ability of the economy to recuperate quickly from the financial crisis may have come from their experience of recent recessions, most of which had been associated with rapid, ‘V-shaped’ recoveries. However, those recessions had not been associated with financial crisis, and financial crises are different.

Silver explains that these events were out of sample, which was a major reason for the failed forecasts. The problem is that few forecasters ever want to look for examples and evidence outside of what their models have already considered:

We will be forced to acknowledge that we know less about the world than we thought we did. Our personal and professional incentives almost always discourage us from doing this.

We forget – or we willfully ignore – that our models are simplifications of the world. We figure that if we make a mistake, it will be at the margin.

In complex systems, however, mistakes are not measured in degrees but in whole orders of magnitude…

One of the pervasive risks that we face in the information age… is that even if the amount of knowledge in the world is increasing, the gap between what we know and what we think we know may be widening. This syndrome is often associated with very precise-seeming predictions that are not at all accurate.

 

FOXES VS. HEDGEHOGS

Silver tabulates Philip Tetlock’s descriptions of foxes versus hedgehogs. (Tetlock is the author of Expert Political Judgment: How Good Is It? How Can We Know? and also Superforecasting: The Art and Science of Prediction.)

How Hedgehogs Think

  • Specialized: Often have spent the bulk of their careers on one or two great problems. May view the opinions of ‘outsiders’ skeptically.
  • Stalwart: Stick to the same ‘all-in’ approach – new data is used to refine the original model.
  • Stubborn: Mistakes are blamed on bad luck or idiosyncratic circumstances – a good model had a bad day.
  • Order-seeking: Expect that the world will be found to abide by relatively simple governing relationships once the signal is identified through the noise.
  • Confident: Rarely hedge their predictions and are reluctant to change them.
  • Ideological: Expect that solutions to many day-to-day problems are manifestations of some grander theory or struggle.

How Foxes Think

  • Multidisciplinary: Incorporate ideas from different disciplines and regardless of their origin on the political spectrum.
  • Adaptable: Find a new approach – or pursue multiple approaches at the same time – if they aren’t sure the original one is working.
  • Self-critical: Sometimes willing (if rarely happy) to acknowledge mistakes in their predictions and accept the blame for them.
  • Tolerant of complexity: See the universe as complicated, perhaps to the point of many fundamental problems being irresolvable or inherently unpredictable.
  • Cautious: Express their predictions in probabilistic terms and qualify their opinions.
  • Empirical: Rely more on observation than theory.

Foxes are better forecasters than hedgehogs. But hedgehogs – because of their big, bold predictions – are much more likely to be interviewed on television.

Silver describes three broad principles that he relies on in the FiveThirtyEight forecasting model:

Principle 1: Thinking Probabilistically

Each forecast comes with a range of possible outcomes. The distribution of possible outcomes is an honest expression of the uncertainty that exists in the real world. What typifies a good forecaster is that the range of possible outcomes is itself supported by the later results of the forecasts. In other words, if you examine all the times when a good forecaster said there was a 90 percent chance of an event happening, those predicted events should have happened about 90 percent of the time.

Foxes very often give a range of possible outcomes, while hedgehogs rarely do.

Principle 2: Update Your Forecasts

When good forecasters get new information that changes the probabilities associated with their prediction, they update their prediction accordingly. A fox has no trouble changing her mind if that’s what the new evidence suggests.

Unfortunately, some people think changing one’s mind on the basis of new evidence is a sign of weakness. But if the forecaster is simply incorporating new information as well as possible, that’s a sign of strength, not weakness. Silver quotes John Maynard Keynes:

When the facts change, I change my mind. What do you do, sir?

Principle 3: Look for Consensus

Very often the consensus estimate is better than most (and sometimes all) individual forecasts:

Quite a lot of evidence suggests that aggregate or group forecasts are more accurate than individual ones, often somewhere between 15 and 20 percent more accurate depending on the discipline.

A common experiment is to present a group of at least thirty people with a jar of pennies, and then ask each person in the group to guess how many pennies are in the jar. In nearly every case, the average guess of the group is more accurate than every individual guess.

Stock prices can be thought of in this way. But there are exceptions occasionally.

The lesson for the fox – in addition to recognizing when the aggregate is likely the best estimate – is to attempt to implement a process of aggregation within your own mind. Try to incorporate as many different types of information and points of view as possible in the process of developing a prediction.f

 

THINKING VERY BIG AND VERY SMALL

Sometimes innovation is very incremental, while other times it involves a big jump forward:

Good innovators think very big and they think very small. New ideas are sometimes found in the most granular details of a problem where few others bother to look. And they are sometimes found when you are doing your most abstract and philosophical thinking, considering why the world is the way that it is and whether there might be an alternative to the dominant paradigm. Rarely can they be found in the temperate latitudes between these two spaces, where we spend 99 percent of our lives. The categorizations and approximations we make in the normal course of our lives are usually good enough to get by, but sometimes we let information that might give us a competitive advantage slip through the cracks.

Most great forecasters constantly innovate and improve.

 

CHAOS THEORY

Silver explains how chaos theory applies to systems in which two properties hold:

  • The systems are dynamic, meaning that the behavior of the system at one point in time influences its behavior in the future;
  • And they are nonlinear, meaning they abide by exponential rather than additive relationships.

Trying to predict the weather is trying to predict a chaotic system:

The problem begins when there are inaccuracies in our data… Imagine that we’re supposed to be taking the sum of 5 and 5, but we keyed in the second number wrong. Instead of adding 5 and 5, we add 5 and 6. That will give us an answer of 11 when what we really want is 10. We’ll be wrong, but not by much: addition, as a linear operation, is pretty forgiving. Exponential operations, however, extract a lot more punishment when there are inaccuracies in our data. If instead of taking 5 to the 5th power – which should be 3,215 – we instead take 5 to the 6th power, we wind up with an answer of 15,625. That’s way off: we’ve missed our target by 500 percent.

This inaccuracy quickly gets worse if the process is dynamic, meaning that our outputs at one stage of the process become our inputs in the next. For instance, say that we’re supposed to take five to the fifth, and then take whatever result we get and apply it to the fifth power again. If we’d made the error described above, and substituted a 6 for the second 5, our results will now be off by a factor of more than 3,000. Our small, seemingly trivial mistake keeps getting larger and larger.

The weather is the epitome of a dynamic system, and the equations that govern the movement of atmospheric gases and fluids are nonlinear – mostly differential equations. Chaos theory therefore most definitely applies to weather forecasting, making the forecasts highly vulnerable to inaccuracies in our data.

Sometimes these inaccuracies arise as the result of human error. The more fundamental issue is that we can only observe our surroundings with a certain degree of precision. No thermometer is perfect, and if it’s off in even the third or the fourth decimal place, this can have a profound impact on the forecast.

Silver notes that perhaps the most impressive improvements have been in hurricane forecasting. Twenty-five years ago, the National Hurricane Center missed by an average of 350 miles when it forecasted a hurricane’s landfall three days in advance. Today the average miss is only about one hundred miles. (Forecasters have not gotten much better at forecasting hurricane intensity, however, since the forces that govern intensity occur at a much smaller scale.)

 

EARTHQUAKES

Seismologists have specific definitions for prediction and forecast:

  • A prediction is a definitive and specific statement about when and where an earthquake will strike: a major earthquake will hit Kyoto, Japan, on June 28.
  • Whereas a forecast is a probabilistic statement, usually over a longer time scale: there is a 60 percent chance of an earthquake in Southern California over the next thirty years. (149)

The United States Geological Survey (USGS) holds that earthquakes cannot be predicted, but they can be forecasted. Silver includes the following table in his book:

FIGURE 5-2. FREQUENCY OF A MAJOR (>= MAGNITUDE 6.75) EARTHQUAKE WITHIN A 50-MILE RADIUS

Anchorage 1 per 30 years
San Francisco 1 per 35 years
Los Angeles 1 per 40 years
Seattle 1 per 150 years
Sacramento 1 per 180 years
San Diego 1 per 190 years
Salt Lake City 1 per 200 years
Portland, OR 1 per 500 years
Charleston, SC 1 per 600 years
Las Vegas 1 per 1,200 years
Memphis 1 per 2,500 years
Phoenix 1 per 7,500 years
New York 1 per 12,000 years
Boston 1 per 15,000 years
Philadelphia 1 per 17,000 years
St. Louis 1 per 23,000 years
Atlanta 1 per 30,000 years
Denver 1 per 40,000 years
Washington, DC 1 per 55,000 years
Chicago 1 per 75,000 years
Houston 1 per 100,000 years
Dallas 1 per 130,000 years
Miami 1 per 140,000 years

 

According to the Gutenberg-Richter law, for every increase of one point in magnitude, an earthquake is ten times less frequent. Thus, given information on past earthquakes and their magnitudes in a given area, it’s straightforward to predict the frequency of more powerful earthquakes in the same area.

As far as specific predictions are concerned, however, weather forecasters are much further along than seismologists. Weather forecasters have been able to develop a good theoretical understanding of the earth’s atmosphere because they can observe a great deal of it. Seismologists, on the other hand, are trying to predict the results of events that mostly occur fifteen kilometers below the earth’s surface. So it’s far more difficult for seismologists to develop a model of what is actually happening.

Overfitting: The Most Important Scientific Problem You’ve Never Heard Of

Mistaking noise for a signal is overfitting. If the model fits past observations too loosely, it is underfitting. If the model fits past observations too closely, it is overfitting. Overfitting is a much more common error than underfitting, as Silver describes:

This seems like an easy mistake to avoid, and it would be if only we were omniscient and always knew about the underlying structure of the data. In almost all real-world applications, however, we have to work by induction, inferring the structure from the available evidence. You are most likely to overfit a model when the data is limited and noisy and when your understanding of the fundamental relationships is poor; both circumstances apply in earthquake forecasting.

…Overfitting represents a double whammy: it makes our model look better on paper but perform worse in the real world. Because of the latter trait, an overfit model eventually will get its comeuppance if and when it is used to make real predictions. Because of the former, it may look superficially more impressive until then, claiming to make very accurate and newsworthy predictions and to represent an advance over previously applied techniques. This may make it easier to get the model published in an academic journal or to sell to a client, crowding out more honest models from the marketplace. But if the model is fitting noise, it has the potential to hurt science.

… To be clear, these mistakes are usually honest ones. To borrow the title of another book, they play into our tendency to be fooled by randomness.

 

ECONOMIC FORECASTING

Economists have a poor track record of predicting recessions. But many of them may not have good incentives to improve.

Silver examined, from 1993 to 2010, economic forecasts of GDP as stated by economists in the Survey of Professional Forecasters. The Survey is unique in that it asks economists to give a range of outcomes and associated probabilities. If economists’ forecasts were as accurate as they thought, then from 1993 to 2010, only 2 forecasts out of 18 would fall outside their prediction intervals. But in fact, actual GDP fell outside the prediction intervals 6 times out of 18.

If you examine how economic forecasts have actually performed, writes Silver, then a 90 percent prediction interval spans about 6.4 points of GDP:

When you hear on the news that GDP will grow by 2.5 percent next year, that means it could quite easily grow at a spectacular rate of 5.7 percent instead. Or it could fall by 0.7 percent – a fairly serious recession. Economists haven’t been able to do any better than that, and there isn’t much evidence that their forecasts are improving.

Silver met with the economist Jan Hatzius, who has been somewhat more accurate in his forecasts (in 2007, he warned about the 2008 crisis). Silver quotes Hatzius:

Nobody has a clue. It’s hugely difficult to forecast the business cycle. Understanding an organism as complex as the economy is very hard.

Silver liststhree fundamental challenges economists face, according to Hatzius:

  • First, it is very hard to determine cause and effect from economic statistics alone.
  • Second, the economy is always changing, so explanations of economic behavior that hold in one business cycle may not apply to future ones.
  • Third, as bad as their forecasts have been, the data that economists have to work with isn’t much good either.

Some data providers track four million statistics on the U.S. economy. But there have only been eleven recessions since the end of World War II. Silver:

If you have a statistical model that seeks to explain eleven outputs but has to choose from among four million inputs to do so, many of the relationships it identifies are going to be spurious. (This is another classic case of overfitting – mistaking noise for a signal…)

For example, the winner of the Super Bowl correctly ‘predicted’ the direction of the stock market in 28 out of 31 years (from 1967 thru 1997). A test of statistical significance would have said that there was only a 1 in 4,700,000 possibility that the relationship was due to chance alone, says Silver.

…of the millions of statistical indicators in the world, a few will have happened to correlate especially well with stock prices or GDP or the unemployment rate. If not the winner of the Super Bowl, it might be chicken production in Uganda. But the relationship is merely coincidental.

Economic variables that are leading indicators in one economic cycle are often lagging indicators in the next economic cycle.

An Economic Uncertainty Principle

Feedback loops between economic forecasts and economic policy can be particularly problematic for economic forecasters. If the economy looks like it’s at risk of going into recession, then the government and the Federal Reserve will take steps to lessen that risk, perhaps even averting a recession that otherwise would have occurred.

Not only do you have to forecast both the economy and policy responses. But even when you examine past economic data, you have to take into account government policy decisions in place at the time, notes Silver. This issue was first highlighted by economist Robert Lucas in 1976. Silver continues:

Thus, it may not be enough to know what current policy makers will do; you also need to know what fiscal and monetary policy looked like during the Nixon administration. A related doctrine known as Goodhart’s law, after the London School of Economics professor who proposed it, holds that once policy makers begin to target a particular variable, it may begin to lose its value as an economic indicator….

At its logical extreme, this is a bit like the observer effect (often mistaken for a related concept, the Heisenberg uncertainty principle): once we begin to measure something, its behavior starts to change. Most statistical models are built on the notion that there are independent variables and dependent variables, inputs and outputs, and they can be kept pretty much separate from one another. When it comes to the economy, they are all lumped together in one hot mess.

An Ever-Changing Economy

An even more fundamental problem is that the American and global economies are always evolving. Even if you correctly grasp the relationships between different economic variables in the past, those relationships can change over the course of time.

Perhaps you correctly account for the fact that the U.S. economy now is dominated more by the service sector. But how do you account for the fact that major central banks have printed trillions of dollars? How do you account for interest rates near zero (or even negative)?

The U.S. stock market seems high based on history. But if rates stay relatively low for the next 5-10, the U.S. stock market could gradually move higher from here. U.S. stocks may even turn out, in retrospect, to be cheap today if there has been a structural shift to lower interest rates.

Furthermore, as Silver points out, you never know the next paradigm shift that will occur. Will the future economy, or the future stock market, be less volatile or more? What if breakthroughs in technology create a much wealthier economy where the need for many forms of human labor is significantly curtailed? Is that the most likely way that debt levels can be reduced and interest rates can move higher? Or will central banks inflate away most of the current debt by printing even more money and/or by keeping rates very low for many more years? No one really knows.

Economic Data is Very Noisy

Most economic data series are subject to revision. Average GDP could be revised up to very high GDP or revised down to a recession. Silver:

So we should have some sympathy for economic forecasters. It’s hard enough to know where the economy is going. But it’s much, much harder if you don’t know where it is to begin with.

 

BAYES’ RULE

Eliezer Yudkowsky of the Machine Intelligence Research Institute provides an excellent intuitive explanation of Bayes’s rule: http://www.yudkowsky.net/rational/bayes

Yudkowsky begins by discussing a situation that doctors often encounter:

1% of women at age forty who participate in routine screening have breast cancer. 80% of women with breast cancer will get positive mammographies. 9.6% of women without breast cancer will also get positive mammographies. A woman in this age group had a positive mammography in a routine screening. What is the probability that she actually has breast cancer?

Most doctors estimate the probability between 70% and 80%, which is wildly incorrect.

In order to arrive at the correct answer, Yudkowsky asks us to think of the question as follows. We know that 1% of women at age forty who participate in routine screening have breast cancer. So consider 10,000 women who participate in routine screening:

  • Group 1: 100 women with breast cancer.
  • Group 2: 9,900 women without breast cancer.

After the mammography, the women can be divided into four groups:

  • Group A: 80 women with breast cancer, and a positivemammography.
  • Group B: 20 women with breast cancer, and a negativemammography.
  • Group C: 950 women without breast cancer, and a positivemammography.
  • Group D: 8,950 women without breast cancer, and a negativemammography.

So the question again: If a woman out of this group of 10,000 women has a positive mammography, what is the probability that she actually has breast cancer?

The total number of women who had positive mammographies is 80 + 950 = 1,030. Of that total, 80 women had positive mammographies AND have breast cancer. In looking at the total number of positive mammographies (1,030), we know that 80 of them actually have breast cancer.

So if a woman out of the 10,000 has a positive mammography, the chances that she actually has breast cancer = 80/1030 or 0.07767 or 7.8%.

That’s the intuitive explanation. Now let’s look at Bayes’Rule:

P(A|B) = [P(B|A)P(A)] /P(B)

Let’s apply Bayes’ Rule to the same question above:

1% of women at age forty who participate in routine screening have breast cancer. 80% of women with breast cancer will get positive mammographies. 9.6% of women without breast cancer will also get positive mammographies. A woman in this age group had a positive mammography in a routine screening. What is the probability that she actually has breast cancer?

P(A|B) = the probability that the woman has breast cancer (A), given a positive mammography (B)

Here is what we know:

P(B|A) = 80% – the probability of a positive mammography (B), given that the woman has breast cancer (A)

P(A) = 1% – the probability that a woman out of the 10,000 screened actually has breast cancer

P(B) = (80+950) / 10,000 = 10.3% – the probability that a woman out of the 10,000 screened has a positive mammography

Bayes’ Rule again:

P(A|B) = [P(B|A)P(A)] /P(B)

P(A|B) = [0.80*0.01] / 0.103 = 0.008 / 0.103 = 0.07767 or 7.8%

Derivation of Bayes’ Rule:

Bayesians consider conditional probabilities as more basic than joint probabilities. You can define P(A|B) without reference to the joint probability P(A,B). To see this, first start with the conditional probability formula:

P(A|B) P(B) = P(A,B)

but by symmetry youget:

P(B|A) P(A) = P(A,B)

It follows that:

P(A|B) = [P(B|A)P(A)] /P(B)

which is Bayes’ Rule.

 

THE PROBLEM OF FALSE POSITIVES

In the case of the age forty women who had a positive mammogram, we saw that only about 7.8% actually had cancer. So there were many false positives. Out of 10,000 age forty women tested, 950 tested positive but did not have cancer.

Silver explains how, in the Era of Big Data, if you look at published scientific results, there are likely to be many false positives. Assume that 100 out of 1,000 hypotheses are actually true. Further assume that 80% of true scientific hypotheses are correctly deemed to be true, while 90% of false hypotheses are correctly rejected. So now we have four groups:

  • True positives: 80 of 100 hypotheses that are true are correctly deemed true
  • False negatives: 20 of 100 hypotheses that are true are incorrectly deemed false
  • False positives: 90 of 900 hypotheses that are false are incorrectly deemed true
  • True negatives: 810 of 900 hypotheses that are false are correctly deemed false

So you can see, under these assumptions, that we’ll have 80 true hypotheses correctly identified as true, but 90 false hypotheses incorrectly identified as true. Silver comments:

…as we know from Bayes’ theorem, when the underlying incidence of something in a population is low (breast cancer in young women; truth in a sea of data), false positives can dominate the results if we are not careful.

 

CONCLUSION

Most of us, including scientists, are not very good at making probability estimates about future events. But there are two pieces of good news, writes Silver:

  • First, our estimates are just a starting point. Bayes’ theorem will allow us to improve our estimates every time we get new information.
  • Second, with practice – and trial and error – we can get much better at making probability estimates in the first place. For instance, see: http://www.goodjudgment.com/

Silver explains the importance of testing our ideas:

Bayes’ theorem encourages us to be disciplined about how we weigh new information. If our ideas are worthwhile, we ought to be willing to test them by establishing falsifiable hypotheses and subjecting them to a prediction. Most of the time, we do not appreciate how noisy the data is, and so our bias is to place too much weight on the newest data point…

But we can have the opposite bias when we become too personally or professionally invested in a problem, failing to change our minds when the facts do. If an expert is one of Tetlock’s hedgehogs, he may be too proud to change his forecast when the data is incongruous with his theory of the world.

The more often you are willing to test your ideas, the sooner you can begin to avoid these problems and learn from your mistakes… It’s more often with small, incremental, and sometimes even accidental steps that we make progress.

 

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: jb@boolefund.com

 

 

 

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

Best Performers: Microcap Stocks

July 13, 2025

Are you a long-term investor? If so, are you interested in maximizing long-term results without taking undue risk?

Warren Buffett, arguably the best investor ever, has repeatedly said that most people should invest in a low-cost broad market index fund. Such an index fund will allow you to do better than 80% to 90% of all investors, net of costs, after several decades.

Buffett has also said that you can do better than an index fund by investing in microcap stocks – as long as you have a sound method. Take a look at this summary of the CRSP Decile-Based Size and Return Data from 1927 to 2020:

Decile Market Cap-Weighted Returns Equal Weighted Returns Number of Firms (year-end 2020) Mean Firm Size (in millions)
1 9.67% 9.47% 179 145,103
2 10.68% 10.63% 173 25,405
3 11.38% 11.17% 187 12,600
4 11.53% 11.29% 203 6,807
5 12.12% 12.03% 217 4,199
6 11.75% 11.60% 255 2,771
7 12.01% 11.99% 297 1,706
8 12.03% 12.33% 387 888
9 11.55% 12.51% 471 417
10 12.41% 17.27% 1,023 99
9+10 11.71% 15.77% 1,494 199

(CRSP is the Center for Research in Security Prices at the University of Chicago. You can find the data for various deciles here: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html)

The smallest two deciles – 9+10 – comprise microcap stocks, which typically are stocks with market caps below $500 million. What stands out is the equal weighted returns of the 9th and 10th size deciles from 1927 to 2020:

Microcap equal weighted returns = 15.8% per year

Large-cap equal weighted returns = ~10% per year

In practice, the annual returns from microcap stocks will be 1-2% lower because of the diffi0 Comments in moderationculty (due to illiquidity) of entering and exiting positions. So we should say that an equal weighted microcap approach has returned 14% per year from 1927 to 2020, versus 10% per year for an equal weighted large-cap approach.

Still, if you can do 4% better per year than the S&P 500 Index (on average) – even with only a part of your total portfolio – that really adds up after a couple of decades.

  • Most professional investors ignore micro caps as too small for their portfolios. This causes many micro caps to get very cheap. And that’s why an equal weighted strategy – applied to micro caps – tends to work well.

 

VALUE SCREEN: +2-3%

By systematically implementing a value screen–e.g., low EV/EBITDA or low P/E–to a microcap strategy, you can add 2-3% per year.

 

GROWING EARNINGS AND IMPROVING FUNDAMENTALS: +2-3%

You can further boost performance by screening for growing earnings and improving fundamentals. One excellent way to do this is using the Piotroski F_Score, which works best for cheap micro caps. See: https://boolefund.com/joseph-piotroski-value-investing/

This screen should increase performance by at least 2-3% a year.

 

POSITIVE MOMENTUM AND OTHER FACTORS: +2-3%

Then our model screens for high shareholder yield, high insider ownership, insider buying, high ROE, low/no debt, and positive momentum.  This screen should further boost performance by at least 2-3% a year.

 

BOTTOM LINE

If you invest in microcap stocks, you can get about 14% a year. If you also use a simple screen for value, that adds at least 2-3% a year. If, in addition, you screen for growing earnings and improving fundamentals, that adds at least another 2-3% a year. Finally, screening for positive momentum and others factors boosts performance at least another 2-3% a year. So that takes you to 20-23% a year.  After fees, that comes to 15-18% a year, which compares quite well to the 10% a year you could get from an S&P 500 index fund.

What’s the difference between 15% a year and 10% a year? If you invest $50,000 at 10% a year for 30 years, you end up with $872,000, which is good. If you invest $50,000 at 15% a year for 30 years, you end up with $3.31 million, which is much better.

Please contact me if you would like to learn more.

    • My email: jb@boolefund.com.
    • My cell: 206.518.2519

 

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 with improving fundamentals and positive momentum. We rank microcap stocks based on these and similar criteria.

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

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

 

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

My e-mail: jb@boolefund.com

 

 

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

 

PUBLIC APOLOGY TO JOE I. BARER, FROM JASON F. BOND

PUBLIC APOLOGY TO JOE I. BARER, FROM JASON F. BOND

To Joe I. Barer,

Twenty-three years ago, I made a serious mistake that caused you pain. I take full responsibility for what I wrote, and I’m deeply sorry.

In 2002, I sent an email that said:

“It’s my world after all, and yours too, at least if you want it badly enough.”

I now understand how dismissive and arrogant those words were. They implied ownership, superiority, and a lack of respect—and I regret writing them more than I can say.

There’s no excuse. I failed to treat you with the care, respect, and dignity you deserved.

You’ve built a remarkable track record in business—one I’ve long respected. I see now that my words may have minimized your experience and left a lasting wound. I’m truly sorry for that.

This apology isn’t about my intentions. It’s about the impact. And the truth is: I didn’t live up to the standards of decency or character that I now try to hold myself to.

If there’s anything I can do to make things right, I’m open to hearing it. I understand why you’ve been angry—and I want you to know your pain is valid and not ignored.

I can’t undo the past. But I hope this apology is a start toward healing.

Though I’ve offered apologies in the past, I know that healing doesn’t follow a schedule. I’m sharing this publicly now in hopes that clarity, humility, and time can do what past efforts could not.

And while this letter is about the harm I caused, I also want to say that I’ve chosen to forgive all that’s happened. Not because it was easy, but because I believe peace is more powerful than pain.

With respect and deep regret,
Jason F. Bond

published July 10, 2025

CASE STUDY: Paul Mueller (MUEL)

5/11/25

Paul Mueller (MUEL) is a company that manufactures innovative stainless steel processing equipment.

(h/t Maj Soueidan of GeoInvesting)

Here are the industries that MUEL currently serves:

    • Dairy farming
    • Biotechnology
    • Process cooling
    • Food processing
    • Beverage processing
    • Chemical processing
    • Thermal energy storage
    • HVAC and heat recovery
    • Water purification/distillation
    • Pharmaceutical manufacturing
    • Industrial tank and vessel fabrication
    • Specialty transport and logistics (contract carriage)

The company has had a high cash balance and virtually no debt for years.  MUEL recently started buying back stock at a P/E of 8 or lower.  Its first buyback was completed in April 2024 at $80 for $15 million.  The buyback recently announced is for $15 million at $250.

But the company still has $55.3 million in cash and only $6.9 million in debt.

The company has little exposure to tariffs, as most of its activities are based in the United States, including recent facility expansions. (But they do have a manufacturing facility in Vietnam.)

MUEL just reported Q1 2025 EPS of $5.26, up from $4.10 a year ago. Sales climbed to $58.9 million from $50.4 million. Q1 is usually the company’s seasonally weakest quarter.

Q4 2024—reported a couple of weeks ago—showed EPS of $11.89 vs. $4.32 in Q4 2023.  Q4 2024 revenue was $70.4 million vs. $55.7 million in Q4 2023.

More importantly, according to the Q1 2025 report, MUEL’s backlog jumped to $254.5 million, nearly tripling from $95.2 million one year earlier. This is MUEL’s highest backlog in years.

If we translate the backlog into earnings, we get about $42 in EPS, or a forward P/E of 6.9.

One major component of the backlog is a newly announced $120 million pharmaceutical contract, which will be fulfilled through 2026​.  This is part of the company’s strategy to enter new growth markets.

Furthermore, in addition to the $30 million stock buyback, MUEL has launched three capacity expansions in 18 months, adding 131,000 square feet to its manufacturing operations.  This includes a $17.9 million project in April 2025, part of the company’s goal to modularize production by pre-assembling large units.

According to the company, the modular assemblies shift complex construction from the customer’s site to MUEL’s controlled manufacturing environment and result in:

    • Reduced risk: Building and testing large equipment modules in-house minimizes surprises. On-site construction in industries like pharma often involves tight space, regulatory scrutiny, and coordination with ongoing operations. By delivering fully assembled, tested units, MUEL lowers the chance of installation delays, compliance issues, or costly errors.
    • Faster implementation: Modular systems arrive ready to go. Instead of weeks or months of assembly at the customer’s location, installation becomes more like plug-and-play. That translates to shorter project timelines, quicker regulatory signoff, and faster time-to-value for the client.

In the 2024 shareholder letter, CEO David Moore explained the advantages of its new modular assembly capabilities:

The modular assembly of processing equipment allows us to set the vessels, heat exchangers, piping, and controls into structural frames shipped to the customer and installed as one module, reducing the time and risk required to assemble this equipment at the customer’s site. This method is popular in the pharmaceutical industry, where the largest modules are known as superskids, but this practice has applications in other industries we serve.

Moore adds:

The current backlog, combined with investments in equipment and talent, puts the Company in a strong operational and financial position.

Moore concludes:

By producing components like tank heads, manways, heat exchangers, and machined parts in-house, fabricating a wide range of vessels, and performing modular construction in our factory, we significantly reduce the number of vendors, risks, and costs for our customers.

The market cap is $269.8 million while enterprise value is $221.4 million.

Here are the metrics of cheapness:

    • EV/EBITDA = 5.05
    • P/E = 8.95
    • P/B = 3.19
    • P/CF = 4.92
    • P/S = 1.05

For a company with MUEL’s growth prospects—based on its capacity expansions and its backlog—these metrics are quite low.

Insider ownership is 7.7%, which is decent (worth over $20 million).  ROE (return on equity) is 39.7%, which is excellent.  The Piotroski F_Score is outstanding at 8.

As noted, the company has $55.3 million in cash and only $6.9 million in debt.  And TL/TA (total liabilities to total assets) is 50%, which is pretty good.

Intrinsic value scenarios:

    • Low case: If there’s a bear market or a recession, the stock could decline temporarily. That would be a buying opportunity.
    • Mid case: The forward P/E is 6.9 but should be at least 16. This translates into a share price of $667.83, which is over 130% higher than today’s stock price of $288.
    • High case: Arguably, the forward P/E should be 20.  This translates into a share price of $834.78, which is 190% higher than today’s stock price of $288.

 

RISKS

    • As noted, there could be a bear market or a recession that would likely drive down the stock price temporarily.

 

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: jb@boolefund.com

 

 

 

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