A Reflection on Reading

I used to love reading, but reading hasn’t been fun for me lately.

I’ve been a big reader since I was an adolescent. A non-embellished family lore story that gets mentioned with some frequency involves my father insisting that I stop wasting my time on mindless recreational activities (I was about eight in this story, so we’re not talking about drugs) and do something productive with my time. Trying to figure out what I could do differently I asked, “Like what?” Exasperated, he replied, “I don’t know, read a book!” “But I’ve read everything already.” “You’ve read every book in this house?” he asked, bemused. He began grabbing books off the shelf in my room at random and quizzing me, “What’s this one about? What about this one?” After doing this five or six times, he gave up, admitted maybe I was using my time as wisely as I could and maybe we didn’t have enough books, either, and agreed right then and there to buy me any book I wanted, any time I wanted, going forward. We started making a lot of trips to Barnes & Noble and Borders after that!

The story is not embellished but it might as well be. My father was too busy building our family business to prioritize reading much of anything that was not industry related. My mother had her hands full raising several small children and tending to the other household needs so she didn’t prioritize reading as much, either. Both my parents saw reading as important — one of those things you recognize the value in because you DON’T do it yourself, I suppose — and wanted their children, including me, to be readers. So I had a bookshelf in my room, and there were a few other titles strewn about here and there, but it wasn’t like we had some sophisticated reference library (we didn’t buy a set of encyclopedias until I was around thirteen, and by then the digital world of the internet had entered my life in a most distracting manner and I found searching for information there more fascinating than paging through a hardbound ‘pedia… who knows what would’ve happened if I had had access to that material when I was eight) and the most complicated story on my shelf at the time was probably a Boxcar Children novel or a collection of Shel Silverstein poetry.

The point is, I loved to read and if I found a book, I generally read it. As I got older, my interests in reading shifted. I spent a lot of time immersed in the fictional worlds of fantasy writing and sci-fi. I ended up owning and reading stacks of paperback novels that would be eight or nine feet high laid on top of one another. I also became interested in news magazines (though not newspapers, which I found cumbersome physically, dirty, and we never seemed to be subscribed to one). By my teenage years I was subscribed to TIME, Newsweek, National Review, Popular Mechanics and Popular Science. As I entered high school I added The Atlantic Monthly and New Yorker to the list, as well as a few others. I continued reading mostly novels, essentially unaware of the world of biography, philosophy, social science and history more generally speaking. I read nothing of business or investing. I just didn’t know the stuff existed, though I wish I had because I can imagine myself enjoying reading it back then.

After going to college, I became more serious about reading. Part of this was because I found myself extremely frustrated in my classes with the material I was being taught and the lack of critical thinking I thought the classes entailed about the subject matter, concerns I’ve laid out in some detail in earlier posts. As a result, I took to a program of parallel self-study in various fields, such as economics. Again, at the time I was unaware that there was a phenomenon called “autodidactism”, which I had been doing a lot of my entire life but never with any discipline, but now I was discovering it and realizing just how powerful a dedicated program of reading and thinking could be for me in connecting the knowledge dots. I found a variety of printable media on sites like http://www.mises.org, entire economic treatises a thousand pages long or more, and started visiting Kinko’s (now FedEx Office) to print and spiral bind these works into more manageable mini-volumes. I’d stuff these things in my book bag and read them on my 30 minute subway commute to class and back, or more generally, in the back of the lecture I was supposed to be listening to instead. My grades suffered a bit (though I think that’s mostly because I found the official subject matter so disingenuous and so worthless that I’d often fall asleep in my apartment trying to study it) but my knowledge exploded. I was hooked on reading.

I’ve been a serious reader ever since. But being a serious reader is a lot different from being someone who loves reading. I’ve struggled with the two lately. Being a serious reader is hard work. It is exhausting. It is demanding of your time and energy and it leaves little room for other priorities. Done the right way, it entails a lot of ancillary obligations as well, in my experience, such as writing and reflecting on one’s reading, compiling annotated notes, meeting with others reading the same material to discuss, etc. It’s much more than a hobby, though it isn’t quite a paid career! And while it has rewarding moments, it isn’t exactly “fun.” It lacks spontaneity and the thrill of the unplanned discovery.

Three years ago I traveled to South America with the Wolf and a friend. Though we were on a nearly 3 week journey, far from home, I took only two books with me– a non-fiction work about a traveler who tries to rediscover Hiram Bingham’s journey to Machu Picchu, which was part of our itinerary, and a copy of Barbara Tuchman’s The Guns of August. I read the Machu Picchu book as a “serious” reader, as some background for the trip we were undertaking. I read the Tuchman book as someone who loves reading.

Since I read Tuchman’s book, I’ve come to understand that there are some academic criticisms of her telling of history in the story. I don’t think it’s so bad that the book is viewed as a complete fabrication of history, but there are people who argue she emphasized the wrong things, or interpreted events in a novel way that isn’t as rigorous as it could be. And I’ve got to say– I don’t give a damn. It was a marvelous book to read. I don’t know why I decided to finally read it, or why I picked that book of all books to accompany me on my long trip, and I don’t know what I expected to get out of it, but it was amazing. We had a hell of a time on our trip and I can honestly say that laying in bed at some of our hostels and inns, reading another chapter from Guns, were part of those happy memories. It reminded me of just how enjoyable reading can be.

As I mentioned, that was three years ago. Sadly, I haven’t had a similar reading experience since then. It has been almost all “serious” reading and if anything it’s gotten worse over the last few years because I made a resolution a couple years ago to double down on my reading discipline and treat it even more mechanically than I had been. Where did that take me?

It took me to a pretty scary place, reading-wise, where my edifying and sometimes enjoyable hobby became a master with a strange power over me. I realized a few days ago when I had hit the wall when I noticed that I was tracking my “currently reading” list on GoodReads.com, which numbered over twenty titles (!?), and I was spending a lot more time worrying about “getting through it all” than I was actually spending reading the damn books! It was beginning to dominate my thoughts– at work, at home, in play, walking the dog… this nagging anxiety that I had so much to read and it was so exhausting and so unrewarding to feel I was forcing myself to do it just followed me everywhere I went.

After chatting with a friend about some fun-sounding titles, I decided to take action. I logged into GoodReads and wiped my reading list. Completely. Just gone, no glaring record of what I might achieve but have not yet achieved in the world of reading. I grabbed the titles I was physically in the middle of that were laying about the house to remind me to keep working on them, and shelved them. I decided if they’re really interesting and worth my time, I will know where to find them– the idea that I’d lose track of a book I really wanted to read without the “help” of a cloud-based book list seemed truly silly. I shook out the contents of my head a little bit and gave myself permission to not be interested in the stuff I was trying to read right now (which I truly wasn’t, at least not RIGHT NOW) and simultaneously gave myself permission to buy and read the first “fun” book I could think of reading. I chose The Subtle Art of Not Giving A Fuck and for the first time in a long time, I used the 2day shipping feature on Amazon to ensure it’d arrive today so I could start reading it. A blaring alarm I was not listening to in this story is the fact that I was in the habit of ordering multiple books at a time and selecting the “Super Saver” shipping option, reasoning that I’d prefer a $1 e-credit because I “didn’t care when my books arrived.” I mean, if that doesn’t tell you something (“bird in the hand is worth two in the bush”… the ancient demonstration of time preference) I don’t know what would.

Now my mind is a bit more free. And I am looking forward to reading this goofy book this evening after it arrives. And I know that if I don’t want to keep turning the page, I can shelve it and pick up something else, order something else or even do something else entirely. There’s a time and a place for being a serious reader, but that time and place shouldn’t be found in my recreational reading regimen. I’m looking forward to loving reading again!

Review – Good To Great

Good To Great: Why some companies make the leap and others don’t

by Jim Collins, published 2001

The G2G Model

“Good To Great” seeks to answer the question, “Why do some good companies become great companies in terms of their market-beating stock performance, while competitors stagnate or decline?” After a deep dive into varied data sources with a team of tens of university researchers, Collins and his team arrived at an answer:

1. Level 5 Leadership
2. First Who… Then What
3. Confront The Brutal Facts (Yet Never Lose Faith)
4. The Hedgehog Concept (Simplicity Within The Three Circles)
5. A Culture Of Discipline
6. Technology Accelerators

The first two items capture the importance of “disciplined people”, the second two items refer to “disciplined thought” and the final pair embodies “disciplined action”. The concepts are further categorized, with the first three components representing the “build up”, the ducks that must be gotten into a row before the second category holding the last three components, “breakthrough”, can take place. The entire package is wrapped up in the physical metaphor of the “flywheel”, something an organization pushes on and pushes on until suddenly it rolls forward and gains momentum on its own.

This book found its way onto my radar several times so I finally decided to read it. I’d heard it mentioned as a good business book in many places but first took the idea of reading it seriously when I saw Geoff Gannon mention it as part of an essential “Value Investing 101” reading list. I didn’t actually follow through on the initial impulse until I took a “leadership science” course recently in which this book was emphasized as worth covering.

I found G2G to be almost exactly what I expected– a rather breathless, New Age-y, pseudo-philosophical and kinda-scientific handbook to basic principles of organizational management and business success.  The recommendations contained within range from the seemingly reasonable to the somewhat suspect and the author and his research team take great pains to make the case that they have built their findings on an empirical foundation but I found the “We had no theories or preconceived notions, we just looked at what the numbers said” reasoning scary. This is actually the opposite of science, you’re supposed to have some theories and then look at whether the data confirms or denies them. Data by itself can’t tell you anything and deriving theory from data patterns is the essence of fallacious pattern-fitting.

Those caveats out of the way, the book is still hard to argue with. Why would an egotistical maniac for a leader be a good thing in anything but a tyrannical political regime, for example? How would having “the wrong people on the bus” be a benefit to an organization? What would be the value in having an undisciplined culture of people who refuse to see reality for what it is?

What I found most interesting about the book is the way in which all the principles laid out essentially tend to work toward the common goal of creating a controlled decision-making structure for a business organization to protect it from the undue influence of big egos and wandering identities alike. In other words, the principles primarily address the psychological risks of business organizations connected to cult-like dependency on great leaders, tendency toward self-delusional thinking and the urge to try everything or take the easy way out rather than focus on obvious strengths. This approach has many corollaries to the value investing framework of Benjamin Graham who ultimately saw investor psychology as the biggest obstacle to investor performance.

I don’t have the time or interest to confirm this hypothesis but I did wonder how many of the market-beating performances cataloged were due primarily to financial leverage used by the organization in question, above and beyond the positive effects of their organizational structure.

A science is possible in all realms of human inquiry into the state of nature. Man and his business organizations are a part of nature and thus they fall under the rubric of potential scientific inquiry. I don’t think we’re there yet with most of what passes for business “research” and management or organizational science, but here and there the truth peeks out. “Good To Great” probably offers some clues but it’s hard to know precisely what is the wheat and what is the chaff here. Clearly if you inverted all of the recommendations of the book and tried to operate a business that way you’d meet your demise rather quickly, but that is not the same thing as saying that the recommendations as stated will lead in the other direction to greatness, or that they necessarily explain the above-average market return of these public companies.

I took a lot of notes in the margin and highlighted things that “sounded good” to me but on revisiting them I am not sure how many are as truly useful as they first seemed when I read them. I think the biggest takeaway I had from the book was the importance of questioning everything, not only as a philosophical notion but also as a practical business tool for identifying problems AND solutions.

Notes – The Intelligent Investor Commentary By Jason Zweig

The Intelligent Investor: A Book of Practical Counsel

by Benjamin Graham, Jason Zweig, published 1949, 2003

The Modern Day Intelligent Investor

The following note outline was rescued from my personal document archive. The outline consists of a summary of the end-chapter commentary written by Jason Zweig. Zweig did such a good job of reviewing Graham’s lessons in each chapter and practically applying them that I find you can get most of the major principles of The Intelligent Investor by reading the combined commentary chapters as if they were a standalone investment book.

Of course, Graham’s original work is a classic in the value investing tradition and it should be read and savored on its own, as well.

Chapter 1, JZ commentary

1. What is investing?
   1. You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock
   2. You must deliberately protect yourself against serious losses
   3. You must aspire to “adequate”, not extraordinary, performance
2. How to invest
   1. An investor calculates what a stock is worth, based on the value of the underlying business
   2. A speculator gambles that a stock will go up in price because somebody will pay even more for it
   3. You should be comfortable owning the underlying business even if you couldn’t get timely, regular quotes of its market price
   4. Price is what the business is selling for, not what it’s worth. Value is what the business is worth. Money is sometimes made in the arbitraging of the two, but price does not dictate value; in the long-term, value dictates price
3. Limit your risk
   1. Never mingle speculative accounts and investment accounts
   2. Never allow your speculative thinking to spill over into your investing activities
   3. Never put more than 10% of your assets into your “mad money” account

Chapter 2, JZ commentary

1. Stocks have not had a perfect record of keeping up with inflation, as measured by the CPI
2. 20% of the 5year periods from 50s today in which inflation dominated saw falling stocks
3. Two strategies for branching out beyond stocks during inflation:
   1. REITs (Real Estate Investment Trusts)
   2. TIPS (Treasury Inflation Protected Securities)
      1. IRS considers an increase in TIPS value to be taxable income

Chapter 3, JZ commentary

1. “By the rule of opposites, the more enthusiastic investors become about the stock market in the long run, the more certain they are to be proved wrong in the short run.”
2. The stock market’s performance depends on three factors:
   1. real growth in earnings and dividends
   2. inflation(-expectations) within the general economy
   3. speculative appetite for stocks/risk (increase/decrease)
3. In the long run, you can reasonably expect stocks to average a 6% nominal return, 4% real return (with inflation calculated at 2% historical rate)
4. Be humble about your ability to forecast future stock returns– don’t risk too much on a forecast that could turn out to be wrong.

Chapter 4, JZ commentary

1. Two kinds of intelligent investors:
   1. active/enterprising – continual research, selection and monitoring of a dynamic mix of stocks, bonds or mutual funds (intellectually/physically demanding)
   2. passive/defensive – create a permanent portfolio that runs on autopilot and requires no further effort but generates very little excitement (emotionally demanding)
2. How to allocate amongst stocks and bonds for defensive investors?
   1. “Age” is arbitrary and pointless
   2. Instead, consider the fundamental circumstances of your life and the financial needs you’ll have for the foreseeable future
   3. For the aggressive investor, 25% in bonds and cash, 75% in stocks
   4. For the defensive investor, 25% in stocks and 75% in bonds and cash
   5. Rebalancing should be done on a predictable, disciplined basis– not when the market dictates, but when the “calendar” or schedule does
3. Income investing (bond choices)
   1. Taxable or tax free? Choose tax free (municipal) unless you are in the lowest income bracket
   2. Short-term or long-term? Intermediate term bonds of 5-10yrs allow you to avoid the guessing game and see-saw risks of short and long-term bonds
   3. Bonds or bond funds? Unless you have a lot of capital to make minimum purchases, probably more cost effective to buy a bond fund
   4. Watch out for preferred stock, the worst of both worlds
      1. Secondary claim on assets in bankruptcies (junior to bonds)
      2. Offer less potential profit than common equity because they are often forcibly called by businesses when interest rates drop or credit ratings improve
      3. Companies can not deduct the interest payments like they can with bond issuance, ask yourself, “Why would a company that is healthy issue preferred rather than bonds?” Answer is, probably because they aren’t healthy
   5. Sometimes, stocks can offer competitive yields with Treasuries, which can increase income yield while raising potential return (as well as increasing potential risk of loss)

Chapter 5, JZ commentary

1. Markets are least risky after a crash, most risky at the top
2. Should you buy what you know? Psychological studies say that we tend to discount risk inappropriately when we feel we are experts on something due to familiarity
3. Dollar-cost averaging can be a disciplined way to force oneself to invest through bear and bull markets

Chapter 6, JZ commentary

1. Junk bonds
   1. Graham warned against them because they were difficult to diversify away the risks of default; today, many junk bond funds exist which allow an investor to diversify
   2. While junk bonds have outperformed 10yr UST even with historical default rates factored in, many junk bond funds charge high fees which reduces their appeal
2. Emerging market bonds
   1. Typically not correlated with US equity markets
   2. Restrict holdings in bond portfolio to 10% (published 2003)
3. Day trading
   1. The increased transaction costs of day trading is a surefire way to bomb a portfolio
   2. Day trading raises transaction costs to the point where returns must be beyond what one could reasonably expect to make with a conservative estimation of returns, just to break even
4. IPOs
   1. Most people who have bought-and-held IPOs have been decimated over time
   2. Hard to find value in the mania buying of an IPO
   3. The public excitement of an IPO often leads investors to forget about valuing the underlying business; many investors have paid ridiculous sums for businesses that were not profitable and never had a chance of being profitable
   4. “It’s Probably Overpriced”

Chapter 7, JZ commentary

1. Market timing is essentially a fools errand: Life can only be understood looking backwards, but it is lived forwards.
2. Growth stocks– the faster the companies grow, the higher goes their stock multiples
   1. A $1B company can double its business fairly easily, but how will a $50B company double itself?
   2. A great company is not a great investment if you pay too much for it
   3. When growth companies expand beyond 25-30 times earnings, they’re expensive and should not be bought
   4. One way growth companies could become temporarily attractive is when they suffer a setback or disclosure of upsetting information, creating “the relatively unpopular large company.”
3. Most great fortunes in the world are made through concentration into one industry or business idea; similarly, most great fortunes are lost this way as well
   1. Because markets are sometimes cyclical, people who got rich in one industry as it boomed will likely lose their fortunes in that same industry when it busts
4. Bargain hunting for stocks can be a winning strategy; consider stocks that are selling at or for less than their net working capital (Current Assets – Total Liabilities, including preferred stock and long-term debt)
   1. One way to quickly find these stocks can be to search for companies that have recently hit new lows for the past 52 weeks
5. Diversifying outside the US (or home market) is adviseable because national economies suffer booms and busts as well as specific industries do
   1. If you had been Japanese in 1989, you would probably think it foolish to invest in America; however, you would lose 2/3 of your equity value over the ensuing decade as a result
   2. The country that you live and work in is already a multilayered bet on the economic prospects of that country’s economy; buying foreign stocks (including emerging markets) provides insurance against the possibility that your home market might be a laggard

Chapter 8, JZ commentary

1. Do not let the movement of Mr. Market, up or down, affect your decision on whether to buy or sell a particular company or stock at a particular time
   1. Don’t buy just because the market is going up
   2. Don’t sell just because the market is going down
2. Graham: “The primary cause of failure is that they pay too much attention to what the stock market is doing currently.”
3. Investing intelligently is about controlling the uncontrollable
   1. your brokerage costs
   2. your ownership costs (mutual fund fees)
   3. your expectations (keep them reasonable)
   4. your risk (how much of your total assets do you put into each investment)
   5. your tax bills (short vs. long term cap gains)
   6. your own behavior
4. “To be an intelligent investor, you must also refuse to judge your financial success by how a bunch of total strangers are doing”
   1. You haven’t lost if everyone else has won
   2. You haven’t won if everyone else has lost
   3. Focus on your own absolute performance
5. Remember: market quotations are what other people think the value of a stock is– not what the true value of the stock is in relation to underlying intrinsic value
6. Selling into a bear market can occasionally make sense in relation to taking a realized loss for tax purposes; consult a tax professional before doing so

Chapter 9, JZ commentary

1. The pitfalls of mutual funds:
   1. avg fund does not pick stocks well enough to overcome the costs of researching and trading them
   2. the higher a fund’s expenses, the lower its returns
   3. the more frequently a fund trades, the less it tends to earn
   4. highly volatile funds tends to stay volatile
   5. funds with high past returns are unlikely to remain winners for long
2. Why don’t more winning funds stay winners?
   1. migrating managers; top mgrs get picked off by higher paying companies or go on to start their own funds
   2. asset elephantitis; when a fund is too large, it reduces the types and size of investments it can possibly make, reducing its nimbleness
   3. no more fancy footwork; many fund “incubate” before going public and whatever advantages they had during incubation are generally lost afterward, yet they use the incubation period performance to promote the fund
   4. rising expenses; it often costs more to trade in size than to trade smaller because markets become illiquid when trading in size
   5. sheepishness/herding; fund mgrs who have been successful and attract higher fees grow accustomed to these fees and their reputation and don’t want to take any risks that might jeopardize either one, so they trade like other fund mgrs
3. The solution for the individual investor is boring, low cost index funds– they won’t beat the market, but they won’t get beaten by it either
4. How to pick good mutual funds?
   1. managers should be the biggest shareholders
   2. they should be cheap/low fee; high returns are temporary, high fees are permanent
   3. they should be run creatively and “dare to be different”
   4. they shut the door before they get too big
   5. they don’t advertise much if at all
5. Expense fee guidelines:
   1. taxable and muni bonds, .75%
   2. US equities, 1%
   3. high-yield bonds, 1%
   4. US equities (small stocks), 1.25%
   5. foreign equities, 1.5%
6. When to sell a mutual fund?
   1. a sharp and unexpected change in strategy
   2. an increase in expenses
   3. large and frequent tax bills (caused by excessive trading)
   4. suddenly erratic returns (big gains or big losses)

Chapter 11, JZ commentary

1. Five decisive elements for determining price multiples
   1. the company’s “general long-term prospects”
      1. Warning flags
         1. the company is a serial acquirer, gaining revenues and profit growth through the acquisition of other businesses
         2. the company is addicted to OPM and is continually floating debt or issuing new stock
            1. cash from operating activities negative, while cash from financing activities positive, on a general or recurring basis, means the company is not profitable in its own line of industry
         3. the company relies on one or only a handful of important customers to generate a significant share of its revenues and profits
      2. Positives in company analysis
         1. the company has a wide “moat” to competition
            1. brand identity
            2. monopoly or near-monopoly
            3. economies of scale
            4. unique intangible asset
            5. resistance to substitution
         2. the company is a marathoner, not sprinter
            1. revenues and income should grow steadily, not in spurts
            2. less likely to attract and then offend “hot stock” money
         3. the company sows and reaps
            1. the company should be spending on R&D to develop new lines of growth in the future
            2. 3-6% of revenues by industry is a typical measure
   2. the quality of its management
      1. is it looking out for #1?
         1. executives should not be paid too much
         2. company should not be reissuing or repricing stock options constantly
         3. use fully-diluted share totals when calculating EPS
         4. insiders should not be selling the company
      2. are they managers or promoters?
         1. mgrs should spend most of their time managing, not being in the media promoting the company’s stock
         2. watch out for accounting opaqueness, recurring non-recurring charges, ordinary extraordinary items and the focus on EBITDA rather than net income, etc.
   3. the financial strength and capital structure
      1. it should generate more cash than it consumes
      2. cash from operations should grow steadily over time
         1. use “owner earnings” (Net Income + Amortization + Depreciation – Cost of Stock Options – Unusual/Nonrecurring Charges – Company Pension Fund “Income”)
      3. capital structure considerations
         1. total debt ( + preferred stock) should be under 50% of total capital
         2. is debt fixed-rate or variable, exposing the company to interest rate risk (check footnotes)?
         3. check annual reports for “ratio of earnings to fixed costs” which can demonstrate if the company is able to make interest payments
   4. its dividend record
      1. the burden of proof is on the company to prove they shouldn’t issue you a dividend because they can grow the company better with the retained earnings
      2. the stock should not be split constantly
      3. stock buybacks should occur when the company’s shares are cheap, not at record highs
   5. its current dividend rate

Chapter 12, JZ commentary

1. Accounting gimmickery
   1. make sure capitalized expenses really ought to be capitalized
   2. watch out for firms realizing revenues on their accounting statements that they have not actually earned
   3. inventory write-downs should not be occurring regularly if the company is using proper inventory accounting methods
   4. “net pension benefit” should not be more than 5% of the company’s net income
2. How to avoid accounting fraud
   1. read backwards; the dirty secrets are buried at the end
   2. read the notes; never buy a stock without reading the footnotes in the annual report
      1. look for terms like “capitalized”, “deferred” and “restructuring”
   3. read more; check out Financial Statement Analysis (Fridson and Alvarez), The Financial Number’s Game (Comiskey), Financial Shenanigans (Schilit)

Chapter 14, JZ commentary

1. Investing for the defensive investor
   1. Substantially all of ones stock picks should be limited to a total stock market index fund; or, 90% total stock market index fund and 10% individual stock picks
2. Graham’s criteria for stock selection:
   1. adequate size; market cap > $2B, unless owned through a “small cap mutual fund” that allows for diversification
   2. strong financial condition; 2:1 current assets:current liabilities ratio
   3. earnings stability; some earnings for the common stock in each of the past ten years
   4. dividend record; the company should pay a dividend, even better if it increases over time
   5. earnings growth; 33% cumulative EPS growth over ten years, or essentially, 3% annual EPS growth
   6. moderate p/e ratio; current price should be no more than 15x avg earnings over past 3 yrs
   7. moderate price-to-book ratio; price-to-assets/price-to-book-value ratio of no more than 1.5
   8. alternatively, multiply p/e ratio by price-to-book and the number should be below 22.5
3. Do the due diligence
   1. do your homework; read at least 5 yrs worth of annual and qtrly reports and proxy statements disclosing managers’ compensation, ownership, and potential conflicts of interest
   2. check out the neighborhood; check for institutional ownership ratios, over 60% probably means the company is overowned and overpriced
      1. if one sells, they’ll all sell; could be a time to find bargains in that stock
      2. check who the biggest holders are, if they’re money mgrs that invest like you, you could be in good hands

Chapter 15, JZ commentary

1. You can practice stock-picking for a year, without investing any real money, and see how you do
   1. if you beat the S&P500, maybe you are good enough to pick stocks
   2. if you don’t, stick to index funds
2. How to pick stocks for the enterprising investor
   1. Start with stocks that have recently hit 52 week lows
   2. use the ROIC method of analysis; ROIC = Owner Earnings / Invested Capital, where Owner Earnings is:
      1. Operating Profit + Depreciation + Amortization of Goodwill – Federal Income Tax – Cost of Stock Options – Maintenance (Essential CapEx) – Income Generated By Pension Funds
      2. Invested Capital = Total Assets – Cash and ST Investments + Past Accounting Charges That Reduced Invested Capital
      3. ROIC can demonstrate, after legitimate expenses, what the company earns from its operating businesses and how efficiently it has used shareholders’ money to generate that return
      4. ROIC of 10% is attractive, 6-7% in special occasions with strong brand name, focused management or the company being temporarily unpopular
   3. you can also look for comparable companies that have been acquired recently for valuations for the company you are looking at
      1. check the “Business Segments” (or “Management Discussion and Analysis”) section of the company’s annual report for industrial sector, revenues and earnings of each subsidiary
      2. then, check Factiva, ProQuest or LexisNexis for examples of other firms in the same industry that have been acquired
      3. then, look at past ARs for these companies for information about purchase price to earnings for those companies before acquisition
      4. this might reveal a “60-cent dollar”, a company whose assets and earnings are selling for 60% or less than the businesses might be worth to an acquirer

Chapter 20, JZ commentary

1. The first objective of investing: “Don’t lose.”; this is Graham’s “margin of safety” concept in a nutshell
2. Consider a market that is returning 5% a year, while you have found a stock that you think can grow at 10%; if you overpay for it and suffer a capital loss of 50% in the first year, it will take you 16 years to overtake the market, and nearly 10 years just to break even again
3. The biggest financial risk we face is ourselves; ask yourself the following questions:
   1. How much experience do I have? What is my track record with similar decisions in the past?
   2. What is the typical track record of other people who have tried this in the past?
   3. If I am buying, someone is selling. How likely is it that I know something they don’t know?
   4. If I am selling, someone else is buying. How likely is it that I know something they don’t know?
   5. Have I calculated how much this investment needs to go up to cover my taxes and trading expenses?
4. Then, make sure you have considered the consequences of being wrong by asking yourself:
   1. How much could I lose if I am wrong?
   2. Do I have other investments that will tide me over if this decision turns out to be wrong? Am I putting too much capital at risk?
   3. Have I demonstrated a high tolerance for risk by continuing to invest after large losses in the past?
   4. Am I relying on willpower alone to prevent me from panicking or have I made preparations in advance by diversifying and dollar-cost averaging?
5. “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.”
6. Never make the mistake of following investment crazes or putting all your eggs in one basket; if you make one error, you will have wiped yourself out
7. Instead, diversify, and always protect yourself from the consequences of being wrong just as much as you hope and plan to enjoy the benefits of being right

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Getting More Out Of Venture Capital

In “We Have Met The Enemy, And He Is Us” (PDF), the Kauffman Foundation gets radically honest about the world of institutional venture capital investing and their own experiences with the asset class:

Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years.

Specifically, they found that:

• The average VC fund fails to return investor capital after fees.
• Many VC funds last longer than ten years—up to fifteen years or more. We have eight VC funds in our portfolio that are more than fifteen years old.
• Investors are afraid to contest GP terms for fear of “rocking the boat” with General Partners who use scarcity and limited access as marketing strategies.
• The typical GP commits only 1 percent of partner dollars to a new fund while LPs commit 99 percent. These economics insulate GPs from personal income effects of poor fund returns and encourages them to focus on generating short-term, high IRRs by “flipping” companies rather than committing to long-term, scale growth of a startup.

And who is to blame? As hinted at in the title, the authors believe the cause is primarily a fundamental misalignment of incentives and weak governance structures allowed by the LPs:

The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will—generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.

Their conclusion is utterly damning:

There are not enough strong VC investors with above-market returns to absorb even our limited investment capital.

The Dismal Asset Class

Is the average VC fund manager earning their keep? According to the Kauffman report, “since 1995 it is improbable that a venture fund will deliver better net returns than an investment in the public markets.” The “mandate” for most VCs in terms of investment returns that justify their existence is that they return 3-5% per annum over a typical benchmark like the S&P 500 as a proxy for public financial market returns. But in reality:

Investors are still attracted to the ‘lottery ticket’ potential VC offers, where one lucky ‘hit’ investment like Zynga or Facebook can offer the potential to mitigate the damage done to a portfolio after a decade of poor risk-adjusted returns.

VC is a proxy for gambling and the average fund is consistently not justifying its fees.

3 Ideas For Improving The VC Investing Experience

I took away three ideas for improving the VC investing experience based on the report. I think these three ideas have applicability outside of VC and speak to the need for improved corporate governance in any investment situation:

1. transparency; eliminate the black box of VC firm economics
2. incentives; pay for performance, not empire building
3. accountability; measure fund performance against the “Public Market Equivalent” concept

A venture capitalist considering an investment for his portfolio will demand to know the internal economics of the business he is investing in as a normal part of due diligence. He wants to know this to ensure the business is being operated in a safe and sustainable manner so his investment will be secure. In particular, he puts emphasis on the incentives of managers and other owners of the business as indicated by their ownership stakes and decision-making structure and their compensation agreements. While an LP investor is not technically an investor or owner in the GP that manages the fund, the arrangements and incentives predominating at the management company level WILL have an influence on the way the portfolio is operated. Rather than argue for a right to know, LPs should ask their GPs to defend their right to privacy. If they’re to be business partners and in a relationship of joint risk taking, why shouldn’t their be sufficient trust to share information such as the following?

• Partner capital contributions (by partner), partnership ownership
• Partner comp amounts and structure– salary, bonus amounts and structure, and the allocation of carry, management company agreement
• Quarterly firm financials– balance sheet, income statement, cash flow
• Full-year firm projected financials, annual budget
• Partner track records, investment cash flow data for public market equivalent (PME) analysis

Further, LPs should have other value-adds besides the cash they bring to the fund. Often this comes in the form of specific industry or personal experience which could be useful to the GPs in evaluating investments for the portfolio. But active agency in a corporate governance structure is another important value-add, missing in too many firms of all sizes, types and industries. Additional transparency could be achieved by involving LPs in the following:

• The right to elect LP representatives to fund Advisory Boards
• Information rights to detailed firm quarterly and annual financials
• Right to review and approve annual firm budgets

According to the Kauffman report, almost two thirds of VC fund revenues come from management fees, NOT carry on performance generated. This means that most funds are incentivized to maximize assets under management by continually building new funds rather than to maximize performance by making outstanding investments while minimizing losses. Why should VC managers get rich regardless of the performance of their investments? The owner of a wholly-owned business only makes money when his business is profitable. He can’t pay himself a big paycheck forever just because he put a lot of capital at risk.

Instead of the standard “2 and 20” model, a VC could manage under an operating budget and a sliding carry system. Under this system, rather than charging a fixed 2% on all AUM regardless of how much or how little it is (and regardless of how many funds paying 2% have been raised historically), the GP tries to estimate its operating expenses needed to manage various levels of scale in advance, including office, support and vendor expense, travel and reasonable salaried compensation for the investment professionals in the firm. This budgeted expense would be spread across all funds and would likely decrease as a percentage of total AUM over time. To enhance the incentive and reward for strong performance, a sliding carry could be instituted in which the GPs are compensated at higher levels of total profits generated as they achieve increasing levels of outperformance against Public Market Equivalent hurdles. (Of course, this system could also employ hurdles such as returning some minimum multiple of invested capital net of fees before performance carry participation, ie, 1x, 1.1x, etc.) An additional recommendation for aligning incentives from the Kauffman report was constructing the VC fund as an “evergreen” fund:

Evergreen funds are open-ended and therefore not subject to the fixed timeframe of a ten-year fund life or the pressure and distraction of fundraising every four to five years. Without the pressure of regular fundraising, evergreen funds can adopt a longer timeframe, be more patient investors, and focus entirely on cash-on-cash returns, rather than generating IRRs to market and raising the next fund.

The final idea is to utilize the Public Market Equivalent (PME) concept to gauge investment performance, versus an indicator such as Net IRR or Net Multiple. The PME is calculated as a ratio of the value of capital in the strategy to the value of capital in a public market equivalent (such as the S&P 500, Russell 2000 or other comparable index based on risk, market cap, volatility, etc.) For example, if an investment was worth $15M at the end of the fund’s life, but would’ve been worth $10M in the Russell 2000 over the same time period, the PME is 1.5, or a 50% out performance. This is useful because it can reveal relative underperformance even when the VC fund achieves a high IRR or other performance metric but the public markets achieve a growth rate still higher. It is also useful because it can put a loss of capital in perspective when the public markets lose even more. The PME measures investment skill relative to the market environment. For Kauffman, “we have used PME to prioritize our best-performing funds, and to concentrate our investment activity and increase our investment amounts in those partnerships.”

Closing Thoughts

After their grand survey, the Kauffman fund managers have become more skeptical about VC as an asset class:

If they are not top-tier VCs, you are very unlikely to generate top-tier returns… Being a better investor in VC for most LPs will translate into being a much more selective investor.

Kauffman suggests there may be as few as 10 (!) such funds worthy of investment in the entire VC universe.

Part of that selectivity involves choosing to invest only with the most talented managers. Another part of the selectivity is sticking to funds whose total committed capital is not so enormous as to make them unwieldy and unsuited for the initially small, risky ventures they’re supposed to back:

Big VC funds fail to deliver big returns; we earned an investment multiple of two times our invested capital only from venture funds whose commitment size was less than $500 million.

According to a study conducted by Silicon Valley Bank, having a discipline about relatively small size is an important determinant of future investment returns:

• The majority (51 percent) of funds larger than $250 million fail to return investor capital, after fees;
• Almost all (93 percent) of large funds fail to return a “venture capital rate of return” of more than twice the invested capital, after fees.
• Small funds under $250m return more than two times invested capital 34 percent of the time; a rate almost six times greater than the rate for large funds.

Incentives matter, and rather than serving as a failed example of economic and investment theory, the VC industry is efficiently responding to the incentives created by LPs who lack the discipline or data to make informed investment decisions.

Quotes – Discipline Through Boundary

Small rooms discipline the mind; large rooms distract it.

~Leonardo da Vinci