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Concerns of Meaningless Peons

The following is a running list of observed concerns and conditions of individuals which would suggest they may be living the lives of meaningless peons, updated as observational faculties permit:

  1. Owning less than an acre of land
  2. Not contemplating life from an Eames chair
  3. Emotionally invested in professional sports
  4. Arguing economics on the internet with idiots trying to vouchsafe wanton criminality in sophistry
  5. Leasing everything, owning nothing
  6. Primary pastimes revolves around drinking with your friends and Facebooking your exploits
  7. Fretting about how to get your child into a “good” public school

Note: the composer of the above list may be guilty of some or even all of the infractions mentioned.

Review – Oglivy On Advertising

Oglivy On Advertising

by David Oglivy, published 1985

How to produce advertising that sells

  • Advertising doesn’t need to be “creative”, it needs to be so interesting that a person is compelled to buy the product
  • When Aeschines spoke, they said, “How well he speaks.” But when Demosthenes spoke, they said, “Let us march against Philip.”
  • The wrong advertising can actually reduce the sales of a product
  • Study the product you are going to advertise and look for a “big idea” that can sell it (a big idea whose genesis is found in your research of the product itself)
  • Find out what kind of advertising your competitors have been doing for similar products, and with what success, to get your bearings
  • Consumer research: investigate how they think about your kind of product, what language they use when they discuss the subject, what attributes are important to them and what promises would be most likely to make them buy your brand
  • Product positioning: what the product does, and who it is for
  • Decide what image (personality) you want for your brand
  • Your advertising should consistently project the same image, year after year
  • People don’t pick products, they pick images; few customers try all products within a space and compare before picking one they like best
  • Unless your advertising contains a big idea, it will pass like a ship in the night
  • When researching: stuff your conscious mind with information and then unhook your rational thought process and see what creative ideas flow in
  • Questions to ask about a potential “big idea”: did it make me gasp when I first saw it? do I wish I had thought of it myself? is it unique? does it fit the strategy to perfection? could it be used for 30 years?
  • Make the product itself the hero of your advertising
  • Just say what’s good about your product, and do a clearer, more honest, more informative job of saying it
  • If you are lucky enough to write a good advertisement, repeat it until it stops selling
  • A good advertisement can be thought of as a radar sweep, constantly hunting new prospects as they enter the market
  • Lessons from direct response: use 2-minute commercials (not 30-seconds), there are more sales late at night (not during prime time), use long copy (not short copy)
  • Do your homework, avoid committees, learn from research, watch what the direct-response advertisers do

How to run an advertising agency

  • If each of us hires people who are smaller than us, we will become a company of dwarfs; but if each of us hires people who are taller than us, we will become a company of giants
  • Every time I give someone a title, I make a hundred people angry and one person ungrateful
  • Even a mature agency with a pool of potential leaders does well to refresh its blood occasionally by hiring partners from outside
  • Don’t hire: your friends, partners’ children, your own children, or clients’ children (ambitious people won’t stay in organizations following nepotism)
  • It is suicide to settle for second-rate performance
  • It is a good idea to start the year by writing down exactly what you want to accomplish, and end it by measuring how much you accomplished (you can pay people bonuses based on something like this)
  • Companies cannot grow without innovation
  • Be ruthless and let all the “chefs” feel that they work in the “best kitchen in the world”
  • The more centers of leadership you create, the stronger your agency will become
  • The final test of a leader is the feeling you have after you leave his presence after a conference; have you a feeling of uplift and confidence?
  • Every company should have a written list of principles and purpose
  • Agencies are seldom for sale unless they’re in some kind of trouble
  • Retirement planning: buy the building that houses your office with your excess capital
  • Never allow two people to do a job that could be handled by one
  • Never summon people to your office, go to see them in their offices, unannounced
  • If you want to get action, communicate verbally

How to get clients/how to find an agency

  • Only first-class business, and that in a first-class kind of way
  • What you should worry about is not the price of your agency, but the selling power of its advertisements
  • Tear out the advertisements you envy, and find out which agency did them
  • Pick the agency whose campaign interests you the most
  • Don’t haggle over price and if anything, offer to pay more to ensure extra attention and service
  • Don’t keep a dog and then bark yourself

Print advertising

  • Five times as many people read the headlines as read the body copy
  • Unless your headline sells your product, you have wasted 90% of your money
  • Promise the reader a benefit
  • Headlines which contain news are sure-fire
  • Headlines that offer the reader helpful information attract above-average readership
  • Include the brand name in your headline
  • In local advertising, including the name of the city in the headline attracts better readership
  • The silliest thing of all is to run an ad without a headline
  • On illustrations: have a remarkable idea; the reader should ask, “What goes on here?” at a glance; illustrate the end-result of using your product; crowd scenes don’t pull; don’t show the human face scaled larger-than-life; babies, animals and sex catch the most attention; when you use photographs of a woman, men ignore the advertisement and vice versa
  • Remember: when people read your copy, they are alone
  • Copy should be written in a language people use everyday
  • Avoid analogies, stay away from superlatives, include a testimonial
  • An ad’s chance of success is directly proportional to the number of pertinent merchandise facts included in the copy
  • Until you have a better answer, copy others
  • Illustration at the top, headline underneath illustration, copy under headline
  • Capitals retard easy reading; don’t place periods at the end of headlines; use serifed fonts as they aid easy reading

How to make TV commercials that sell

  • The more amateurish the performance, the more credible
  • Commercials which name competing brands are less believable and more confusing
  • Provided they are relevant to your product, characters are above average in their ability to change brand-preference
  • Cartoons can sell things to children but they are below average in selling to adults
  • Use the name within the first ten seconds
  • Play games with the name
  • Open with the fire, you only have 30 seconds
  • Sound effects can make a positive difference
  • It is better to have the actors talk on camera
  • Show the viewer something she has never seen before
  • The only limit is your imagination
  • Make your commercials crystal clear
  • Because radio is a high-frequency medium, people get tired quickly of the same commercial so make several

Competing with Procter & Gamble

  • They use research to determine the most effective strategy, and they never change a successful strategy
  • They always promise the customer one important benefit
  • They believe that the first duty of advertising is to communicate effectively
  • All their commercials include a ‘moment of confirmation’
  • In 60% of commercials, they use demonstrations
  • Their commercials talk directly to the consumer, using language and situations which are familiar to her
  • They communicate the brand name, always within the first 10 seconds and an average of 3 times in addition thereafter
  • Their commercials deliver the promise verbally and reinforce it with supers
  • They show consumers what the product will do for them
  • They show the users of their products deriving some emotional benefit
  • They use slices of life, user testimonials and talking heads, all proven ad techniques
  • They do not spend their money naming competing brands
  • Continually test new executions of ongoing strategies
  • Continually test higher levels of expenditure
  • Almost all brands are advertised throughout the year

Miracles of research

  • Research lets you measure the reputation of your company
  • Research can estimate the sales of new products and the advertising expenditures necessary to earn maximum profits
  • Research can help you determine optimum positioning of your product
  • Research can define your target audience
  • Research can find out what factors are most important in the purchase decision and what vocab consumers use when talking about your kind of product
  • Research can save you time and money by ‘reading’ your competitor’s test markets
  • Research can determine the most persuasive promise; advertising which promises no benefit to the consumer does not sell, yet the majority of campaigns contain no promise; the selection of the promise is the most valuable contribution that research can make to the advertising process; try to find a process that is not only persuasive, but unique
  • Research can tell you which of several premiums work best
  • Use research to measure a commercial’s ability to change brand preferences; recall testing is a waste of time

What little I know about marketing

  • You can judge the vitality of a company by the number of new products it brings to market
  • Concentrate your time, your brains and your advertising money on your successes
  • In the long run, the manufacturer who dedicates his advertising to building the most sharply defined image for his product gets the largest market share
  • Sales are a function of product-value and advertising. Promotions can not produce more than a temporary kink in the sales curve
  • Regard advertising as part of the product, to be treated as a production cost, not a selling cost
  • The task of advertising is not primarily one of conversion but rather of reinforcement and assurance

Observations On Expectations

A story of expectations met and unmet, in two parts.

Part the first. I spoke in front of a group of students at a local continuation high school this morning. The original topic was my career (what do I do? what do I like/dislike about it? etc.) and my career path (what’s my background? education? how’d I get to where I am?) but I never quite got there. I mostly ended up talking about economics as I was speaking to an economics class, nominally, and the program coordinator kept prompting me on that subject.

I introduced two economic concepts to the assembled: TNSTAAFL/opportunity cost, and subjective value theory. I tried to apply them to “real life” to make them tangible and interesting to the audience. I talked about how everyone got suckered into the Housing Bubble, which cost a lot of people their homes, their personal finances, their jobs and sometimes more. I suggested that a person who understood that TNSTAAFL wouldn’t have gotten suckered in because he would’ve recognized the bubble for what it was and played it safe as he could. Subjective value theory I used to explain why we have an economy and why people work jobs, to serve each other’s subjective needs. I encouraged the class to think about their own values and to pursue them, and recognize that when people tell them what to do they’re simply telling them they should follow subjective values other than their own. I tried to highlight the role opportunity cost plays in pursuing subjective values, for example, people often get into traps such as pursuing money to provide for their families in such a way that they don’t get to spend time with their families. This opportunity cost is forgotten or ignored.

I also covered time value of money and the function of credit during a brief tangent, prompted by the program coordinator emphasizing the importance of personal finance principles.

The instructor goaded the students into applauding me before I had even spoke, as some kind of polite welcome for someone who had taken the time to stand before them and pontificate on a subject they cared little about. I said, “We’ll see if you still feel like applauding me at the end” and then began my talk. At the end of it, as the students rose to leave at the sound of the Pavlovian bell, one of the young men closest to me in the front of the room turned to his classmate and said in a quite intentionally audible way, “Thank GOD that is over!”

The morning’s events completely met my expectations and as a result, I was satisfied with myself when I myself left. I had entered a prison, whose inmates were being held against their will, by force of law, who had been assembled before me because they had no other choice save punishment and who had little to no interest in the subjects I had been invited to speak about before them. You certainly can’t blame a person in such circumstances for being disengaged, melodramatic and at times downright hostile.

If you put me in a cage I’d be uncomfortable and not in a friendly mood, either.

I didn’t expect to touch anyone, change a life or spark a fire or interest in anyone for the subjects I spoke about (economics, careers, my career, me) and if I happened to do that despite my intentions, that’s fine. I expected to go in there, treat the poor beasts with respect and maybe a bit of sympathy, having once been caged in a similar manner myself, and deliver my thoughts as articulately and coherently as I could. I expected to get practice speaking before an audience and trying, not necessarily succeeding, at making a foreign subject engaging or relatable for them.

In this, I met my expectations and so I believe I succeeded and thus I felt satisfied.

Part the second. For some time now I have watched in despair as a previously favorite blog of mine has gone into seemingly terminal decline. What was once a source of original thinking, unique coverage and respectable ideological consistency has in time become a haven for hacks and simpletons, its content hollowed-out and refocused on a few topics I just don’t have much interest in. The purveyor of the site has taken numerous opportunities, on his blog and his new webcast radio show, to demonstrate qualities of his personality I’ve found surprising, disappointing and at times reprehensible.

My distress with this reached a fever pitch early this week when a long-awaited debate on the subject of “intellectual property” was joined by the purveyor and another popular blogger on the subject. While the purveyor’s behavior leading up to the discussion gave me no reason to believe it’d be an intelligent, objective attempt at sussing out the truth by the two parties, but rather much evidence that it would be a battle of wills and ego characterized by willful blindness of reason and savage emotional assaults on each respective victim, the final product was so shockingly extreme in terms of all the undesirable qualities I suspected it would contain that I almost couldn’t believe these two adults had allowed themselves to be recorded, their outrage to be shared in front of a public audience of strangers.

I found myself so disappointed with the whole thing. It was anti-intellectual and truly uncivilized, the kind of stuff blood feuds at made of (gusto about sacred honor and the like that can never be satiated by way of reasonable argument). I knew both men were capable of a bit of underhandedness, but at least in the past the underhandedness seemed to have some kind of productive point. This time, after I finished sitting through two and a half hours of two middle-aged men calling each other names and screaming at one another, waiting for a point, I realized too late that there was none beyond sharing pure hate and distrust.

Who was to blame for my dissatisfaction in this instance? Initially, I found myself disgusted with these two people for subjecting me to this idiocy. “How dare they!” Then I thought about it some more. They are who they are. Their current skills and capabilities with regards to interpersonal communication and intellectual reasoning are aspects of their identity that exist as they do, whether I find them appealing or satisfying or not. I expected them to work hard to please me in their debating efforts (despite, I should add, much evidence that they were capable of no such thing) and when they didn’t live up to my expectations, I was disappointed.

Not by them, but by myself. For expecting people to live to serve my intellectual and emotional needs.

In the first part, I participated in something that could easily be seen as a disastrous waste of everybody’s time. Yet, I walked away from it in a positive state of mind. In the second part, I witnessed a true social tragedy and felt depressed and upset. Both circumstances were undesirable, but my reaction was different each time because my expectations were different.

Expectations can glorify our existence or cast the light of our lives down a dark abyss. I hope to remind myself of this fact more often.

Review – How To Get Rich

How To Get Rich: The Distilled Wisdom of One of Britain’s Wealthiest Self-Made Entrepreneurs

by Felix Dennis, published 2009

This will likely be one of the shortest reviews on record here. One reason is because I don’t want to spoil too much of this book for anyone else who might be interested in it; I do think it has to be fully read by oneself for it’s message to be understood.

Another reason is that I am not rich myself, so I don’t know how valuable my critical impressions of Dennis’s logic and experience will be and I don’t have any real opportunity to run a controlled experiment and find out. I’m going to take his thesis into mind and live my life as I see fit and maybe I’ll end up rich, or at least quite wealthy.

When Dennis says “rich” he means “filthy” rich. As in, it’d take several generations of slouches to piss through it all. This is the kind of rich he’s talking about. He’s not talking about retiring with a pension. And this book is psychological in that Dennis spends a lot of time detailing the mindset and motivations of people who are rich, not just particular strategies or actions to achieve this level of wealth (though he discusses that, too).

Besides the survey of rich life and rich world views, the book provides numerous general lessons on business, business management and entrepreneurial practices which are all valuable in their own right even if one doesn’t want to be rich, but doesn’t feel like being poor, either.

This book’s strongest point is honesty. And now, Felix Dennis’s “Eight Secrets to Getting Rich”:

  1. Analyze your need. Desire is insufficient. Compulsion is mandatory.
  2. Cut loose from negative influences. Never give in. Stay the course.
  3. Ignore ‘great ideas’. Concentrate on great execution.
  4. Focus. Keep your eye on the ball marked ‘The Money Is Here’/
  5. Hire talent smarter than you. Delegate. Share the annual pie.
  6. Ownership is the real ‘secret’. Hold on to every percentage point you can.
  7. Sell before you need to, or when bored. Empty your mind when negotiating.
  8. Fear nothing and no one. Get rich. Remember to give it all away.

Notes – Buffett Partnership Letters, 1957-1970

Recently I sank into my overstuffed armchair (in this situation, “sank” is used derisively to connote frustration and discomfort with regards to ideal reading conditions) with a copy of Buffett’s partnership letters from the 1957-1970 period in my hands. I found them on CSInvesting.org and had never taken the time to read them before, but figured it was about time as I was curious to consult a primary source on this period of Buffett’s investment career, having already read a 3rd-party recounting in The Snowball.

My interest was to read critically. Buffett’s letters have been read and analyzed and mulled over by thousands of investors and business people and have been discussed ad nauseum. But everyone seems to come away with the same lessons and the same pithy quotes that they throw up on their blogs when appropriate. I wanted to see if I could find anything original. From my own set of knowledge and understanding of Buffett and “how he did it”, I achieved my goal, but I can not guarantee creativity to anyone else who may be reading this. Somehow, somewhere in some overlooked nook of this vast interweb, I may have missed the discussion where someone went over these exact points.

Market timing, or the “value climate”

Amongst value investors, the sin of attempting to time the market is considered to be one of the greatest (for example, see the special note at the end of my recent review of The Intelligent Investor). Luminaries like Graham warn us that attempting to jump in and out of the markets according to their perceived price level being high or low is a speculative activity that will be rewarded as such, which is to say, it’ll eventually end in disaster.

However, while value gurus like Graham warned against market timing as a primary tool of analysis in an investment program, it’s also true that both Graham and Buffett were nonetheless intimately aware of market valuations and sentiment and both of them discussed the way their perception of market valuation influenced their portfolio orientation at any given time. For Graham and his intelligent investors, the response was to weight the portfolio toward bonds and away from stocks when the market was high and the opposite when the market was low. Similarly, Buffett advised in his 1957 letter:

If the general market were to return to an undervalued status our capital might be employed exclusively in general issues… if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio

This quote alone, along with many others just like it throughout the partnership letters, makes it clear the Buffett did not ignore broad market valuations. And not only did he not ignore them, he actively manipulated his portfolio in response to them. However, there are a few key things to note in terms of the heavily nuanced differences between what Buffett did and what the average market timer does:

  • Market timers are forecasters, they act on a perceived market level because of their anticipation about future market levels; Buffett refused to speculate about what the future of the market level might be and instead accepted it for what it was, changing what he owned and in what proportions, not whether he was invested or uninvested
  • Market timers are binary, choosing between “risk on” or “risk off”; Buffett responded to higher market levels by seeking to gain greater exposure to market neutral opportunities (special situations revolving around corporate action) while still continuing to make investments in individual undervalued businesses as he found them
  • Market timers always maintain the illusion of “full control” knowing they can always sell out or buy in any time they like in response to market valuations; Buffett acknowledged that many times he might desire to have greater market neutral exposure but that such opportunities might dry up in the late stages of a bull market, dashing his plans

The importance of relative performance

Another concept of Buffett’s money management style that stood out was his obsession with relative performance. I found this interesting again because the orthodox value investment wisdom is that it is not relative, but absolute, performance which matters– if you permanently lose a portion of your capital in a period, but your loss is smaller than your benchmark, you’ve still lost your capital and this is a bad thing.

Again, from the 1957 letter, Buffett turned this idea on its head:

I will be quite satisfied with a performance that is 10% per year better than the [Dow Jones Industrial] Averages

Because Buffett calculated that over the long-term the DJIA would return 5-7% to shareholders including dividends, Buffett was aiming for a 15-17% per annum performance target, or about 3x the performance of the Dow. But, as always, there was an important twist to this quest for relative out performance. In his 1962 letter, Buffett stated in no uncertain terms:

I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets. Preferably these should involve a substantial decline in the Dow. Our performance in the rather mild declines of 1957 and 1960 would confirm my hypothesis that we invest in an extremely conservative manner

He went on to say:

Our job is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%

And he concluded by noting:

Our best years relative to the Dow are likely to be in declining or static markets. Therefore, the advantage we seek will probably come in sharply varying amounts. There are bound to be years when we are surpassed by the Dow, but if over a long period we can average ten percentage points per year better than it, I will feel the results have been satisfactory.

Specifically, if the market should be down 35% or 40% in a year (and I feel this has a high probability of occurring in one year in the next ten– no one knows which one), we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much

In his 1962 letter, he added further detailing, sharing:

Our target is an approximately 1/2% decline for each 1% decline in the Dow and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative

Why did Buffett focus so much on relative out performance in down years? Because, as a value investor, he was obsessed with permanent loss of capital. In a broad sense, making money in the market is somewhat easy as over long periods of time as the market has historically tended to rise higher and higher. Every now and then, however, it corrects sharply to the downside and it is in these moments when the average investor panics and sells out at a loss, thereby permanently impairing his capital.

Buffett believed that by buying at a discount and taking a more conservative approach to the investment problem from the outset, he would limit any losses he might sustain in the inevitable downturns in the market. This by itself would put him ahead of other market participants because he’d have more of his capital intact. The real power behind this strategy is what comes afterward, as then the just-as-inevitable recovery would continue the compounding process again– with more of his original capital than the other guy, Buffett would enjoy greater pure gain over time as he would have a relatively shallower hole to climb out of each time.

True Margin of Safety: two pillars of value

Fellow value investor Nate Tobik over at OddballStocks.com has talked repeatedly about one of Ben Graham’s concepts which he refers to as the “two pillars of value”, namely, that a company which represents a bargain both on the basis of a discount to net assets and a discount earnings is the most solid Margin of Safety one can possess because you’re not only protected two ways but you also have two ways to “win.”

Reading the Buffett partnership letters, it’s clear that the reason Buffett was knocking it out of the park in his early years was because he relied upon the same methodology. Buffett later was critical of his own early practices and many others have derided the investment style as akin to picking up soggy cigar butts and taking the last puff before discarding them, but there is no denying in studying several of the investments Buffett disclosed that Buffett was buying things which were “smack you over the head” cheap.

For example, in the 1958 letter, Buffett disclosed the partnerships’ investment in Commonwealth Trust Company of New Jersey, a small bank. Buffett claimed the company had a computed per share intrinsic value of $125, which was earning $10/share and trading for $50. This meant that Buffett bought the company for 40% of book value, or at a 60% margin of safety to indicated value. And, in two pillar tradition, he was also buying at a 5x multiple of net earnings– by any standards, an incredibly cheap value. If one were to look at the company as a bond and study it’s earnings yield, this company was offering a 20% coupon!

Making good buys, not good sales

In the example of Commonwealth Trust Co. discussed earlier, though Buffett calculated an intrinsic value of $125/share, he ultimately sold for only $80/share. He did not sell out near intrinsic value but rather far below it. Still, because he had originally bought at $50/share, he nonetheless earned a 60% return despite the company trading at a still-substantial discount to intrinsic value.

As Buffett chirped in his 1964 letter:

Our business is making excellent purchases– not making extraordinary sales

Why does Buffett harp on this idea so frequently? There are a few reasons.

One, an excellent purchase price implies a substantial discount to intrinsic value and earnings power, therefore there is a built-in margin of safety and the downside is covered, a principle of central importance to sound investing.

Two, an individual has 100% control over when they buy a security but relatively little control over when and in what conditions they sell, particularly if they use margin. You may not always get the price you want when you are ready to sell but you will always get the price you want when you buy because that decision is made entirely by you and doesn’t require the cooperation of anyone else. Buying at a discount ensures you “lock in” a profit up front.

Three, buying at a discount gives one optionality. If a better deal comes along, it is more likely you can get back out of your original investment at cost or better when you buy it cheap. When your original purchase price represents a substantial discount you have a better chance of finding a buyer for your shares because even at higher prices such a sale would probably still represent a bargain to another buyer meaning both parties can feel good about the exchange.

This last point was critical in Buffett’s Commonwealth situation. He was happy to sell at only $80/share despite a $125/share intrinsic value because he had found another opportunity that was even more compelling and because his original purchase price was so low, he still generated a 60% return. Meanwhile, the other party who took this large block off his hands was happy to provide the liquidity because they still had a 56% upside to look forward to at that $80/share price.

Early activism, the value of control

Another lesson from Buffett’s partnership letters is the importance and value of activism and control. From an activism standpoint, the examples of Sanborn Maps and Dempster Mills are well-known and don’t require further elaboration in this post (follow the links for extensive case study analysis at CSInvesting.org, or even read Buffett’s partnership letters yourself to see his explanation of how these operations worked).

But activism is something that is best accomplished with control, and often is its by-product. On the topic of control, Buffett said in his 1958 letter with regards to Commonwealth:

we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal

By gaining a large ownership share in an undervalued company, an investor can play a more active role in ensuring that potential catalysts which might emerge serve to adequately reward shareholders. Similarly, time is money and when one has control,

this has substantial advantages many times in determining the length of time required to correct the undervaluation

An investment situation offering, say, a 30% return, offers a 30% annualized return if captured within a year, a 15% annualized return if gained after two years and only a 10% annualized return if it takes 3 years to realize value. Having control can often be the difference between a 30% and a 10% annualized return by allowing an investor to accelerate the pace at which they turn over their capital.

It is a myth, therefore, that Buffett only became a wholesale/control buyer as he employed greater amounts of capital in his later years. While many of his investments were passive, minority positions in the partnership years, Buffett never shied away from control and activism, even saying in his 1961 letter:

Sometimes, of course, we buy into a general with the thought that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen

In this sense, “value is its own catalyst” and something which is cheap and remains cheap for an extended period of time can actually be a unique opportunity to accumulate enough shares to acquire control, at which point the value can be unlocked through asset conversion, a sale or merger of the company or through a commandeering of the company’s earnings power.

Portfolio buckets: generals, work-outs and control

In his 1961 letter, as well as later letters, Buffett outlined the three primary types of investments that could be found in the partners’ portfolios, the approximate proportion of the portfolio to be involved with each and the basis upon which such investments should be chosen.

The “bread and butter” according to Buffett was his “generals”, businesses trading at substantial discounts to their intrinsic value which were purchased with the intent of eventually being resold at a price closer to the intrinsic value:

our largest category of investment… more money has been made here than in either of the other categories… We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen… Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price… individual margin of safety coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential… [we] are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner

While admitting that the particular and eventual catalyst was often not known with the average investment in a general security, Buffett also admitted in his 1963 “Ground Rules” letter section:

Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use

The next category was workouts:

our second largest category… ten or fifteen of these [at various stages of development]… I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior

The beauty of work-outs is that they relied on corporate action, not market action, to realize value. In this sense, they could provide a meaningful buffer to share price declines in generals during bear markets as their performance was largely “market neutral.” For example, in his 1963 (1962 being a bear market) letter Buffett said:

This performance is mainly the result of having a large portion of our money in controlled assets and workout situations rather than general market situations at a time when the Dow declined substantially

The final category was control, which started out as something of an after-thought or an accidental consequence of investing in certain generals which remained cheap, but later turned into an active category Buffett would search for opportunities in.

Buffett also mentioned the idea of the “two-way stretch” in control situations– if bought at a significant discount, there were generally two ways to profit from a control investment. Either the stock price remained low for a long period of time and control was acquired, in which case “the value of our investment is determined by the value of the enterprise,” or else the stock would move up in the process of consolidating a position in which case it could be sold at a higher level in the way one would normally “complete a successful general operation.”

Time horizons for performance

This particular point is more well-known but it bears repeating here. Buffett was obsessed with long-term performance and constantly advised his partners about appropriate timelines for judging investment performance, especially based-upon the particular type of investment being considered. For example, in his 1960 letter he said:

My own thinking is more geared to five year performance, preferably with tests of relative results in both strong and weak markets

In the 1961 letter, Buffett discussed “establishing yardsticks prior to the act” and again emphasized:

It is my feeling that three years is a very minimal test of performance, and the best test consists of a period at least that long where the terminal level of the Dow is reasonably close to the initial level

In other words, what did your performance look like after a three year period where the broad market index made no progress, or even reversed?

With control situations specifically, Buffett advised:

Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it

Diversification

It’s clear that Buffett had 15-21 “generals” or about 50-60% of his portfolio, with another 10-15 positions in workouts or another 15-30%, with the remainder in control situations. However, control situations could scale up to as much as 40% of the portfolio in an individual investment if the situation called for it in Buffett’s mind.

And while Buffett mentioned in an earlier letter of having approximately 40 positions in the portfolio in total, he later (around the time he started being influenced by Charlie Munger and other “quality over quantity” investment practitioners) became more critical of the idea of diversification. In the 1966 letter, Buffett lamented:

if anything, I should have concentrated slightly more than I have in the past

He also castigated “extreme diversification”:

The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has in the overall portfolio expectation

Buffett was learning the merits of “concentration” in areas outside the portfolio, as well. In discussing slight additions to the office space at Kiewit Plaza and the hiring of additional support personnel, Buffett added:

I think our present setup unquestionably lets me devote a higher percentage of my time to thinking about the investment process than virtually anyone else in the money management business

Of course, the results of this focus were obvious to all in time.

Sizing things up

Buffett dwelled on “the question of size” at length in his letters to partners. He made it clear that portfolio size and investment opportunity looked something like a continuum with small size on the left of the spectrum and large size on the right, with “generals” hanging near the left pole (size is a disadvantage), workouts inhabiting some kind of middle ground where they were neither benefitted nor impaired by size and control situations distinctly on the right where size was an enormous advantage.

Generals and control situations are, in this sense, almost opposites because Buffett warned that some generals were too small to buy meaningful stakes in for a large portfolio, whereas a small portfolio might never be able to acquire enough shares to gain control of certain investments.

Inflation-adjusting Buffett’s portfolio positions and capital at various points in time also gives important clues to the role size played in his operations. For example, Sanborn Maps was apparently around a $4.5M market cap when he mentioned the company in his letters. This would be about $35M or so in today’s dollars (this is not an endorsement of BLS/CPI measurement techniques, just a convenient rule-of-thumb), so clearly Buffett was hunting in a small/micro-cap space at least at this time.

In a similar vein, Buffett started with $105,000 in capital in 1956, which is about $893,000 in 2012. In his 1966 letter, he complained that the amount of capital being managed at the time, $43,645,000, was beginning to be burdensome in terms of size versus opportunities. This would be about $312,000,000 in 2012, to put it into perspective.

Apparently, the value investment framework Buffett created could work quite well even at a scale that we might consider to be decently large.

Serendipity: the reason for Buffett’s rise, and retirement

Few ever think to mention the incredible role serendipity played in Buffett’s early fortunes, but Buffett himself was well-aware. Not only did he begin his career at the outset of an astounding decade-long-plus bull market, but in 1952,

and for some years subsequently, there were substantial numbers of securities selling at well below the “value to a private owner” criterion we utilized for selection of general market investments

As the bull market started to grow gray hairs in the late 1960s and Buffett began contemplating an exit from the business, he similarly remarked in his 1967 letter:

Such statistical bargains have tended to disappear over the years. This may be due to the constant combing and recombing of investments that has occurred during the past twenty years, without an economic convulsion such as that of the ’30s to create a negative bias toward equities and spawn hundreds of new bargain securities

The comment on the aftermath of the 1930s bears repeating. The primary reason for the prevalence of bargain issues in the market around the time Buffett started investing was due to a massive psychological paradigm shift in attitudes about the stock market following the crash of 1929 and subsequent depression of the 1930s. By the late 1960s, a new inflationary thrust had managed to erase this psychology and great gains were actually made in sending it in the reverse direction. Buffett was convinced of

the virtual disappearance of the bargain issues determined quantitatively

the kind whose figures “should hit you over the head with a baseball bat”, which were being replaced by

speculation on an increasing scale

So how did Buffett respond to these new market conditions where his toolkit didn’t seem to work as well? Did he compromise his standards, or try to shape-shift his style into the “New Era” of investors and keep going? Well, anyone who has studied Buffett already knows the answer. Buffett knew his circle of competence and he knew what worked. When what he knew worked stopped working (because the opportunities weren’t available), he quit.

Despite writing in his 1968 letter that the answer to a potential phase out of the partnerships was “Definitely, no.” Buffett nonetheless in his 1969 letter suggested that “the quality and quantity of ideas is presently at an all time low” and that “opportunities for investment that are open to the analyst who stresses quantitative factors have virtually disappeared” and for this reason, he decided to close up shop.

There’s a lesson for all of us here. As Joel Greenblatt has argued, value investing doesn’t work all the time, which is why it works. We should respect this, just as Buffett did– when the deals dry up, we should go fishing (or at the very least, look for bargains in other markets that are in a different stage of psychology/sentiment/valuation). Trying to make great long-term returns when valuations won’t support it is a fools game and more likely to end in failure.

A few miscellaneous notes

In the 1968 letter, Buffett referred to 10-12% as “worthwhile overall returns on capital employed”.

With regards to dividends, although Buffett always described the return of the Dow for each annual period inclusive of dividends earned, and although when describing his investment in Commonwealth he specifically mentioned that the company was not paying dividends, and although we know from an anecdote in The Snowball that Buffett was receiving substantial dividend checks from his partnership portfolios because his wife Susie accidentally through a few away one time, I noticed that Buffett makes no specific mention in any of the letters of the importance of dividends nor that dividends impacted his investment decisions or philosophy.

How Did I Come Up With My 16 JNets?

A couple days ago someone who follows my Twitter feed asked me what criteria I had used to pick the 16 JNets I talked about in a recent post. He referenced that there were “300+” Japanese companies trading below their net current asset value. A recent post by Nate Tobik over at Oddball Stocks suggests that there are presently 448 such firms, definitely within the boundaries of the “300+” comment.

To be honest, I have no idea how many there are currently, nor when I made my investments. The reason is that I am not a professional investor with access to institution-grade screening tools like Bloomberg or CapitalIQ. Because of this, my investment process in general, but specifically with regards to foreign equities like JNets, relies especially on two principles:

  • Making do with “making do”; doing the best I can with the limited resources I have within the confines of the time and personal expertise I have available
  • “Cheap enough”; making a commitment to buy something when it is deemed to be cheap enough to be worthy of consideration, not holding out until I’ve examined every potential opportunity in the entire universe or local miniverse of investing

That’s kind of the 32,000-ft view of how I arrived at my 16 JNets. But it’s a good question and it deserves a specific answer, as well, for the questioner’s sake and for my own sake in keeping myself honest, come what may. So, here’s a little bit more about how I made the decision to add these 16 companies to my portfolio.

The first pass

The 16 companies I invested in came from a spreadsheet of 49 companies I gathered data on. Those 49 companies came from two places.

The first place, representing a majority of the companies that ultimately made it to my spreadsheet of 49, was a list of 100 JNets that came from a Bloomberg screen that someone else shared with Nate Tobik. To this list Nate added five columns, to which each company was assigned a “1” for yes or a “0” for no, with category headings covering whether the company showed a net profit in each of the last ten years, whether the company showed positive EBIT in each of the last ten years, whether the company had debt, whether the company paid a dividend and whether the company had bought back shares over the last ten years. Those columns were summed and anything which received a “4” or “5” cumulative score made it onto my master spreadsheet for further investigation.

The second place I gathered ideas from were the blogs of other value investors such as Geoff Gannon and Gurpreet Narang (Neat Value). I just grabbed everything I found and threw it on my list. I figured, if it was good enough for these investors it was worth closer examination for me, too.

The second pass

Once I had my companies, I started building my spreadsheet. First, I listed each company along with its stock symbol in Japan (where securities are quoted by 4-digit numerical codes). Then, I added basic data about the shares, such as shares outstanding, share price, average volume (important for position-sizing later on), market capitalization, current dividend yield.

After this, I listed important balance sheet data: cash (calculated as cash + ST investments), receivables  inventory, other current assets, total current assets, LT debt and total liabilities and then the NCAV and net cash position for each company. Following this were three balance sheet price ratios, Market Cap/NCAV, Market Cap/Net Cash and Market Cap/Cash… the lower the ratio, the better. While Market Cap/Net Cash is a more conservative valuation than Market Cap/NCAV, Market Cap/Cash is less conservative but was useful for evaluating companies which were debt free and had profitable operations– some companies with uneven operating outlooks are best valued on a liquidation basis (NCAV, Net Cash) but a company that represents an average operating performance is more properly considered cheap against a metric like the percent of the market cap composing it’s balance sheet cash, assuming it is debt free.

I also constructed some income metric columns, but before I could do this, I created two new tabs, “Net Inc” and “EBIT”, and copied the symbols and names from the previous tab over and then recorded the annual net income and EBIT for each company for the previous ten years. This data all came from MSN Money, like the rest of the data I had collected up to that point.

Then I carried this info back to my original “Summary” tab via formulas to calculate the columns for 10yr average annual EBIT, previous year EBIT, Enterprise Value (EV), EV/EBIT (10yr annual average) and EV/EBIT (previous year), as well as the earnings yield (10yr annual average net income divided by market cap) and the previous 5 years annual average as well to try to capture whether the business had dramatically changed since the global recession.

The final step was to go through my list thusly assembled and color code each company according to the legend of green for a cash bargain, blue for a net cash bargain and orange for an NCAV bargain (strictly defined as a company trading for 66% of NCAV or less; anything 67% or higher would not get color-coded).

I was trying to create a quick, visually obvious pattern for recognizing the cheapest of the cheap, understanding that my time is valuable and I could always go dig into each non-color coded name individually looking for other bargains as necessary.

The result, and psychological bias rears it’s ugly head

Looking over my spreadsheet, about 2/3rds of the list were color-coded in this way with the remaining third left white. The white entries are not necessarily not cheap or not companies trading below their NCAV– they were just not the cheapest of the cheap according to three strict criteria I used.

After reviewing the results, my desire was to purchase all of the net cash stocks (there were only a handful), all of the NCAVs and then as many of the cash bargains as possible. You see, this was where one of the first hurdles came in– how much of my portfolio I wanted to devote to this strategy of buying JNets. I ultimately settled upon 20-25% of my portfolio, however, that wasn’t the end of it.

Currently, I have accounts at several brokerages but I use Fidelity for a majority of my trading. Fidelity has good access to Japanese equity markets and will even let you trade electronically. For electronic trades, the commission is Y3,000, whereas a broker-assisted trade is Y8,000. I wanted to try to control the size of my trading costs relative to my positions by placing a strict limit of no more than 2% of the total position value as the ceiling for commissions. Ideally, I wanted to pay closer to 1%, if possible. The other consideration was lot-sizes. The Japanese equity markets have different rules than the US in terms of lot-sizes– at each price range category there is a minimum lot size and these lots are usually in increments of 100, 1000, etc.

After doing the math I decided I’d want to have 15-20 different positions in my portfolio. Ideally, I would’ve liked to own a lot more, maybe even all of them similar to the thinking behind Nate Tobik’s recent post on Japanese equities over at Oddball Stocks. But I didn’t have the capital for that so I had to come up with some criteria, once I had decided on position-sizing and total number of positions, for choosing the lucky few.

This is where my own psychological bias started playing a role. You see, I wanted to just “buy cheap”– get all the net cash bargains, then all the NCAVs, then some of the cash bargains. But I let my earnings yield numbers (calculated for the benefit of making decisions about some of the cash bargain stocks) influence my thinking on the net cash and NCAV stocks. And then I peeked at the EBIT and net income tables and got frightened by the fact that some of these companies had a loss year or two, or had declining earnings pictures.

I started second-guessing some of the choices of the color-coded bargain system. I began doing a mish-mash of seeking “cheap” plus “perceived quality.” In other words, I may have made a mistake by letting heuristics get in the way of passion-less rules. According to some research spelled out in an outstanding whitepaper by Toby Carlisle, the author of Greenbackd.com, trying to “second guess the model” like this could be a mistake.

Cheap enough?

Ultimately, this “Jekyll and Hyde” selection process led to my current portfolio of 16 JNets. Earlier in this post I suggested that one of my principles for inclusion was that the thing be “cheap enough”. Whether I strictly followed the output of my bargain model, or tried to eyeball quality for any individual pick, every one of these companies I think meets the general test of “cheap enough” to buy for a diversified basket of similar-class companies because all are trading at substantial discounts to their “fair” value or value to a private buyer of the entire company. What’s more, while some of these companies may be facing declining earnings prospects, at least as of right now every one of these companies are currently profitable on an operational and net basis, and almost all are debt free (with the few that have debt finding themselves in a position where the debt is a de minimis value and/or covered by cash on the balance sheet). I believe that significantly limits my risk of suffering a catastrophic loss in any one of these names, but especially in the portfolio as a whole, at least on a Yen-denominated basis.

Of course, my currency risk remains and currently I have not landed on a strategy for hedging it in a cost-effective and easy-to-use way.

I suppose the only concern I have at this point is whether my portfolio is “cheap enough” to earn me outsized returns over time. I wonder about my queasiness when looking at the uneven or declining earnings prospects of some of these companies and the way I let it influence my decision-making process and second-guess what should otherwise be a reliable model for picking a basket of companies that are likely to produce above-average returns over time. I question whether I might have eliminated one useful advantage (buying stuff that is just out and out cheap) by trying to add personal genius to it in thinking I could take in the “whole picture” better than my simple screen and thereby come up with an improved handicapping for some of my companies.

Considering that I don’t know Japanese and don’t know much about these companies outside of the statistical data I collected and an inquiry into the industry they operate in (which may be somewhat meaningless anyway in the mega-conglomerated, mega-diversified world of the Japanese corporate economy), it required great hubris, at a minimum, to think I even had cognizance of a “whole picture” on which to base an attempt at informed judgment.

But then, that’s the art of the leap of faith!

Doing The Hugh Hendry

Below is some commentary from Hugh Hendry I found in an FT.com editorial I since can not access as I don’t have a login. But I thought it was interesting when I first read it awhile back and I still think it’s interesting now. I meant to post it earlier. Rectifying my mistake:

For the moment, let us forget the chances of a hard landing in China. Forget the drama of Europe’s circus of politically inspired economic incompetency. Forget that the good news of the US economy’s succession of positive economic surprises is really bad news as fixed income managers have sold copious amounts of too cheap volatility and because it has made equity investors turn bullish, sending stock market volatility back to 2007 levels. This is dangerous. Improved US data may represent a classic short-term cyclical upturn amid a profound global deleveraging cycle.

Such moves have been commonplace for the past three years and have yet to prove a harbinger of any structural upswing. I worry that the pathological course of the last several years will see volatility rise sharply once again. Even so, there exists, in terms of my parochial world of hedge fund investing, a bigger issue.

I fear that my no longer small community has been compromised. Last year was generally very tough for long/short strategies and I commiserate with all concerned. But last year world class funds lost more than 15 per cent in just two months. Today they are celebrated again for making double digit returns in the last quarter even though they still languish below high water marks and their reputation for risk management, at least to those clients who have poured over their copious due diligence statements, has been sorely compromised.

You can probably live with that if you are a pension scheme or a large, sophisticated fund-of-fund because you have a global macro sub-sector that can benefit from short-term shifts in volatility. But the unfortunate thing is that this group exercised its stop losses somewhere between the great stock market rallies of 2009 and 2010. That is to say, they honoured the pact they had with clients. They adhered to the terms of their risk budget: they lost money and they reduced their positions. I fear that owing to this nasty experience the financial world is in danger of harvesting a monoculture of fund returns that could prove less than robust should the global economy suffer another deflationary reversal.

To my mind the situation has parallels with the plight of the banana. Today the world eats predominately just one type of banana, the Cavendish, but it is being wiped out by a blight known as Tropical Race 4, which encourages the plant to kill itself. Scientists refer to it as programmed death cell destruction. In stressful situations bananas fortify themselves by dropping leaves, killing off weaker cells so that stronger ones may live to fight anew. They operate a stop-loss system.

But modern mass production of single type bananas has replaced jungle diversity with commercial monocultural fields that provide more hosts to harbour the blight. The economy keeps producing stressful volatility events. Good managers keep shedding risk and monetising losses and are duly fired, leaving us with a monoculture of brazen managers who will never stop loss because they are convinced central banks will print more money.

Diversification has proven the most robust survival mechanism against failures of judgment by any one society, hedge fund manager or style. But what if we are now a single global hedge fund community afraid to take stop losses and convinced of an inflationary outcome to be all short US Treasuries and long real assets?

This is pertinent as I have always been fascinated by that second rout in US Treasuries in 1984, long after the inflation of the 1970s was met head on by Paul Volcker’s monetary vice and a deep recession. How could 10-year Treasury yields have soared back to 14 per cent and how could so many investment veterans have been convinced that a second even more virulent inflation wave was to hit the global economy?

Psychologists tell us the explanation is embedded deep in the mind. They refer to the “availability heuristic”. Goaded by the proximity to the last dramatic event, investors overreacted to the news that the US economy was pulling out of recession in 1984. They saw high inflation where there was none.

With this in mind, I would contend that it may take several more years before the threat of debt and deflation can be successfully exorcised from investors’ minds, even if the global economy were not set on such a perilous course. Such is the potency and memory of 2008’s crash that anything remotely challenging to the economic consensus could be met by a sudden and severe reappraisal to the downside.

Should such an event send 30-year Treasury yields back to their 2008 low of 2.5 per cent, we believe enlightened investors might better be served by thinking the opposite. Only then might it prove rewarding to short the government bond market and embrace what may turn out to be a much promised once in a lifetime buying opportunity for risk assets.

 

Review – Influence: The Psychology Of Persuasion

Influence: The Psychology of Persuasion

by Dr. Robert B. Cialdini, published 1984, 2006

Another study in the motivations underlying human behavior

Originally published in 1984, Cialdini’s “Influence”  has gone through several updates and reprints since. The book outlines 6 categories of persuasion, most of which we encounter on a daily basis (frequently by someone who wants us to buy something, but not always), and most of them are so ingrained in us that we barely even notice ourselves complying with them anymore.

Now this is not to say that you won’t recognize the 6 categories, in fact you’ll know them all too well, but the genius of the book lies in describing how each one of these methods is currently used unbeknownst to us, you’ll start recognizing them being used the second someone’s using them, which helps to ignore them if you want.

The 6 categories of influence

  1. Consistency & Commitment – continuing a course of action to be consistent with your previous actions (e.g. you subscribed to our cable service last year, so why not this year?)
  2. Reciprocation – feeling obligated to give something in return just because someone gave you a gift (e.g. take these free mailing labels, can you make a donation to the Children Need _________ Fund?)
  3. Social Proof – when there is a lack of objective, 3rd party evidence, people typically use what other people are doing as a guide for their actions, which is acceptable in most situations, but also horribly unacceptable in many others (e.g. Buy this product because these people did! )
  4. Authority – ever done something just because someone was wearing a uniform? It’s easy to put a lot of stock into what someone says just because they’re wearing a $20 uniform or have a title in front of their name.
  5. Liking (Similarity) – ever agreed with someone just because they seemed to be like you, and people like you are agreeable, therefore what they say makes sense right? Erm…sometimes it doesn’t…
  6. Scarcity – this one is ingrained in us like the need to eat and sleep. When we feel there is the potential for there to be less of something in the very near future, we automatically value it more (e.g. But don’t wait, call now before we run out!)

Truth runs deep beneath the surface

The average person can grasp these concepts with ease, but that’s not to say they’re simplicity prevents them from being profound. In fact, the truth is that these things go much, much deeper.

  • Have you ever continued on a path you knew was silly just because you’d already committed to it?
  • Have you ever had difficulty resisting what other people are doing simply because so many people were doing it?
  • Have you ever agreed with someone for the moment simply because you felt similar to them, only to realize after the fact that you don’t really agree with them at all?

I have absolutely done all of these things, and as you get older most people become less susceptible to the weak forms of these strategies (but this book certainly helped me leap frog my previous understanding of them). These strategies of influence are not inherently bad, but knowing when they’re being used will allow you to step back from the persuader, realize the strategy being used, and assess whether you want to continue your current course of action.

And the implications of these forms of influence go further than just understanding how marketing or advertising messages work. Think about the investment markets– how many investors put their money into something because they heard someone else they respect is doing it (similarity), they’re concerned there isn’t enough to go around such as in an IPO (scarcity), because the government said they’re backstopping it (authority) or because they were caught up in a bubble and everyone else was doing it (social proof).

Review – Billion Dollar Lessons

Billion Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years
by Paul B. Carroll and Chunka Mui, published 2008, 2009

The seven deadly business sins

The authors of Billion Dollar Lessons identified seven “failure patterns” that typify the path to downfall of most businesses:

  1. synergy; overestimating the cost savings or the profit-enhancement of synergy
  2. aggressive accounting; becoming addicted to creative accounting practices which eventually invites outright fraud to keep up with
  3. rollup acquisitions; assuming the whole is greater than the sum of the parts
  4. blindness to catastrophe; dancing on the deck of the Titanic, ignoring that the ship is sinking
  5. uneconomic adjacency acquisitions; assuming there are benefits to combining similar businesses which are actually dissimilar
  6. disruptive technology; committing oneself to the wrong technology and betting it all
  7. consolidation indigestion; assuming that consolidation is always the right answer and that it solves all corporate problems

In Part I, each chapter addresses one of these failure patterns, explaining the principles and problems of the failure pattern, giving numerous real-world examples of the pattern in action and finishing with a list of tough questions for managers and shareholders/board members to ask before pursuing one of the potentially flawed strategies mentioned.

In Part II, the authors offer a behavioral/psychological explanation for why companies and individuals routinely make these same mistakes, basing their assertions on the idea of “human universals.” The idea is that being aware of them is not enough– one must also put into place processes and self-check systems that are independent of any one person’s self-honesty (or lack thereof) to allow a company to essentially “check itself before it wrecks itself.” The most important corporate institution suggested is the Devil’s Advocate.

Illusions of synergy

According to the text,

A McKinsey study of 124 mergers found that only 30 percent generated synergies on the revenue side that were even close to what the acquirer had predicted… Some 60 percent of the cases met the forecasts on cost synergies

In general, there are three main reasons why synergy strategies fail:

  1. synergy may exist only in the minds of strategists, not in the minds of customers
  2. companies typically overpay for an acquisition, meaning the benefits from synergies realized are not enough to overcome the initial investment cost
  3. clashes of culture, skills or systems often develop following an acquisition, killing the potential for synergies

Double-check your synergy strategy by asking yourself the following tough questions:

  • Do you need to buy a company to get the synergies, or could you just form a partnership?
  • How do you know that customers will flock to a new product, service or sales channel?
  • If you think you’re going to improve customer service, then how exactly will that look from the customer’s perspective?
  • What could competitors do to hurt you, especially during the transition while you integrate the company you’re taking over?
  • Who in the combined organization will resist the attempts for revenue synergies? Whose compensation will be hurt?
  • What are the chances you’re right about revenue synergies?
  • What percent of your customer base might go elsewhere following this corporate change?
  • Acquisition cost:
    • What is the target company worth on a stand-alone basis?
    • What would the business be worth if you achieved all synergies mapped out?
    • What would the business be worth if you discounted the synergies, based on the fact that few companies achieve all the synergies planned?

Faulty financial engineering

Many companies find themselves in hot water because they believe their own creative accounting too much. They let sophisticated financial legerdemain conceal the uneconomic nature or riskiness of their business. Managers often become addicted to this accounting, finding themselves stuck on the “treadmill of expectations” and give in to the temptation to commit outright fraud to keep it going, destroying the business in the process.

There are four primary risks to financial engineering strategies:

  1. encourage flawed financial products which are attractive to customers in the short-term but expose the seller to incommensurate risk of failure over time
  2. hopelessly optimistic levels of leverage
  3. aggressive and unsustainable financial reporting
  4. positive feedback loops which cause the system to implode

Double-check your financial engineering strategy by asking yourself the following tough questions:

  • Can the strategy withstand sunshine? (Would you be embarrassed if it was widely known and understood?)
  • Can the strategy withstand storms? (Is it fragile and susceptible to being tipped over by less-than-perfect conditions?)
  • Will that accounting generate positive cash flow or just make the profit-and-loss statement look better?
  • Does the strategy make any sense? (ex, does it make sense to offer long-term financing on short-term depreciating assets?)
  • When does it stop?

Deflated rollups

According to business research,

more than two-thirds of rollups fail to create any value for investors

The rollup strategy is initially attractive because

the concept makes sense, growth is unbelievable, and problems haven’t surfaced yet

But they rely a lot on positive momentum to succeed because

Rollups have to keep growing by leaps and bounds, or investors disappear, and the financing for the rollup goes with them

There are four major risks to a rollup strategy:

  1. rollups often wind up with diseconomies of scale
  2. they require an unsustainably fast rate of acquisition
  3. the acquiring company doesn’t allow for tough times in their calculations
  4. companies assume they’ll get the benefits of both decentralization and integration, when in reality they must choose between one or the other

Double-check your rollup strategy by asking yourself the following tough questions:

  • Will your information systems break down if you increase the size of your business by a large factor?
  • What other systems might break down at the new scale?
  • How much of senior management’s time is going to go to putting out fires, coordinating activities, etc.?
  • How much business will you lose in the short run as competitors use takeover confusion to try to poach business?
  • What regulations might change and how will they affect the business?
  • Will your cost of capital really decline? If so, how much? How do you know?
  • If you think your pricing power will increase, why?
  • What will you have to spend, both in time and money, to get the efficiencies you expect from a takeover?
  • Who has a vested interest in keeping you from achieving all the efficiencies you expect?
  • How much will prices of acquisitions rise over time, as your rollup intentions become clear?
  • If you’re financing with debt, just how big a hit to your business can you withstand? What if you take a hit to cash flow for a period of years? If you’re buying with stock, what do you do if your stock price falls by 50%?
  • How do you prevent people from cooking the books when the bad times come?
  • Have you discounted the gains you expect to get from integration?
  • How much loss of revenue are you assuming if you replace local managers and systems?
  • What is the end game? How big do you need to get?
  • How slowly can you go?
  • Do you have to be a national rollup, or would a regional one make sense? Can you at least start as a regional rollup and work out the kinks?

Staying the (misguided) course

Businesses often adhere to a failed strategy or a dying technology because they either can’t envision how they’d adapt or can’t admit that they’re on a failed business course.

The three main risks to staying the course are:

  1. tend to see the future as a variant of the present
  2. tend to consider whether to adopt a new technology or business practice based on how the economics compare with those of the existing business
  3. tend not to consider all their options

Double-check your core strategy by asking yourself the following tough questions:

  • Are you considering all your options?
  • Declining business model, based upon Michael Porter’s five forces:
    • does your industry have a favorable structure for decline, where, like steel, it will provide profits even as it declines? Or, is your industry like traditional photography, which would mostly disappear once digital took hold?
    • can you compete successfully for the remaining demand, like Kodak, with a great brand? Or do you not only lack a brand but also lack other assets, such as a low cost structure?

Misjudged adjacencies

Adjacent market expansion entails attempting to sell new products to existing customers, or existing products to new customers, by building on a core organizational strength to expand the business in a significant way.

But sometimes, businesses expand into markets that seem adjacent, but are not– just because your branded-sunglasses customers like your sunglasses brand, doesn’t mean they’ll necessarily like it on their sportscar tires, or on their surfboards, because you imagine your market is “sport lifestyle.”

There are four fundamental risks to an adjacency strategy to be aware of:

  1. the move is driven more by a change in a company’s core business rather than by some great opportunity in the adjacent market
  2. lack of expertise in the adjacent market, causing misjudgment of acquisitions and mismanagement of the competitive challenges of the new market
  3. overestimation of the strengths of importance of core business capabilities in the new market
  4. overestimation of the hold on customers, creating expectations of cross-selling or up-selling that won’t materialize

Double-check your adjacencies strategy by asking yourself the following tough questions:

  • How do the sales channels differ in the new market?
  • How do the customers differ?
  • How do the products differ?
  • Are the regulatory environments differ?
  • Do you have at least a 30% advantage on costs before entering the new market?
  • What if the economy goes seriously south?
  • What if the sector you’re moving into goes into decline?
  • What if your expectations about opportunities for efficiency and revenue growth don’t happen?
  • How much do you have to be off in your estimates of cost savings or revenue increases for the adjacency strategy to be a bad idea?
  • What don’t you know about your new market?
  • What don’t you know about making acquisitions?
  • How many of your acquisitions will be lemons?
  • Will your customers really follow you into your new market?

Fumbling technology

Businesses often bet the farm on a technology that turns out to be nowhere close to as profitable and revolutionary as they initially expect it to. Often, market research is created which suffers from “confirmation bias”.

There are three important technological “laws” to be mindful of, which are often ignored, as well:

  1. Moore’s Law; computer processors double in power every eighteen to twenty-four months
  2. Metcalfe’s Law; the value of a network is proportional to the square of the number of users
  3. Reed’s Law; new members increase a network’s utility even faster in networks that allow arbitrary group formation

There are four major mistakes businesses make when evaluating a technological strategy:

  1. evaluate their offering in isolation, rather than in the context of how alternatives will evolve over time
  2. confuse market research with marketing
  3. false security in competition, believing the presence of rivals equates to a validation of the potential market
  4. design the effort to be a front-loaded gamble instead of developing it piece-by-piece

Double-check your technology strategy by asking yourself the following tough questions:

  • What will your competition look like by the time you get to market? What if you’re six months late? A year?
  • How does your performance trajectory compare with the competition’s?
  • Do your projections incorporate Moore’s Law, for both yourself and your competition?
  • Have you allowed for Metcalfe’s Law and what it says about the relative value of networks? Is Reed’s Law relevant?
  • Is the market real?
  • Do you have to do it all at once? Or can you try things a bit at a time and learn as you go along?

Consolidation blues

Consolidation seems to be a fact of maturing industries. As an industry matures, smaller companies go out of business or are acquired. Most business people figure they want to be the acquirer; in the process, they ignore the possibility that they might be more valuable as a target, or by sitting and doing nothing (neither consolidating, nor selling out).

There are four main issues that tend to muck up consolidation strategies:

  1. you don’t just buy assets as a consolidator, you buy problems
  2. there may be diseconomies of scale
  3. assumption that the customers of the acquired company will be held
  4. may not consider all options (being an acquisition target, doing nothing)

Double-check your consolidation strategy by asking yourself the following tough questions:

  • What systems might fail under the weight of increased size? How much would it cost to fix them? How long would it take? What revenue might be lost in the interim?
  • What relationships might be harmed?
  • What departments are too small, or are for some other reason not up to the task of handling the new size? Which people aren’t up to the task?
  • How much will be lost as people jockey for position in the new organization?
  • How much drag will develop as you try to find efficiencies by standardizing processes?
  • Who will resist change? How effective will they be?
  • What are all the reasons why customers might defect?
  • How does consolidation benefit the customers?
  • What percentage of customers do you think might leave? How much do you think you’ll have to pay to entice these customers to stick around?
  • What are some potential results if you sold out or did nothing, instead of consolidating?

Coda

In summary, the most common problems that result in business failure are:

  • Underestimating the complexity that comes with scale
  • Overstating the increased purchasing power or pricing power or other types of power that come from growing in size (beware of “critical mass” strategies)
  • Overestimating your hold on customers
  • Playing semantic games (any strategy that relies on a turn of phrase is open to challenge)
  • Not considering all the options
  • Overpaying for acquisitions

Avoiding these mistakes: the Devil’s Advocate

How can you avoid these mistakes?

Put in place a process for reviewing the quality of past decisions.

Watch out for cohesive teams who develop the traits of dehumanizing the enemy and thinking they’re incompetent; limiting the number of alternatives they will consider; show even more overconfidence than members would as individuals; create “mind guards” who stomp out dissent.

Probably most important, establish the institution of Devil’s Advocate. Either assign an in-house, permanent DA (who gains experience with each episode, but carries the risk of being labeled as the “naysayer” and ignored) or assign the role on a rotating basis with each new decision (preferable).

The Devil’s Advocate is a powerful tool for avoiding business failure because

More often than not, failure in innovation is rooted in not having asked an important question, rather than having arrived at an incorrect answer