A Dozen Things Charlie Munger has said about Reading

 

  1. “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero.”

 

  1. “You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.” 

 

  1. “As long as I have a book in my hand, I don’t feel like I’m wasting time.”

 

  1. “I’ve gotten paid a lot over the years for reading through the newspapers.”

 

  1. “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading. I don’t think any one book will do it for you.”

 

  1. “For years I have read the morning paper and harrumphed. There’s a lot to harrumph about now.”

 

  1. “We read a lot.  I don’t know anyone who’s wise who doesn’t read a lot.  But that’s not enough: You have to have a temperament to grab ideas and do sensible things.  Most people don’t grab the right ideas or don’t know what to do with them.”    

 

  1. “By regularly reading business newspaper and magazines I am exposed to an enormous amount of material at the micro level.  I find that what I see going on there pretty much informs me about what’s happening at the macro level.”  

 

  1. “Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we’ve turned that quirk into a positive outcome for ourselves. We both insist on a lot of time being available almost every day to just sit and think. That is very uncommon in American business. We read and think.”

 

  1. “If you get into the mental habit of relating what you’re reading to the basic structure of the underlying ideas being demonstrated, you gradually accumulate some wisdom.”

 

  1. “Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.”

 

  1. “I met the towering intellectuals in books, not in the classroom, which is natural. I can’t remember when I first read Ben Franklin. I had Thomas Jefferson over my bed at seven or eight. My family was into all that stuff, getting ahead through discipline, knowledge, and self-control.”

 

p.s., “Obviously the more hard lessons you can learn vicariously, instead of from your own terrible experiences, the better off you will be. I don’t know anyone who did it with great rapidity. Warren Buffett has become one hell of a lot better investor since the day I met him, and so have I. If we had been frozen at any given stage, with the knowledge we had, the record would have been much worse than it is. So the game is to keep learning.”

A Dozen Things I’ve Learned from Paul Tudor Jones About Investing and Trading

Paul Tudor Jones is the founder of the hedge fund Tudor Investment Corporation. The New York Times reported in March of 2014: Mr. Jones can “claim long-term annual returns of close to 19.5 percent in his $10.3 billion flagship fund, Tudor BVI Global.”

 

1. “Certain people have a greater proclivity for [macro trading] because they don’t have the need to feel intellectually superior to the crowd. It’s a personality thing. But a lot of it is environmental. Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility, of the late ’70s and early ’80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician. It’s very hard to find a pure fundamentalist who’s also a very successful macro trader because it is so hard to have a hit rate north of 50 percent. The exceptions are in trading the very front end of interest rate curves or in specializing in just a few commodities or assets.”

There are many ways to make a profit by trading and investing. For example, venture capitalists buy mispriced optionality and traders buy mispriced assets based on factors like momentum. Comparing value investing with what Paul Tudor Jones does for a living is interesting.  What could be more anti-Ben Graham and value investing than a statement like:  “We learned just to go with the chart. Why work when Mr. Market can do it for you?”

“While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.”

Set out below are some statements by Paul Tudor Jones that reveal a bit about his trading style:

When I think of long/short business, to me there’s 5 ways to make money: 2 of those are you either play mean reversion, which is what a lot of long/short strategies do, or you can play momentum/trend, and that’s typically what I do.  We’ve seen cheap companies get cheaper many, many times.  If something’s going down, I want to be short it, and if something’s going up, I want to be long it.  The sweet spot is when you find something with a compelling valuation that is also just beginning to move up.  That’s every investor’s dream.”

 

“I love trading macro. If trading is like chess, then macro is like three-dimensional chess. It is just hard to find a great macro trader. When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. It’s a hell of a lot easier to get an information edge on one stock than it is on the S&P 500. When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form. The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade. Markets have consistently experienced “100-year events” every five years. “

 

“These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates the illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action. The pain of gain is just too overwhelming for all of us to bear!”

 

“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”

 

“One principle for sure would be: get out of anything that falls below the 200-day moving average.”

 

“I teach an undergrad class at the University of Virginia, and I tell my students, “I’m going to save you from going to business school.  Here, you’re getting a $100k class, and I’m going to give it to you in two thoughts, okay?  You don’t need to go to business school; you’ve only got to remember two things.  The first is, you always want to be with whatever the predominant trend is. My metric for everything I look at is the 200-day moving average of closing prices.  I’ve seen too many things go to zero, stocks and commodities.  The whole trick in investing is: “How do I keep from losing everything?”  If you use the 200-day moving average rule, then you get out.  You play defense, and you get out.”

 

“It’s just the nature of a rip-roaring bull market. Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic.” 

 

My takeaway: Paul Tudor Jones is timing non-rational human behavior based primarily on his pattern recognition skills. He does things like “spend an entire day watching a projection of his hedge fund’s positions blinking as they change.” What he does is interesting, but I am not interested in trying to replicate it myself. It does not suit my temperament, interests or skills. In other words, I am temperamentally unsuited to adopt his trading approach. I would rather drop a 100 pound stone on my toe than to watch blinking lights on a screen for a living. I put what Paul Tudor Jones does in what Charlie Munger might call the “not interested” pile. Would I put money in a hedge fund Paul Tudor Jones ran?  That is a moot question since he has no need or desire to raise money from people like me just as David Tepper would not invest money for me if I asked him. Would I invest with someone else who said he or she would replicate what they do? I doubt it, and certainly not anyone I know of right now. Whether I would invest in a tweaked index fund that considered a factor like momentum is a different question. I have not done this so far and it would certainly depend on the fees charged by the manager. Outperformance that is less than the manager’s fees is not interesting to me.

Understanding a factor like momentum is a big part of what Paul Tudor Jones does. Ben Carlson gives an excellent summary of the momentum approach to trading here which reads in part:

“The momentum factor is based on buy high, sell higher or alternatively, cut your losses and let your winners run. Value investing is based on a long-term reversion to the mean. Momentum investing is based on that gap in time that exists before mean reversion occurs. Value is a long game, while momentum is usually seen in the short- to intermediate-term… And it is a terrible idea to chase performance if you don’t know what you’re doing or why you’re doing it. Momentum is chasing performance, but in a systematic way, with an entry and exit strategy in place. Momentum tries to take advantage of performance chasers who are making emotional decisions. This is why the best momentum investors use a rules-based approach, to avoid those emotions.”

It is worth noting that momentum has been on a favorable roll lately. That does not mean the performance of momentum as a strategy will continue, but that momentum can work to outperform the market is a fact.

Despite his unique system, Paul Tudor Jones shares many approaches and methods with other great investors who have adopted different systems. I describe some of these commonalities below.

 

2. “I am always thinking about losing money as opposed to making money.”

“Don’t focus on making money; focus on protecting what you have.” 

“At the end of the day, the most important thing is how good are you at risk control.”

“Where you want to be is always in control, never wishing, always trading, and always, first and foremost protecting your butt.”

“I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.”

“[I’m looking for] 5:1 (risk /reward).  Five to one means I’m risking one dollar to make five.  What five to one does is allow you to have a hit ratio of 20%.  I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.”

The focus of great investors on not losing money is universal. Warren Buffett says the same thing, as do Seth Klarman and Howard Marks. This desire not to lose money is another way of saying that great investors and traders want to find bets with a lot more upside than downside. In other words, they are looking for asymmetry of potential outcomes: big upside and small downside. That’s optionality. They want to find bets that are very substantially in their favor. Great investors and traders are not gamblers since they seek positive expected value when making a bet.

 

3. “If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in. There is nothing better than a fresh start.”

Only bet when the odds are substantially in your favor. Don’t bet unless you have a margin of safety. If you are not feeling certain and comfortable with your bet, then don’t bet. Put differently by Charlie Munger: “the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time they don’t. It is just that simple.”

 

4. “I think one of my strengths is that I view anything that has happened up to the present point in time as history. I really don’t care about the mistake I made three seconds ago in the market. What I care about is what I am going to do from the next moment on. I try to avoid any emotional attachment to a market.”

Treating past decisions as sunk and looking at each position on that basis is a great skill for an investor to have. Researchers put it this way: “People have trouble cutting their losses: They hold on to losing stocks too long, they stay in bad relationships, and they continue to eat large restaurant meals even when they’re full. This behavior, often described as ‘throwing good money after bad’, is driven by what behavioral scientists call the ‘sunk-cost bias’” What has been spent is spent. Once it is gone it is gone.

 

5. “By watching [my first boss and mentor] Eli [Tullis], I learned that even though markets look their very best when they are setting new highs, that is often the best time to sell. He instilled to me the idea that, to some extent, to be a good trader, you have to be a contrarian.”

That you can’t perform the market if you are doing just the same things as the market is a mathematical fact. You must sometimes be a contrarian and sometimes be right about that view in a way that makes the magnitude of what you do right outperform the crowd.  Paul Tudor Jones said once: “I also said that my contrarian trading was based on the fact that the markets move sideways about 85 percent of the time. But markets trend 15 percent of the time and you need to follow the trend during those times.” How he does this is a mystery to me. It’s pattern recognition, but what’s the pattern?

 

6. “[Eli] was the largest cotton speculator in the world when I went to work for him, and he was a magnificent trader. In my early 20s, I got to watch his financial ups and downs and how he dealt with them. His fortitude and temperament in the face of great adversity were great examples of how to remain cool under fire. I’ll never forget the day the New Orleans Junior League board came to visit him during lunch. He was getting absolutely massacred in the cotton market that day, but he charmed those little old ladies like he was a movie star. It put everything in perspective for me.”

“I want the guy who is not giving to panic, who is not going to be overly emotionally involved, but who is going to hurt when he loses. When he wins, he’s going to have quiet confidence. But when he loses, he’s gotta hurt.”

Having control over your emotions is a very valuable thing since most mistakes are emotional or psychological. I believe this anecdote is making the point that people who can keep emotions and actions in spate buckets have a big advantage. Self-control and self-awareness are very valuable.

 

7. “My guiding philosophy is playing great defense. If you make a good trade, don’t think it is because you have some uncanny foresight. Always maintain your sense of confidence, but keep it in check.”

“Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”

This is a series of statements about the dangers of hubris. Oscar Lavant put it this way: “What the world needs is more geniuses with humility; there are so few of us left.” The best investors and traders are humble. They know they have made, and will continue to make, some mistakes.

 

8. “I got out of the brokerage business because I felt there was a gross conflict of interest: If you are charging a client commissions and he loses money, you aren’t penalized. I went into the money management business because if I lost money, I wanted to be able to say that I had not gotten compensated for it. In fact, it would probably cost me a bundle because I have an overhead that would knock out the Bronx Zoo. I never apologize to anybody, because I don’t get paid unless I win.”

This is a quote about having “skin in the game.” Advisors with skin in the game perform better and are more accountable. What is good for the advisor or manager is good for you which lowers conflicts of interest. Aligned incentives are a very good thing, not just in investing but in life generally.  The more aligned interests are the more you can base a relationship on trust. The more trust that exists the fewer resources need to be devoted to compliance. The optimal outcome is what Charlie Munger calls “a seamless web of deserved trust.”

 

9. “This skill is not something that they teach in business school.”

That Paul Tudor Jones can do it does not mean that you can do it: “I get very nervous about the retail investor, the average investor, because it’s really, really hard.  If this was easy, if there was one formula, one way to do it, we’d all be zillionaires.” The danger of writing something like this blog post is that many knuckleheads will surely say “Oh, I can be just like Paul Tudor Jones.” No, the chances of that being true are vanishingly small. There is only one Paul Tudor Jones. You are not Paul Tudor Jones. But his record exists. It can’t be ignored.

 

10. “I’ve done really well on the short side.  There’s nothing more exciting than a bear market.  But it’s not a wonderful way for long-term health and happiness.”

“I spent 20 years doing it, it’s not the right way to make a living trading.  It’s simply not.”

Shorting stocks has negative optionality. Mohnish Pabrai says:  “When you are long on a stock, as it goes down in price, the position is going against you and it becomes a smaller portion of your portfolio. In shorting, it is the other way around: if the short goes against you, it is going to become a larger position of your portfolio. When you short a stock, your loss potential is infinite; the maximum you can gain is double your value. So why will you take a bet where the maximum upside is a double and the maximum downside bankruptcy?” Warren Buffett points out: “You’ll see way more stocks that are dramatically overvalued than dramatically undervalued. It’s common for promoters to cause a stock to become valued at 5-10 times its true value, but rare to find a stock trading at 10-20% of its true value. So you might think short selling is easy, but it’s not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it’s worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, “Hey! Look at all that value creation!” and the game goes on. [As a short seller,] you could run out of money before the promoter runs out of ideas.”

 

11. “The single most important things that you can do is diversify your portfolio.  Diversification is key, playing defense is key, and, again, just staying in the game for as long as you can.”

It may seem odd that what some people call a gut trader like Paul Tudor Jones is focused on diversification.  What he and other investors are saying is that if you don’t play defense and you lose, you are out of the game. They know that you can’t win unless you remain in the game.  Diversification also allows you to “practice patience.” Paul Tudor Jones said on one occasion “if you don’t see anything, don’t trade.” He adds: “there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.”

 

12. “The secret to being successful from a trading perspective is to have an indefatigable and an undying and unquenchable thirst for information and knowledge.”

Paul Tudor Jones may be a momentum trader but he is also an investor who looks at fundamentals.  You can’t find mispriced assets unless you have an investing edge and that edge can come from better information and knowledge.

 

 

Notes:

Market Wizards:  http://www.amazon.com/Market-Wizards-Interviews-Weinstein-High-Percentage/dp/1592802761

 

Buckley School Graduation Speech: http://dealbreaker.com/2009/06/paul-tudor-jones-gets-ridiculously-real-with-ninth-graders/

 

WSJ interview: http://turtletrader.com/paul-tudor-jones-interview/

 

Notes on a talk at UVA: http://www.marketfolly.com/2013/06/notes-from-virginia-investment.html#ixzz3dotoQ7Bn

 

Meb Faber: http://mebfaber.com/2014/11/06/paul-tudor-jones-on-the-200-day-moving-average/

 

Ivanhoff:  http://ivanhoff.com/2012/12/09/13-insights-from-paul-tudor-jones/

 

A Dozen Things I’ve Learned from Sam Altman about Venture Capital, Startups and Business

Sam Altman is the president of Y Combinator. He was also the cofounder of Loopt, a location-based social networking app. Altman studied computer science at Stanford University.

1. “The best companies are almost always mission oriented.”

“Eventually, the company needs to evolve to become a mission that everyone, but especially the founders, are exceptionally dedicated to. The ‘missionaries vs. mercenaries’ soundbite is overused but true.”

If the founders of a startup are not passionate about solving a customer problem which they care deeply about, the odds are small that they will be able to successfully create a business generating financial returns that are attractive to a venture capitalist.  I am not talking about launching a new business like a car wash or a pizza restaurant but rather a startup that might be attractive to a venture capitalist. Creating a scalable, repeatable and defensible business that generates hyper growth and a large profitable business is a rare event. The best way to create passion in a founding team is to create a mission-driven culture within the business. Venture capitalists love founders with passion because missionaries endure in situations where mercenaries often quit.

 

2. “In general, it’s best if you’re building something that you yourself need. You’ll understand it better than if you have to understand it by talking to a customer.”

Passion and a mission are more likely to exist if the business is proving solutions that the founders want for themselves. Deep understanding of a customer problem and potential solutions is rather obviously fostered if the founders are themselves potential customers for the solution. Not only is this more efficient and cost effective, but there is less likely to be communications “path loss” between the potential customers who have the problem and the business trying to solve that problem. Yes, it is helpful to have “beginners mind” about potential new solutions. No, having relevant domain expertise is not necessarily a handicap.

 

3. “You want an idea that not many other people are working on, and it’s okay if it doesn’t sound big at first.”

“The truly good ideas don’t sound like they’re worth stealing.”

“You want to sound crazy, but you want to actually be right.” 

“We are the most successful when we fund things that other people don’t yet think are going to be a really big deal but two years later become a big deal. And it’s really hard to predict that.”

“A lot of the best ideas seem silly or bad initially—you want an idea at the intersection of ‘seems like bad idea’ and ‘is a good idea’.”

Both a founder of a startup and a venture capitalist are trying to find mispriced optionality.  The probability of finding opportunity that is mispriced is far greater if the startup is not working on the same problem as many other businesses. In other words, less competition with other businesses seeking mispriced optionality in a given area of business is a valuable thing. Ideas that are “half-crazy” are far more likely to reflect mispricing since most businesses love the safety of conventional wisdom. Big companies in particular tend to be afraid of half-crazy ideas and tend to overinvest in ideas that are at the peak of a hype cycle. There were a few people who recently concluded that since some VCs passed on investing in Airbnb that the process of picking startups to invest in is random. This is probably incorrect due to the power laws that exist in VC and the persistent outperformance of the top VC firms over decades.

The nature of VC involves optionality, which requires failure to work. Again, some degree of failure is essential to optionality, especially mispriced optionality.  No one, even the very best VCs can predict which of  ~30 startups will be the one or two unicorns. The job of the VC is to pick the best unicorn candidates knowing full well that most startups will fail. Many startups that look half-crazy and may for that reason possess the necessary optionality are crazy or too early. Which of the best will be a unicorn, if any, is sorted out over time. My posts on optionality and venture capital go into greater depth on this topic.

 

4. “No growth hack, brilliant marketing idea, or sales team can save you long term if you don’t have a sufficiently good product.”

“Make something people want.  You can screw up most other things if you get this right; if you don’t, nothing else will save you.”

“All companies that grow really big do so in only one way: people recommend the product or service to other people. What this means is that if you want to be a great company someday, you have to eventually build something so good that people will recommend it to their friends–in fact, so good that they want to be the first one to recommend it to their friends.”

“Figure out a way to get users at scale (i.e. bite the bullet and learn how sales and marketing work).  Incidentally, while it is currently in fashion, spending more than the lifetime value of your users to acquire them is not an acceptable strategy. Obsess about your growth rate, and never stop. The company will build what the CEO measures.  If you ever catch yourself saying ‘we’re not really focused on growth right now’, think very carefully about the possibility you’re focused on the wrong thing.  Also, don’t let yourself be deceived by vanity metrics.”

There is no substitute for solving a real customer problem.  Bill Campbell doesn’t mince words about the importance of the right product: “If you don’t have the right product and you don’t time it right… you are going to fail.” Without a valuable customer value proposition the customer acquisition cost (CAC) of the sales-driven effort will inevitably be fatal. Companies that don’t deliver compelling value end up having to pay too much to acquire customers. Paying too much to acquire customers is not a solvable problem since churn, COGs, ARPU and a cost of money can all kill any chance you have of creating shareholder value. Bill Campbell also says: “When I work with startups, the last thing I work with them on is marketing. I don’t want to overestimate marketing. Apple’s marketing is having great products.”

 

5. “It’s worth some real up front time to think through the long term value and the defensibility of the business.”

“Have a strategy.  Most people don’t.  Occasionally take a little bit of time to think about how you’re executing against your strategy.”

Every business must find at least one barrier-to-entry (a moat) to generate a profit. Moats can take many forms and must constantly be refreshed since they are always under attack by competitors. Without a moat of some kind, competitors will increase supply of the offering to a point where financial return is equal to the opportunity cost of capital. It is worth repeating this point: competitors increasing the supply of what you sell kills value for you. Without some limit on supply you will not earn an economic profit. On moats, read Michael Porter. Porter teaches:  “if customers have all the power, and if rivalry is based on price… you won’t be very profitable.”

 

6. “Every company has a rocky beginning.”

“You have to have an almost crazy level of dedication to your company to succeed.”

The process of creating and managing a business will never go completely according to plan. There is no manual you can follow that will create business success. There are no fool proof recipes and formulas that founders and CEOs can follow. For these reasons it is the ability of the Founders, the CEO and the team to make wise decisions given an uncertain future that will determine success. Courage, perseverance and determination will be needed to produce positive outcomes. My blog post on VC Ben Horowitz that will dig more deeply into this set of issues.

 

7. “If you’re not an optimist, you make a very bad venture capitalist.”

Great entrepreneurs and venture capitalists are supernaturally optimistic despite the fact that most of what they do will result in financial failure as measured by frequency of success. What matters in the world of startups and venture capital is not frequency of success but rather magnitude of success.  Even one unicorn in a lifetime of starting companies investing can justify the efforts and struggles of a founder. Maintaining an optimistic attitude in the face of uncertainty and repeated failure is a challenge. Which reminds me of a joke. An optimist entrepreneur and a pessimist entrepreneur were sitting in a café talking. The pessimist turns to the optimist and says: “Things can’t possibly get worse. The optimist replies: ‘Sure they can!”

 

8. “Great execution is at least 10 times more important and 100 times harder than a good idea.”

“Remember that you are more likely to die because you execute badly than get crushed by a competitor.”

While having the great idea should be the starting point in any business, that idea will result in little or nothing if great business execution is missing. Watching a great team execute under the leadership of someone like Jim Barksdale or John Stanton is a valuable experience. Trains running on time is a beautiful things to see. Ralph Waldo Emerson pointed out the obvious when he said: “Good thoughts are no better than good dreams, unless they be executed.” After all “However beautiful the strategy, you should occasionally look at the results” (Sir Winston Churchill).  Mark Twain famously expressed a similar view: “There are basically two types of people. People who accomplish things, and people who claim to have accomplished things. The first group is less crowded.”

 

9. “Stay focused and don’t try to do too many things at once.” 

“Eliminate distractions.”

“The hard part of running a business is that there are a hundred things that you could be doing and only five of those actually matter and only one of them matters more than all of the rest of them combined. So figuring out there is a critical path thing to focus on and ignoring everything else is really important.”

Any business, but especially startups, will face many challenges and much uncertainty. There will always be more things that could possibly be done than people and resources to do them.  Great founders and entrepreneurs know the difference between what could be done and should be done. Setting priorities and staying focused is critical. Jim Barksdale put it this way:  “The main thing is to keep the main thing, the main thing.”

 

10. “At the beginning, you should only hire when you have a desperate need to.”

“Later, you should learn to hire fast and scale up the company, but in the early days the goal should be not to hire.”

“Hiring is the most important thing you do; spend at least a third of your time on it.”

When a business is just getting started, small teams are very efficient and translate to cash burn rates that can be kept relatively low until key milestones are achieved.  Low cash burn rates allow the business more time to build something that customers really love. If the cash burn rate of the startup is high, a business is under pressure to commit to an idea and doing that prematurely is often fatal.

When the time comes to scale the business recruiting becomes a huge priority. Great founders spend far more time recruiting than people imagine. As Keith Rabois says: “The team you build is the company you build.”

 

11. “One thing that founders always underestimate is how hard it is to recruit.”

“You think you have this great idea that everyone’s going to come join, but that’s not how it works.”

“A great team and a great market are both critically important—you have to have both.  The debate about which is more important is silly.”

“Don’t let your company be run by a sales guy.  But do learn how to sell your product.”

Experienced venture capitalists are looking for evidence that founders have strong sales skills. One early test of a founder’s sales skill is when they make a fundraising pitch. The idea is simple: If the founders can’t sell the idea to a venture capitalist, how are they going to be able to recruit great people, sell the product, and find great distribution?  The ability to sell the offering to investors, sell the potential of the business to employees and sell products to customers is core to any business. If you don’t like to sell these things starting a business is probably not the right path for you.

 

12. “Keep an eye on cash in the bank and don’t run out of it.”

“Do reference checks on your potential investors. Ask other founders how they are when everything goes wrong.”

“Good investors are worth a reasonable premium. Go for a few highly involved investors over a lot of lightly engaged ones.”

If the founders have a great idea and a strong team, money is not the scarce ingredient in creating a successful business. What is scarce is value-added capital (investors who supply the business with more than money). Even scarcer is value-added capital that will be a big help when things are going wrong (which is inevitable as noted above). The last thing founders need are fair weather investors. Taking the time to research potential investors is wise since the relationship will last for many years. Among the questions that should be asked:  What are the investors like when things don’t go according to plan? Are they fun to work with? Do the investors pitch in to help on things like recruiting when asked? Taking a higher valuation from an investor who is a known jerk is unwise. Why would you ever want to do that?  Life is short. Happiness and having fun are underrated.

 

Notes:

How to Start a Startup – Lecture 1

blog.SamAltman.com – The Only Way to Grow Huge

 

SVBJ Interview – Founder Lessons

Esquire Interview

 

blog.SamAltman.com – Startup Advice

Medium – What You Need to Know about Hiring

 

blog.SamAltman.com – The Days are Long but the Decades are Short

blog.SamAltman.com – Startup Advice Briefly

Techcrunch Interview – Elements of a Successful Startup

A Dozen Things I’ve Learned from Ben Horowitz about Management, Investing and Business

Ben Horowitz is a co-founder of the venture capital firm Andreessen Horowitz.  Prior to being a venture capitalist,  he co-founded Loudcloud, a managed services provider which became Opsware, a data center automation software provider.  He is the author of The Hard Thing About Hard Things: Building a Business When There Are No Easy Answers.  Horowitz earned a BA in Computer Science from Columbia University in 1988 and a MS in Computer Science from UCLA in 1990. On his blog Ben suggests that if you want to learn more about him you read his entry in Wikipedia.

 

1. “You read these management books that say ‘these are the hard things about running a company’. But those aren’t really the hard things.”

“My old boss Jim Barksdale said that most management consultants have never managed a hot dog stand.” 

“Wartime CEO is too busy fighting the enemy to read management books written by consultants who have never managed a fruit stand.”

“When I was a CEO, the books on management that I read weren’t very much help after the first few months on the job. They were all designed to give you directions on how not to screw up your company. But it doesn’t take long before you get beyond that and you’re like OK I’ve screwed up my company; now what do I do? Most books on management are written by management consultants, and they study successful companies after they’ve succeeded, so they only hear winning stories.” 

People who write about management tend to follow a formula that Michael Mauboussin has described: “The most common method for teaching business management is to find successful businesses, identify their common practices, and recommend that managers imitate them.…This formula is intuitive, includes some compelling narrative, and has sold millions of books. [The reality is that]  attributing a firm’s success to a specific strategy may be wrong if you sample only the winners.…When luck plays a part in determining the consequences of your actions—as is often the case in business—you don’t want to study success to identify good strategy but rather study strategy to see whether it consistently led to success.” Ben Horowitz decided to write a different sort of book that rejects the approach described by Michael Mauboussin in favor of a reality-based approach. He decided to write about what he calls “the Struggle” which is “basically what you feel like when your world is caving in.”

Ben Horowitz adds to the point made by Michael Mauboussin by saying, you can do things recommended by these books like setting a “big, hairy, audacious goal” and still have the business flounder. What do you do then? Running a business isn’t the equivalent of a well-planned garden party. As my late friend Keith Grinstein told me years ago, once a business gets beyond the planning stage: “stuff breaks.” Things will go haywire at unexpected times and places. And when that happens, having great managers who have the ability and willingness to adapt pays big dividends.

 

 

2. “Management turns out to be really dynamic and situational and personal and emotional. So it’s pretty hard to write a formula or instruction book on it.”

“There isn’t one lesson that solves everything.”

“Any advice you give is based on your [experience]; it’s not general advice. People try to generalize it — and I try to generalize it, too — but without knowing where it comes from it’s not nearly as useful.”

“Nobody is born knowing how to be a CEO. It’s a learned skill and unfortunately you learn it on the job.”

“The only thing that prepares you to run a company, is running a company.”

When a CEO is engaged in the Struggle there are no formulas to follow. Being a CEO is like being an investor in that experience can’t be simulated. In both cases you learn by doing, just as everyone else who has come before you.

Having said that, just because the skills required to be a successful CEO must be learned on the job doesn’t mean that you can’t learn something by observing another CEO.  For example, Ben Horowitz had the opportunity while working at Netscape to observe Jim Barksdale who many people I know feel is one of the best CEOs of all time. Ben has identified Bill Campbell and Ken Coleman as having been his mentors. There are no formulas to follow in being a CEO, but you can still learn things like the types of decisions that a CEO must make to be a success by looking as what other CEOs have done. For example, one conclusion I have reached over several decades of working with different CEOs is that the best CEOs are not cut from the same mold. Each CEO I have encountered in my life has had different strengths and weaknesses, but the really great CEOs all know how to surround themselves with people who complement their weaknesses.  I have no way of knowing whether the strong supporting cast surrounding the CEO in any given case arrived mostly due to luck. But without exception they all had a great supporting team around them. As another example, some CEOs use profanity and some don’t,  some yell sometimes and some don’t, but all of them are effective communicators in their own way.

 

 

3. “In reality companies are what they are and nobody has ever worked anywhere where everything is perfect. And so pretending that things are perfect isn’t actually very effective.”

“I don’t know that I’m drawn to conflict; you don’t necessarily in these businesses want conflict with other companies, though you get it a fair amount. But, and this is one of the best management pieces of advice I ever got from Marc Andreessen: he was quoting Lenin, who was quoting Karl Marx, who said: ‘sharpen the contradictions.’ Marx was talking about labor and capital, which is not generally what you’re talking about when you’re running a company. But the conflict is where the truth is. And so when there’s a conflict in the organization, you do not want to smooth it over. You want to sharpen the contradictions, heat up both opinions, and resolve it. Good CEOs are really good at doing that. And it’s miserable to work for someone who tries to smooth things over.” 

The key words in this set of quotes from Ben Horowitz are “conflict is where the truth is.” Every business and almost everything in life is not perfect.  Identifying the things that should be changed to improve a business is fostered if you identify conflict and work to resolve it. Hiding conflict causes problems to fester and grow. Here’s Ben again: “You do not want to smooth over conflicts. You want the conflicts to surface and you want to resolve them. If you don’t, you have got problems. If you do surface and resolve them you will be a pretty good manager.”

 

 

4. “When a company goes astray, you talk to employees and they say, ‘We have no strategy. We don’t know where we’re going.’ The strategy is the story. They’re not different. The strategy is the story you tell. It’s the why. If you can’t tell that in a massively compelling way, who’s going to follow you? That’s what makes people get up in the morning and do stuff.”

“The story must explain at a fundamental level why you exist. Why does the world need your company? Why do we need to be doing what we’re doing and why is it important?”

“You can have a great product, but a compelling story puts the company into motion. If you don’t have a great story it’s hard to get people motivated to join you, to work on the product, and to get people to invest in the product.”

“The mistake people make is thinking the story is just about marketing. No, the story is the strategy. If you make your story better you make the strategy better.”

“Storytelling is the most underrated skill.”

In Ben’s view the CEO and founders must own the story of the business.  It is their responsibility to keep it up to date and compelling. The CEO and founder’s task is made easier by the fact that humans love a good story. Because they often have trouble understanding or remembering ideas and instructions, stories help people stay on track and motivated. It is important to emphasize that Ben Horowitz is making a point here about strategy, which as Michael Porter points out, is driven by what a company does differently than its competitors. The story must convey what the business does that is uniquely valuable and how that will create a sustainable competitive advantage (a moat).

As an example of the importance of a story, I had a conversation recently with a person who is a venture capitalist and owns a winery. We agreed that when talking about an industry in which the story is key to the product, wine should be font and center.  The terrain, the grapes, the winemaker etc. are all about story telling. Many people seem to enjoy the story of the wine more than the wine itself, or at least the former drives the latter. The food television personality Andrew Zimmern said once: “Food tastes good. Food with a story tastes better.” Of course, that is mostly a statement about marketing. Ben Horowitz believes that the story should drive the strategy. For example, how will the wine business run their business in a unique ways that creates a moat? How can it create sustainable differentiation in what is a very competitive industry? What can be done to create barriers to entry in the part of the market the winery has decided to serve?

 

 

5. “Thinking for yourself …the distinguishing characteristic of the great entrepreneurs.”

“The trouble with innovation is that truly innovative ideas often look like bad ideas at the time.”

“Innovation is almost insane by definition: most people view any truly innovative idea as stupid, because if it was a good idea, somebody would have already done it. So, the innovator is guaranteed to have more natural initial detractors than followers.” 

Founders who deliver great new value to the world think differently. That value comes from believing or recognizing something as true that other people do not see. The founders are inevitably breaking one important assumption that others have made. AirBnB is a classic example of founders thinking differently. Ben’s partner Marc Andreessen said once that the conventional wisdom about AirBnB was to ask things like: “People staying in each other’s houses without there being a lot of axe murders?” Great founders and CEOs don’t outperform the market by following the crowd. As is the case with investing, it is mathematically impossible to follow the crowd and perform better than the crowd.

No one puts it better than Howard Marks:  “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Not only must the founder and CEO occasionally be contrarian, but they must be sufficiently right about a contrarian view in a way that drives outperformance. In measuring outperformance it is magnitude of success and not frequency of success that matters. The best way to be a successful contrarian is, as Ben Horowitz points out, to think for yourself. Being a contrarian by definition means that you must be prepared to sometimes be lonely with respect to some of your views. Thinking differently separates you from the warmth of the crowd.

 

 

6. “People say that the CEO should be ‘the best salesman at the company’ or the ‘product visionary’ or all these things. No. The CEO is the CEO. They’ve got to deliver very quality decisions at a very high rate of speed. And if they don’t make a decision, the company freezes up.  In order to do that, you need to be talking to everybody. You need to figure out what’s going on with your finance people, and your engineering people. Because by the time this s–t comes to you, you won’t have time to do that. You won’t have time to make your decision.”

The ability of a person to make timely and wise decisions is the mark of a great CEO.  As an analogy, the best defensive baseball players are standing there waiting for the ball when it arrives. They are already in great position before the ball is hit. Great business decision makers similarly are ready to make decisions when the time comes because they have done the necessary preparation. That preparation allows them to make timely and more accurate decisions. Charlie Munger talks about this same idea in investing.  Most of the time Charlie Munger is reading and thinking. He is getting ready to act quickly and aggressively when the time comes. It looks like nothing is happening but the reality is that Munger is working hard to be ready when the right time arrives. When Charlie Munger makes an investment he has been preparing to make that investment for a long time. He knows the business and the market. Great managers are prepared and ready to act, standing in just the right place when the equivalent of the baseball drops into their glove.

 

 

7. “Sometimes an organization doesn’t need a solution; it just needs clarity.” 

“Often any decision, even the wrong decision, is better than no decision.”

Not making decisions is, of course, making a decision – as is not making a decisions quickly and decisively. Too often the answer executives provide a company when faced with a decision is like the old joke about the psychiatrist who asks his patient if he has trouble making decisions? The patient says, “Well, doctor, yes and no.”

I have a friend who is a venture capitalist and one day, during a press interview in his office he was asked by a journalist, “What is the secret of your success?” He said, “Two words.” “And, what are they?” asked the journalist. “Right decisions.” “But how do you make right decisions?” asked the journalist. “One word,” he responded. “And, what is that? Asked the journalist” “Experience.” “And how do you get experience?” “Two words.” “And, what are they?” “Wrong decisions.”

A related common problem is that sometimes, when we are presented with several options, they may blind us to other choices — including the simplest and most sensible one.  During a visit to a psychiatric hospital, a visitor asked the doctor how they determine whether or not a patient should be institutionalized. “Well,” said the doctor, “We fill up a bathtub, then we offer a teaspoon, a teacup and a bucket to the patient, and ask them to empty the bathtub.” “I see,” said the visitor. “A normal person would use the bucket because it is bigger than the spoon or the teacup.” “No,” said the doctor, “a normal person would pull out the plug. Do you want a bed near the window?”

 

 

8. “The primary thing that any technology startup must do is build a product that’s at least ten times better at doing something than the current prevailing way of doing that thing. Two or three times better will not be good enough to get people to switch to the new thing fast enough or in large enough volume to matter.”

“If you don’t have winning product, it doesn’t matter how well your company is managed, you are done.”

The essence of business is to cost-effectively acquire a customer. The greater the value delivered by the business, the less time and money that will be required to sell the product or service. Given that humans suffer from inertia, it takes a compelling value to get people to switch to a new product or service. If you pay too much for sales and marketing to acquire that customer you can quickly (or slowly) go broke. In a customer lifetime value model too much acquisition costs can be fatal. Sam Altman puts its simply: “Be suspect about buying users.” The better approach is to have customers who are attracted by a better product or service.

 

 

9. “Figuring out the right product is the innovator’s job, not the customer’s job. The customer only knows what she thinks she wants based on her experience with the current product. The innovator can take into account everything that’s possible, often going against what she knows to be true. This requires a combination of knowledge, skill, and courage.”

The famous relevant Steve Jobs quote is, of course: “It’s really hard to design products by focus groups. A lot of times, people don’t know what they want until you show it to them.” If something is going to be 10x better the product or service is going to need to be different than what the customer has seen before. A “me too” product or service is not going to move the needle for a startup.

 

10. “There are only two priorities for a start-up: Winning the market and not running out of cash. Running lean is not an end.”

“The only mistake you cannot make is running out of cash.”

Several times in this blog series I have quoted Harold Geneen as having said: “The only unforgivable sin in business is to run out of cash” but it is such an important point that it is worth repeating. Earnings are an opinion. Cash is a fact. Should a business spend every penny wisely? Absolutely. But don’t run of out of cash.  Is equity dilution something to be avoided? Sure. But don’t run out of cash. Can too much cash cause a business to solve problems with money rather then culture? Yep, but don’t run out of cash.  Can innovation be greater when a company has less capital on hand? Yes, but don’t run out of cash. Oh, and did I mention: don’t run out of cash. Horowitz and A16Z have a helpful guide to raising funds here.

 

 

11.  “What do you get when you cross a herd of sheep with a herd of lemmings? A herd of venture capitalists.”

“The most important rule of raising money privately: Look for a market of one. You only need one investor to say yes, so it’s best to ignore the other thirty who say ‘no.’”

The best venture capitalists think for themselves just like the best CEOs think for themselves. Anyone who is paying attention knows that venture capital is a cyclical business. This results for the same reason as economic cycles happen: people do not make decisions independently. Venture capitalists who do think independently generate better financial returns.  For example, the best venture capitalists have left social media focused startups when the hype cycle hits its peak but then may circle back once the poseurs are gone. Bargains are most often found where others are not looking, particularly when it comes to the optionality that drives venture capital returns.

Founders who are raising money must keep in mind that venture capital firms commit errors of omission all the time. Many venture capitalists passed on Uber and AirBnB and other big financial successes. That they pass on your pitch does not mean you will not find success with another firm. No one knows for sure which investments will succeed. Raising money requires that you have a thick skin. People who successfully raise money never give up. A great example of this from Ben’s own life was the so-called “IPO from Hell” when LoudCloud raised funds in a market that many believed was dead. The Wall Street Journal noted that on March 8, 2001 LoudCloud had “just completed a backbreaking, initial public offering road show that landed (Horowitz) in 70 meetings in 16 days with moneymen scattered across North America and Europe.” They may have been the last tech IPO out the door in that cycle but they got it done and that was what mattered.

Ben and Marc also raised funds for their first a16z fund in 2009 – which was not an easy time to raise money. A journalist wrote about that time period: “in a market where LPs are fastidiously avoiding new VC fund commitments, I’m a bit amazed that LPs would consider placing a $250 million bet on a first-time fund with this type of profile.”

 

 

12. “All the returns in venture capital go to a tiny number of firms and the same firms every year….this is not true in mutual funds or hedge funds or anything else. You don’t have persistent returns across decades.”

I have raised this topic in several of my posts including on Marc Andreessen and Fred Wilson. Some people go as far as to say that venture capital can’t really be an asset class if the difference between the top 10 venture capital firms and the bottom quartile of venture capital firms reflects a power law (the argument is that the difference in financial returns is too great to group them together; considering a16z, Benchmark, Sequoia etc. with firms in the bottom quartile of venture capital performance is apples and oranges). What this means as a practical matter for a founder is that whether you are able to raise funds from one of those firms will have a great deal to do with whether you are successful. Why? Path dependence. Potential employees, investors, consumers and distributors take cues from previous success in making decisions. Past success in this way feeds back on itself, and the best firms get the best results in a distribution of income that reflects a power law.

Notes:

Horowitz on the Future of the Internet Economy

‘The Struggle,’ According to Ben Horowitz

 

The Consigliere of Silicon Valley

Ben Horowitz Gets Real: You Laid Off People Because You F—ed Up

 

Super Investor Ben Horowitz On Abandoning Your Formulas For Success

The Case for the Fat Startup

 

A Q&A With Ben Horowitz On His New Book, The Hard Thing About Hard Things

Ben Horowitz on Conflict

 

“Why We Prefer Founding CEOs”

The Keys to Success

 

Your Story is Your Strategy

The Last Days of Net Mania

A Dozen Things I’ve Learned from Leon Cooperman About Investing

Leon Cooperman is the founder of the multi-billion dollar hedge fund Omega Advisors. Cooperman founded the firm after a 25 year career at Goldman Sachs where he was a partner and served as chairman and CEO of Goldman Sachs Asset Management. His biography is extensive. The fund’s approach to investing is described as: “We are a value-based, catalyst driven investor, focused on a variant perception of company fundamentals. Our disciplined, fundamental approach to company analysis allows us to estimate a company’s business value and compare it to market value. Once the investment decision has been made, we determine the appropriate exposure/sizing in the context of prudent risk control and liquidity of the investment.”

1. “We are trying to look for the straw hats in the winter. In the winter, people don’t buy straw hats, so they’re on sale.”

“We’re looking for things that are mispriced, where opportunity for achieving excess returns exists.”

The primary job of any value investor is to find assets that are sufficiently mispriced so they can be bought at enough of a bargain that the purchase price provides a margin of safety. When Mr. Market is greedy about owning more hats, don’t buy hats.  When Mr. Market is fearful about owning hats, it can be a good time to buy hats. The “best time to buy straw hats is in the winter” principle is simple, but actually following it is hard. John Kenneth Galbraith said once that “The conventional view serves to protect us from the painful job of thinking” and this is often applicable to investing. Seneca adds: “When a mind is impressionable and has none too firm a hold on what is right, it must be rescued from the crowd: it is so easy for it to go over to the majority.” It is mathematically the case that  you can’t outperform a crowd by following it. It is also the case that always avoiding what is popular is folly. The goal is to sometimes be contrarian and to be right when doing so.  That requires work and thinking. Cooperman has also said: “With an average IQ, a strong work ethic and a heavy dose of good luck, you can go very far.” And “The harder I worked, the luckier I got.” If you don’t want to work and think, buy a low cost index fund.

2. “[In July 2008.] To some degree, I feel like a kid in a candy store.”

2008 was the last time in recent memory when were loads of assets in many asset classes available for purchase at a substantial discount to their intrinsic value. Many great value investors had cash to buy assets that year because that cash was a residual of there being few bargains when the market was euphoric. It may look like people with cash in 2008 successfully timed the market turn around, but in fact they kept their focus on the prices of individual stocks. A value investor fundamentally works from the bottom up when making investment decisions and that means starting from the fundamentals of the specific business.

When a value investor like Warren Buffett says: “I felt like an oversexed guy on a desert island. I didn’t find anything to buy,” it is a time like 1973. Just a year later Buffett was saying: “This is the time to start investing.” A fundamental difference between value investors and many other investors is that value investors say things like “this stock is attractively priced” rather than “I think the market will go up soon.”

3. “I am very knowledgeable and cognizant of what the S&P represents; [in 2015] it’s an index of 500 companies, on an average they are growing about 5 percent a year, they yield about 2 percent, they trade a little under three times their book value. They have got 35 or 36 percent of debt in their capital structure and for those financial statistics you pay on an average today about 16.5–17 times earnings. So, I look for, as a value investor, I am looking for either more growth at a lower multiple, I am looking for more asset value or more yield. Some combination that says, ‘Buy me,’ and my team and I spend all day long, 7 days a week, 24/7 trying to look for things that are mispriced to the market.”

“As a value investor, I’m looking for more, but for less. I‘m looking for more growth at a lower multiple. I‘m looking for more yield versus what I can get from the S&P.  Or, I’m looking for more asset value.”

“About 95% of publicly traded companies have two values. One is the auction market value, which is the price you and I would pay for one hundred shares of a company. The other is the so called private market value, which is the price a strategic or financial investor would pay for the entire business.”

Leon Cooperman is explaining that what you pay (price) is not always what you get (value). You need to look very hard and be very patient as well. When you see the opportunity you must also act quickly and aggressively.  Few investors have the temperament to do this since they panic when the crowd is fearful. “Inverting” your emotions in an opposite direction from the crowd is not an easy thing to do. Most everyone is better served by sticking to a low cost diversified portfolio of index funds.

4. “We’re very confident in the companies we own because they incorporate a margin for error.”

He is referring here to the margin of safety principle of value investing. If you buy at a substantial discount to intrinsic or private market value you can make a mistake and still do just fine. And if things work out better than you thought you get an additional bonus. Cooperman points out: “We have a very narrow assignment, and that’s to know the companies we know better than anyone else and own the right companies.”  You can’t do the former without the latter since to understand the stock you must understand the business. Since risk comes from not knowing what you are doing, know what you are doing when doing. It’s that simple.

5. “I look for a stock in the public market that is selling at a significant discount to private market value where I can identify catalysts for a potential change.”

This approach is similar to Mario Gabelli, who I have profiled previously. Gabelli places so much importance on catalysts that his firm actually filed for a trademark on the phrase (Private Market Value with a Catalyst™). For example, a catalyst exist if an investor believes that a business selling at a discount also possesses a possible value accelerant that the market does not recognize. This catalyst approach is a tweak on value investing that is optional. Some investors seek an catalyst and some don’t. Bruce Greenwald and his co-author’s write:

“There are two kinds of catalysts: specific and environmental. Specific catalysts are those changes, either anticipated or recently occurring, that alter the prospects of a particular company. The grimly labeled ‘death watch’ stocks are attractive to investors who believe that the departure of the CEO or a large shareholder will allow the company, once freed from re­straints, either to improve its performance or to restructure itself, includ­ing here selling the whole thing. … Other company-specific catalysts include all types of financial or operational restructurings, such as the spin-off of a di­vision or a significant repurchase of shares, a change in management, and investments in new business developments….In many instances, the environment in question is the government, in its legislative, administrative, and regulatory roles. Even in the most free market of countries, governments cast enormous shadows over the econ­omy and the companies operating within it…. Other environmental catalysts emerge as the consequences of disrup­tive shifts in technology that facilitate the reorganization of whole indus­tries. The most unavoidable one in our time is the Internet…”

6. “We’re a value-oriented, research-driven firm that buys undervalued stocks, shorts overvalued ones, and participates in selected overseas debt and equity markets. May not be an exciting approach, but it works.”

Boring “get rich slow” approaches attract fewer competitors which is helpful in the competitive world of investing. Investing where the competition is dumb, misinformed and lazy is an excellent way to boost financial returns. The good news here is that get rich quick type people these are who you are competing against. If other investors and traders were not muppets sometimes, value investing would not work. Turning their dysfunctional behavior into profit is your opportunity.

7. “If you don‘t have the free cash flow, you don‘t have anything.” 

The only unforgivable sin is to run out of cash. Charlie Munger points out that “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” On another occasion Charlie Munger added: “There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash —and I don’t want to go back.”

8. “A lot of companies Warren Buffett owns would not be considered value in the classical sense. A company can be growing at an extremely high rate but happens to be trading at a very reasonable multiple.”

“[You want] a business that has a moat around it, where it’s competitively insulated to some large degree.”

What Leon Cooperman is referring to here is that Warren Buffett, with the help of Charlie Munger, was able to evolve his value investing style when Ben Graham style cigar butts companies trading at less than liquidation value disappeared after the Great Depression. In other words, Buffett and investors like Cooperman began to look for quality as an element in the bargain that creates the margin of safety. In the second quote Cooperman is talking about one particularly  key elements in the quality of any business which is a moat. Without a sustainable competitive advantage (a moat) competition among suppliers will cause price to drop to a point where there is no long term industry profit greater than the cost of capital. Greater supply kills value. So you want some aspect of the business that puts a limit on supply and the duration of that limit on supply is a key part of what defines the value of the moat.

9. “Analysts tend to be cheerleaders for corporate repurchase programs. In my view, these programs only make sense under one condition – the company is buying back shares that are significantly undervalued. Most management teams have demonstrated the total inability to understand what their businesses are worth. They‘re buying back shares when the stock is up, and have no courage to buy when the stock is down.”

This view is very consistent with both Warren Buffett and Henry Singleton. Businesses buying shares back when prices are high instead of low is driven by short-term investing myopia. Company management has the same opportunity as any investor to do the reverse, which is to buy low instead of high. The best time to be buying back shares are times like 2008 when Mr. Market was fearful.

10. “What the wise man does in the beginning, the fool does in the end.”

It is easy to get caught up in the movement of a herd. And it is easiest of all to follow the herd when it is close to the end of a cycle. Even the wisest investors can fall victim to crowd folly. The basic underlying force at work is that people rarely make decisions independently.  Fear of missing out (FOMO) and laziness make people follow the lead of other people and that process can snowball. Or not. And it will continue until it doesn’t.

11. “There are roughly speaking 10,000 mutual funds that are happy to manage your funds for 1% or less. And roughly 10,000 hedge funds that have the chutzpah to ask for 2 and 20. If clients are going to pay 2 and 20, they have a right to expect more. You’re always on the balls of your feet.” 

“If you are paying somebody two and 20, as opposed to 1%, you basically have the right to expect more from that person.”

Since it is possible to invest based on what John Bogle calls the ‘low fee hypothesis’, if you are paying hedge fund style fees or even 1% just for assets allocation or stock picking you have a right to expect outperformance. One thing you should definitely do if you decide to seek that outperformance is write down actual performance. With an actual pen and paper. Force yourself to consider your real world after fee results. I have several friends who did this and not are index fund investors. Always consider that you may not want to be a member of any fund that will have you as a member. The number of investors profiled in this blog that will not take you on as an investor is huge.

12.  “I think it was my discovery of Teleydne and its extraordinary CEO Henry E. Singleton. In my opinion Dr. Singleton was one of the greatest managers in the annals of modern business history. No less an authority than Warren Buffett called Dr. Singleton “the best operating manager and capital deployer in American business.” Dr. Singleton started buying up his company’s own shares and from 1972 to 1984 he tendered eight times and reduced his share count by some 90%. His ability to buy his stock cheaply and correctly and time the short and long-term troughs is truly extraordinary.”

Cooperman can claim lot of credit for discovering the investing and business genius of Henry Singleton, who I’ve previously profiled here. Charlie Munger has interesting things to say about Singleton that I can’t say better:

“We respect Henry Singleton for a very simple reason: He was a genius. Henry Singleton never took an aptitude test where he didn’t score an 800 and leave early. He was a major mathematical genius. Even when he was an old man, he could play chess blindfolded, at just below the Grand Master level. He had an awesome intellect, well into the top 1/1,000 of one percent. This was an extreme analytic. Of course, he did create a conglomerate because it was legally allowed at the time. He did it the way everybody else was doing it, he did it better, and he made a lot of money. When they ran out of favor, the stock went way down, he bought it all back for less than it was worth.

Of course, he died a very wealthy man. He was a totally rational human being in things like finance. What I found interesting about Henry Singleton, which has interesting educational implications, is that in watching both Henry and Warren invest and operate at the same time, we had two great windows of opportunity to examine human nature. Henry was very rational. He was quite similar to Berkshire in some ways. Henry never issued a stock option. He had certain commonalities with Warren that were just logical outcomes. What was interesting to me was how much smarter Warren was at investing money than Henry. Henry was born a lot smarter, but Warren had thought about investments a lot longer. Warren just ran rings around Henry as an investor even though Henry was a genius, and Warren was a mere almost-genius.”

Notes:
Bloomberg: http://www.bloomberg.com/news/articles/2012-06-28/cooperman-says-earning-13-in-stocks-takes-average-iq-

CNBC: http://www.cnbc.com/id/101823194

Interview: http://www.valueinvestorinsight.com/Nov_06Trial.PDF

Interview: http://wagsome1.rssing.com/chan-1906771/all_p22.html

Interview: http://www.bloomberg.com/news/articles/2012-02-22/cooperman-shuns-treasuries-favors-stocks-transcript-

Graham and Doddsville: http://www8.gsb.columbia.edu/rtfiles/Heilbrunn/Graham%20%20Doddsville%20-%20Issue%2014%20-%20Fall%202011.pdf

Graham and Doddsville: http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Leon%20Cooperman/cooperman.pdf

Business Insider: http://www.businessinsider.com/leon-cooperman-observations-on-life-hedge-funds-and-the-investment-outlook-2012-9?op=1
2015 Daily Journal Meeting  http://www.forbes.com/sites/phildemuth/2015/04/27/charlie-mungers-2015-daily-journal-annual-meeting-part-4/

A Dozen Things I’ve Learned from Peter Fenton About Business, Investing and Venture Capital

Peter Fenton is a partner at Benchmark. He spent seven years as a partner with Accel before joining Benchmark. The list of businesses he has invested in and mentored is extensive. They include Twitter, Yelp, New Relic, Hortonworks, Quip, Zuora, Zendesk, and Polyvore – among others. He is so well spoken and careful about conveying his ideas that it is particularly hard to add my usual commentary to what he says below.

1. “The principal question that we focus on before an investment is the quality of the person we’re going to work with. There are three attributes that I try to be reductionist about that define the greatness that we see in our world.  First, I think there’s just a profound, deep, innate motivation. Second, I think there’s a common trait that I would call ability to learn. [The] third thing, is perhaps the most obvious which is the ability to attract great people.”

Peter Fenton efficiently coveys three key themes within this series of blog posts when I am talking about successful venture capitalists: 1) motivated people are far more likely to persevere through inevitable adversity and do the necessary hard work; 2) the ability to be a learning machine means the business can adapt and grow in an uncertain world; and 3) the ability to recruit people to a mission or cause rather than just a business is essential. One commonality you see in whatever Peter says is a strong focus on building the business rather than finance or deal terms. His advice is so grounded in business fundamentals it is as applicable to a new bakery or grocery store as a startup. Without a sound underlying business all the finance in the world will deliver exactly nothing of value. When you are building a business you don’t want a cheerleader as your venture capitalist – you want someone who has extensive and relevant business skills.

2. “The great entrepreneurs have found they need to find complements. So, if you look at yourself and reflect on your skills and your talents and your unique abilities you’ll find that everybody has their gaps.”

Everyone has strengths and weaknesses. Having the right partners and colleagues is a way to create a force multiplier by filling in gaps in your skills and talents. As an example, Warren Buffet has said: “One plus one with Charlie Munger and me certainly adds up to more than two… CEOs get into trouble by surrounding themselves with sycophants. It’s beneficial to have a partner who will say, ‘You’re not thinking straight.’”

Richard Zeckhauser describes why 1+1 is more than two here: “Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop new technologies.”  If your strength is technical, find people who have other skills and vice versa. If you like uncertainty find someone with complementary skills and talents who knows how to manage its consequences. If you like novelty, find someone with complementary skills and talents who makes trains run on time. Michael Eisner has written a book on why partnerships succeed. Complementary skills and talents are a key to not only great partnerships, but better investing results..

3. “[Some venture capitalists aren’t ] in touch with the human realities of running a company and they had a false sense of the ability to predict things and be certain about the future. When you are running a company you don’t know much of anything about the next six, 12 months, you’re working through a lot of ambiguity.”

I’ve written about uncertainty, risk and ignorance before in my post on venture capitalists Vinod Khosla and Keith Rabois.   Strong teams that can adapt as conditions and opportunities change create tremendous optionality for a business given the reality of an unknown business environment. Since venture capital is a search for rare but massive financial payoffs that can be harvested by finding mispriced optionality, it should surprise no one that Peter Fenton is focused on challenges associated with ambiguity and being humble about anyone’s ability to predict the future.

4. “The term we like to use is “shoulder to shoulder,” where there’s a real depth of engagement and we don’t know how to create more time in the day for that. So the business model we have doesn’t scale. And the core premise, I think, of the Benchmark model has always been optimize for the depth of the relationship with the specific companies we’re working with.”

Over the past few decades I’ve known many Benchmark partners past and present and in my view what Peter Fenton says about how they love to work alongside the team running the business is just part of who they are. Every Benchmark partner I have known loves to actively participate in the creation of a new and valuable business. This style makes what they do more fun and that makes them better at what they do. If you like novelty, uncertainty, making a positive difference and solving problems/puzzles, what could be more fun?

5. “There’s no substitute for creating the magic of the product in capturing our attention. And if that doesn’t occur, and it’s more about getting money from a venture firm to enable that, I challenge the assumption that you need us. We want to do company-building, and to do that we need to be committed exclusively in a matrimonial kind of way where we can give our heart, and our souls, and our energies to a company.”

Startup founders who just want to raise money are short changing themselves.  Money is not scarce if you have the right opportunity and the right team. Peter is saying if all you want is money, Benchmark is not the right firm for you.  What the best founders want is value-added capital.  The best venture capitalists deliver the best financial results again and again for a reason. They add business value and not just capital to the startups in their portfolio.

6. “We love the day-to-day work with the entrepreneurs, which prevents us from scaling. We don’t have an ability to offload any part of our relationship in the way we practice it, to anyone other than ourselves. So, there’s no associates, no principals, there is really nothing beyond the group of people here and our assistants who keep our lives sane. That’s a strategy. Another perfectly cogent strategy is to try and build a certain set of services that you use to differentiate.”

There are several different ways to be successful in the venture capital business. Benchmark’s approach works very well for them.  It suits the personalities of the partners and makes them happier. Being happy and having fun are highly underrated.

7. “The attributes of the great board meetings that I can point to are really focused on asking tough questions and applying critical thinking, as opposed to just updates. A lot of the entrepreneurs I work with, I encourage to get rid of the PowerPoint. A typical board meeting will have 30 to 60 PowerPoint slides. So, I ask entrepreneurs I work with to think about that as a Word document, and can you reduce it down to something we can read before the board meeting, so we don’t sit there looking at slides for three hours.”

If you can’t describe what you want to do in simple declarative sentences in a written document you have not thought it through. I am a fan of the Amazon “write a Word document describing the purpose of the meeting if you are the one who called it” approach. While many broken underlying assumptions can be easily hidden in a PowerPoint slide deck, the same is not the case for a Word document.

8. “[There is] a ten-year plus learning curve for being any good at the venture business.”

No one is born to be an investor. It is a skill that must be learned on the job over a period of years. We all have a set of biases and dysfunctional heuristics that cause us to make emotional and psychological mistakes. The best way to learn how to invest is to invest. “You can’t simulate investing” writes Keith Rabois and I agree. In that sense, the human process of learning to learn to invest is like machine learning.  If you have the right process in place, making mistakes can make you smarter.  Or not, if you are not paying attention or willing to change.

9. “Be a learn-it-all, not a know-it-all.”

This is a version of a simple Charlie Munger philosophy: be a learning machine. Be humble and hungry to learn.  A “know-it all” approach to investing and life is a great way to experience a big fall resulting from hubris. If you never are encountering situations in which you make decisions where you are wrong it is strong evidence that you are not learning. If you have not destroyed a cherished idea at least once a year (Charlie Munger’s standard), you probably have a broken learning process. A major problem with not discovering small mistakes is often that you are setting yourself up to make a big painful mistake.

10. “The saying that we like to have at Benchmark is that good judgment comes from experience, which comes from bad judgment. So, we get it wrong a lot, but what’s interesting is when you get it right.”

Charlie Munger’s approach to investing is again applicable: pay attention to your mistakes and the mistakes of others.  Learn and adapt. Make new mistakes. All these approaches will help you deal with the fact that life and the investing environment requires people to make decisions in an environment typified by risk, uncertainty and ignorance. People who do best with uncertainty are those who know how to adapt to change. If you think you can stop learning and that you “know it all,” you are in big trouble.

11. “What we discovered is you can take product-driven entrepreneurs and back them in the enterprise market and achieve orders of magnitude more scale than you could with a sales-driven model.”

When the dogs love eating the dog food and are telling other dogs how good the dog food tastes, any business scales better. As a bonus, a business that is product-driven involves more creativity and is more fun. Founders who are driven by products and services instead of sales make better products and services. In an age when it is so easy to get information on which products and services work well and don’t, better products and services mean the business scales better since their adoption can become viral. The Matthew effects kick in when a product or service is viral, but with a really attractive customer acquisition cost (CAC) and low churn.  Like happiness, low CAC is highly underrated.  High CAC is a stone cold killer since it is one of the Five Horsemen of the Service Provider Apocalypse.

12. “What you hope for is that the product model and the business model play off with one another, and so that’s what we look for… can you get resonance where if I use the product in a certain way, it’ll open up the economic opportunity. Google is the best example of that, of course, where the product model is the business model.”

The biggest successes in the venture business all involve feedback/reflectivity. You can’t deliver the scaling qualities that can generate grand slam tape measure financial returns without creating at least one nonlinear phenomenon that comes from positive feedback.  What is most desired in a startup is a lollapalooza phenomenon of several types of mutually reinforcing positive feedback loops. Creating and sustaining virtuous cycles is powerful and rare which is why unicorns are rare and several distributions of success in the venture business reflect a power law. But when a positive feedback loop happens, it can be magical. Alignment of the product model and the business model is particularly magical. Peter Fenton has generated far more than his share of magic. When someone is successful repeatedly in the venture business that is something truly special.

Notes:

http://blog.semilshah.com/2013/07/14/sunday-conversation-1-peter-fenton-benchmark-capital/

http://blogs.wsj.com/venturecapital/2011/06/30/benchmark-capitals-peter-fenton-on-the-importance-of-hadoop/

http://www.bloomberg.com/video/are-tech-valuations-bubbly-5XW2MoNwT8S3QYDOrvIj4w.html

http://techcrunch.com/video/backstage-with-peter-fenton-of-benchmark-capital/517989635/

http://recode.net/2014/03/13/the-boys-of-benchmark-talk-about-s-f-s-tenderloin-diversity-and-artisanal-venture-capitalism-part-one/

http://www.forbes.com/sites/tomiogeron/2012/05/02/benchmarks-peter-fenton-on-the-air-war-disrupting-the-enterprise-midas-list/

A Dozen Things I’ve Learned from Mario Gabelli about Investing and Business

Mario Gabelli is the founder of the money-management firm GAMCO Investors, Inc.  Bloomberg writes: “His investment methodology combines the pioneers of value-oriented investing and the iconic boss of Berkshire Hathaway Inc.”

 

1. “We’re not buying a piece of paper when we buy stock, we’re buying a business.”

“Think like an owner.”

A security represents a partial share in an actual business. When you are buying that business you should understand it.  This first bedrock principle of value investing is a simple but often ignored idea. What you are buying is not a piece of paper that should be traded as if it were a baseball card.  I can’t believe I have to say this, but let’s be clear since some people have made contrary assertions: The fact that Ben Graham invested in a lot of businesses does not mean he was an index investor. He actually understood each business that he bought through research. How much a given value investor diversifies is a personal choice, but understanding and researching each company as well as applying the other bedrock principles is not optional if you want to be a value investor. An index fund that is tweaked to consider a value “factor” is not Ben Graham-style value investing. Buying a factor-driven indexed fund is one choice, but it isn’t value investing but rather index-based investing with a value factor.

 

2. “What you do is identify a company in the public markets that is selling below a channel called ‘intrinsic private market value.’”

“We define Private Market Value (PMV) as the value an informed industrialist would pay to purchase assets with similar characteristics. We measure PMV by scrutinizing on- and off-balance sheet assets and liabilities and free cash flow. As a reference check, we examine valuations and transactions in the public domain. Our investment objective is to achieve an annual return of 10% above inflation for our clients.”

“That gives you a margin of safety, and help protect the downside by providing a cushion, because it is selling at a significant discount to “private market value.”

“You approach stocks as if they were pieces of a business you want to buy at a discount.” “Why am I buying it? Because I have a margin of safety.” 

“Value investing works because it is founded on the notion of buying something for less than it is worth.”

Invest in an asset only if you have a “margin of safety” is the second of four bedrock principles of Ben Graham-style value investing. When you buy assets with a margin of safety you can make a mistake and still do fine as an investor. As Mario Gabelli puts it:  “The value investor has the best of both worlds: upside potential and the comfort of owning a business with a margin of safety.” Mario is a big fan of Warren Buffett who advises investors to: “Have the purchase price be so attractive that even a mediocre sale gives good results.” This is another simple idea that many people want to look beyond for some other “trick.” There is no trick.  If you buy dollars for 70 cents it is harder to lose money.  Those opportunities won’t happen very often, so most of the time a value investor does nothing. Most people can’t stand doing nothing most of the time so they are not candidates to be successful value investors.

 

3. “Markets fluctuate.”

“Mr. Market gives you opportunities to buy above and below intrinsic value.”

That Mr. Market should be your servant and not your master is the third of four bedrock principles of Ben Graham-style value investing.  Mr. Market is a bipolar maniac rather than a perfectly informed rational agent. Prices in markets will inevitably move rapidly and unpredictably up and down. Markets are far from wise in the short term.  This is obvious to a child of ten. Warren Buffett writes: “Ben’s Mr. Market allegory may seem out-of-date in today’s investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising ‘Take two aspirins'”?

 

4. “Quality is quality, and just because Mr. Market allows you to buy a share of a company well below its intrinsic value, doesn’t change the underlying value.”

Price is what you pay and value is what you get.  Price and value are often different because Mr. Market is not wise and the prices he offers to buyers and sellers gyrates wildly in the short term. Those prices are sometimes higher and sometimes lower than intrinsic value. Value investors believe that you should not try to predict those short term gyrations. As an example, it is unlikely that value of a business that drops 10% in price in a single day has actually dropped in value by 10% . What has changed is the market price, which is set in the short term by a herd of highly emotional and psychologically challenged people. Some people will never understand that price and value can be different and as a result will never understand value investing.  That’s OK. It happens all the time. You either understand value investing or you don’t.

 

5. “Our investment process centers on the application of principles first articulated in 1934 by the founders of modern securities analysis, Benjamin Graham and David Dodd, in their seminal work Security Analysis (1934). To this, we add what Warren Buffett contributed to the field of investing: the notion of valuing a business’s franchise and taking a substantial stake in portfolio companies.”

“Value investing, the way I define it, is finding a good business run by smart people, at a reasonably good price relative to its values today and five or more years from now.”

Value investing is a get rich slow approach. Gains will be lumpy and during a bull markets there will be underperformance relative to an index. This explains why value investing is less popular than it should be. Mario Gabelli is saying that he has taken the Graham approach and in and terms of his own style evolved in it the way Warren Buffett and Charlie Munger did when it ceased to be possible to buy “cigar butt” businesses trading at less than liquidation value (these cigar butt opportunities disappeared after a significant period had passed after the Great Depression).

 

6. “What would be the element [the catalyst] that would help narrow the spread between private market value and the stock price? A catalyst may take many forms and can be an industry or company-specific event. Catalysts can be a regulatory change, industry consolidation, a repurchase of shares, a sale or spin-off of a division, or a change in management.”

In using the term “catalyst” Mario Gabelli has created a way to describe the idea that one can look for secular and other changes that may increase or decrease value. A catalyst represents extra potential upside in the view of the person doing the analysis. This is another tweak on value investing that has been adopted by some value investors but not others.

 

7. “When the informed industrialist is evaluating a business for purchase, he or she is not going to put a lot of weight on stated book value. What that informed industrialist wants to know is: How much cash is this business throwing off today and how much is he going to have to invest in this business to sustain or grow this stream of cash in the future.”

From time to time, some people lose track of the importance of cash. These people forget that the only unforgivable sin in business is to run out of cash. Charlie Munger said once: “There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash —and I don’t want to go back.” Liberty’s Greg Maffei said to me once during a period of market euphoria in the 1990’s: “cash will again be king.” Markets are cyclical and he was surely right. Of course, you can’t time precisely when this will happen.

 

8. “We believe free cash flow, defined as earnings before interest, taxes and depreciation (EBITD), or a slight variation, EBITDA, both minus the capital expenditures necessary to grow the business, is the best barometer of a company’s value. Just as growth-stock investors will pay a higher price-to-earnings ratio for higher earnings growth, private-market-value investors will pay a higher multiple of cash flow for faster cash-flow growth.”

The key words in this statement are: “minus the capital expenditures necessary to grow the business.” Charlie Munger points out: There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business. Mario Gabelli also says: “We believe that an average management running an above average franchise will do an above average job. An above average management running a lousy franchise will do a lousy job.” For more about what Mario Gabelli looks for in a business see:  http://gabelli.com/news/articles/gakraut.html

 

9. “We don’t have to swing at everything.”

Some business can’t be valued with any reasonable degree of certainty. One great beauty of investing is that you can simply put that decision in the “too hard pile” and move on. There are no “called strikes” in investing. Stated differently, there is no premium for hyperactivity in investing. In fact, there is a penalty. By being patient, but aggressive when the time is right, the investor can “swing big” just when the situation is most advantageous and the odds are substantially in their favor.

 

10. “If you understand a business, buying the business has less risk.”

As Warren Buffett points out, risk comes from not knowing what you are doing. Risk is not a number and certainly risk is not a number that defines volatility. Volatility is certainly “a” risk but it is not the only risk. Charlie Munger points out: “Using [a stock’s] volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return. Some great businesses have very volatile returns – for example, See’s [a very profitable candy company owned by Berkshire] usually loses money in two quarters of each year – and some terrible businesses can have steady results.”

 

11. “When things look bleak there’s a great opportunity for everyone.”

The best opportunity to buy a mispriced snow shovel is usually in a month like August not in the middle of winter. Similarly, the best time to buy financial assets is when other investors are fearful. Much of the profit in investing and business is made in downturns.  The trick is to have cash to invest at such times. The best investors have cash at such times since it is a residual of not being able to find enough securities and others assets to buy during the euphoric part of the business cycle. If you stay focused on buying assets at a margin of safety to intrinsic value, the cash will naturally tend to be available for investing when a period of market euphoria ends and bargains appear.

 

12. “Always keep your portfolio and your risk at your own individual comfortable sleeping point.”

Different people have different emotional temperaments. If you are having trouble sleeping because of your level of investment risk, you have too much risk in your portfolio. The famous investor Jesse Livermore said once: “If you can’t sleep at night because of your stock market position, then you have gone too far. If this is the case, then sell your position down to the sleeping level.” Mario Gabelli adds: “if you hold certain cash-generating companies and you buy at a reasonable price, you’re going to make more than you will in Treasury bills. The mistake is not staying focused on that.” “If I’m an individual investor and I have $100,000 I want to invest in the next five to 10 years, I’d have no problem doing what Warren Buffet recommends — buy an S&P 500 index fund. You’re going to earn 5 percent to 7 percent over the next 10 years. The 10-year government bond is yielding only 2.3 percent, so you could earn five percentage points higher.”

 

Notes:

Gabelli on Value Investing http://www.gabelli.com/news/articles/reg-selby_123099.html

Graham & Doddsville – Columbia Business School    https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/Graham%20%20Doddsville%20-%20Issue%2013%20-%20Fall%202011%20-%20v2.pdf

 

2002 Gabelli talk: http://www.gabelli.com/news/mario_times022502.html

Investment Gurus: A Road Map to Wealth from the World’s Best Money Managers by Peter J. Tanous  http://www.amazon.com/Investment-Gurus-Wealth-Managers-Selection/dp/0132607204

 

Forbes: http://www.forbes.com/sites/davidwismer/2012/12/10/billionaire-fund-manager-mario-gabelli-i-like-phds-poor-hungry-and-driven-and-some-investment-themes/

Fordham  http://legacy.fordham.edu/campus_resources/enewsroom/inside_fordham/january_18_2011/news/gabelli_calls_busine_78047.asp

 

Value Investing: A Conversation with Mario Gabelli http://blogs.cfainstitute.org/insideinvesting/2013/02/16/a-conversation-with-mario-gabelli/

Bloomberg http://www.bloomberg.com/news/2014-12-08/gabelli-on-his-botched-google-bid-and-the-beauty-of-compound-interest.html

 

A Dozen Things I’ve Learned from Jim Goetz about Business, Startups and Venture Capital

Jim Goetz is a venture capitalist at Sequoia Capital.  His list of accomplishments is long and impressive.

1. “I am looking for unknowns, who are passionate and mission-based.”

Mercenaries are motivated primarily by money. Missionaries, in contrast, are driven by a cause. Missionaries are not only more likely to persevere during hard or challenging times they are more likely to work to keep the business independent – which tends to produce the most “tape measure financial home runs.” Underdogs with huge ambition for their business are rarer than most people imagine. Too often the founder has an idea for a decent or even very good business, but that is not the sort of business that a venture capitalist wants to fund give their need for Unicorn-style financial returns. As an example of what he is talking about here, Jim Goetz said once about Whatsapp: “It was mission-based and very different than what everyone else was doing at the time.”

2. “Many of the entrepreneurs that we back are attacking a personal pain.”

“The common thread [between Sandy Lerner and Len Bosack (the founders of Cisco), Reid Hoffman (LinkedIn) and Omar Hamoui (AdMob)] is that these were all sketchy misfits, unknowns, who all focused on [solving] personal pain points and were all willing to put something out early and iterate.”

Passion for the customer pain point conveys the desired missionary quality.  It also means that the founder understand the problem deeply and less research is required. If a business is not solving a genuine customer problem in a unique and compelling way and in a manner that is defendable via a moat, a business is unlikely to succeed.

As an example of this point, Jim Goetz said once about Whatsapp: “they were designing something for themselves first. Jan, for example, wanted to reach out to friends and relatives in Russia and how to do that was the most important part. Both he and Brian were very driven, just not by financials and not by economic outcome.” Great pitches to venture capitalists and customers are inevitably a story and few things make a story more compelling than making it personal. Eating a fish dinner accompanied by a great fish story makes the food taste better.

Here’s the first of several slides in this post from a Jim Goetz presentation (link to all slides is in the notes) that sets out the elements of a good story that may be attractive to a venture capitalist:

Jim Goetz plan3. “We’re looking for clarity and focus.”

“One in 15 entrepreneurs that come through our doors can convey their initial market position in literally 5 minutes.”

Jim Goetz recommends that significant time be spent developing this pitch early in the life of a startup. Can the entrepreneur limit this part of the pitch to only five minutes? How about in just two minutes? Can the idea for the business be conveyed with clarity and focus in 2-3 sentences? He specifically recommends approaches developed by Geoffery Moore. Here’s a slide with an example of a simple elevator pitch that worked:

Network Pitch

4. “…existing market category but with a 3 or 5 X improvement in price/performance.”

“Most interesting to us are new categories.”

When you are in a new category there is less likely to be strong competition. Having breathing room at the start of a business is an underrated benefit. Jim Goetz identifies two types of categories that he finds interesting in this slide:

Categories

5. “Think big, start small.” 

“A great deal of passion and energy around a specific pain point….for a very specific customer.  Focus, focus, focus.”  

“Our view is that, early on, if you’re solving a meaningful problem, even if it’s for a small group of people, there is an opportunity to expand beyond that over time.

Jim Goetz tells the story of Apple, Cisco and other companies to make this point. In reach case the founders found a solution to a specific customer pain point before they moved on to bigger ambitions. If a business can generate adoption and credibility in solving a single customer problem they can then move to cross-sell and upsell additional services. Product and service extensions will arise naturally. Goetz points out that the founders: “defined WhatsApp by simplicity and that’s spectacular.”

 

6. “What are your unfair advantages?”

“You need to be able to break into a market and dominate.”

This is where strategy kicks in the hardest. What is it that the entrepreneur will do differently? How can the business create a sustainable competitive advantage? In the technology business the best “moat” of all has at least part of its source in network effects. However, factors other than network effects can contribute to that creating a lollapalooza effect. Moats are so hard to create that Warren Buffett and Charlie Munger admit they buy moats rather than trying to create them. For a look at what it takes to create a moat my post on Michael Porter is here: The Sequoia slide on moats in this presentation is:

One way for a founder to reduce credibility is to not be realistic about existing competitors. Entrepreneurs should be honest about the competition. If you are not truthful about any part of your presentation your entire presentation is immediately suspect. Founders who identifying competitors clearly build trust with stakeholders. Many small businesses outmaneuver large companies. Being first to market is not always essential. For example, Google was not the first search engine. But pretending competitors don’t exist in a presentation to investors and potential employees is unwise.

7. “Business models can be a weapon against incumbents.”

“The [subscription and cloud based] business model, thanks to Marc Benioff, is now a weapon for all of you.”

Many times the innovation that drives the success of a business *is* the business model. Jim Goetz is saying that the business model of software as a service (SaaS) is an example of this phenomenon. One of the key elements of the SaaS business model is that it is so beneficial to customers. Capital and operating expenditures are transferred to the service provider and the customers pay only as they need the service. Paying only for what you need just in time is a huge customer benefit. That creates new challenges for the provider of course. But those challenges can be a source of barriers to entry.

8. “We are looking for depth and substance of passion for the pain and experience.”

“We are very interested in your expertise on the domain.”

It is amazing how much can be accomplished when you know what you are doing. Having a Zen-style “beginner’s mind” toward creating solutions to new problems is helpful, but that does not mean that it is ideal to be clueless about the domain itself. Expertise in the domains relevant to the business are very valuable as is humility about what you do not know. Richard Feynman said once “I can live with doubt, and uncertainty, and not knowing. I think it’s much more interesting to live not knowing than to have answers which might be wrong.”  In the case of Whatsapp, the founders domain expertise came “from their lives and frustrations from working at Yahoo (both Koum and Acton worked there) and seeing what happened when the company shifted its focus to advertising and away from the user.”

9. “We talk about ‘times ten’ productivity. That’s where you assemble a small group of elite engineers and get them amped up….It happens because they’re genuinely excited to their core.” 

Engineers who are in an enabling and challenging environment feel empowered and that empowerment translates into extreme levels of productivity. As an example, Whatsapp is a famous example (backed by Jim Goetz) of an empowered team doing amazing things with a very small number of engineers/employees.

10. “Do the numbers make sense?”

“A company which raises more money than needed may lose some discipline in the culture… and you may start to see some behavior that may not be the foundation for a long term enduring business.”

There are a range of key performance indicators (KPIs) which are relevant to any business. The KPIs are not always the same since business models vary, but they always designed to help the company get to get to the right place. When a team has a clearly defined an understandable set of unit economics, incentives can be created that drive success. Everyone on the team should ideally know what metrics drives success. One aspect of a startup business that makes life far easier is high gross margins. Life is so much letter for a business if gross margins are approach 80-90%.

Sales and marketing, research and development and general and administrative expenses come after that and can kill a business if the gross margins are too low. The customer acquisition cost (CAC) and churn are always critical. Every business has CAC, but sometimes is takes the form of a free services and hides as COGS. Yes, some venture capitalists will claim a business has no CAC, but there’s always COGS and free offering somewhere in the business in those cases. The importance of an entrepreneur knowing and being able to convey numbers to potential investors is the lesson! If the entrepreneurs don’t know their numbers the best investors won’t find the business to be credible. Especially when founders are trying to raise a series A round, it is  impossible at that stage to be selling just a dream.

Capital efficiency

11. “If it begins to work it will exceed wildly everyone expectations. We desperately try to convince the founders to remain independent.”

Venture capital is a business with a lot of failure since success follows a power law. For this reason, when something really succeeds, which is not that often, the financial returns tend to be 10-1,000X. This is the nature of any process where the foundation of the mispricing of the asset is related to optionality. My post on optionality are here and here. Positive feedback as a determinant of results in a business is gaining steam in the world as it becomes more digital (which increases the ability of phenomena to scale).

Nassim Taleb describes this world as Extremistan. Taleb writes: “Almost all social matters are from Extremistan. Another way to say it is that social quantities are informational, not physical: you cannot touch them.” And adds: “A scalable profession “is good only if you succeed. They are competitive, produce monstrous inequities and are far more random, with huge disparities between efforts and rewards — a few can take a large share of the pie, leaving others out entirely…” When you combine Extremistan with the Matthew Effect (cumulative advantage causes the rich to get richer) you can better understand many things that are happening in the world today.

12. “I don’t try to tout the next great thing I want to get in front of, because I don’t set that course. The entrepreneurs do that.”

No venture capitalist can understand all domains and so it is their job to learn from the entrepreneur. Being humble and a life-long learner can pay big dividends for the venture capitalist and the entrepreneur.

Notes:

Stanford Entrepreneurship Videos Online  http://www.adub.net/post/43944867150/stanford-entrepreneurship-videos-online

“In the Studio,” Sequoia’s Jim Goetz Puts A New Spin On Consumerization Of The Enterprise http://techcrunch.com/2012/09/16/in-the-studio-sequoias-jim-goetz-puts-a-new-spin-on-consumerization-of-the-enterprise/

Business Plans: Jim Goetz, Sequoia Capital  https://www.youtube.com/watch?v=gnmYSze9M2g

Jim Goetz of Sequoia Capital Talks About What It Takes to be an Entrepreneur http://www.foundersspace.com/a/jim-goetz-of-sequoia-capital-talks-about-what-it-takes-to-be-an-entreprenuer/

Think Big But Start Small http://www.slideshare.net/dealhorizon/jim-goetz-of-sequoia-capital-at-stanford

Writing a Business Plan http://www.sequoiacap.com/grove/posts/6bzx/writing-a-business-plan

A Dozen Things I’ve Learned from Seneca The Younger About Venture Capital, Startups, Business and Life

Lucius Annaeus Seneca was born 4 BCE in Córdoba, Spain and died in 65 CE in Rome. He was a philosopher, writer and orator, among other things. He was at times in his life a wealthy man who was for many years an advisor to the Emperor Nero.

1. “The time will come when diligent research over long periods will bring to light things which now lie hidden. A single lifetime, even though entirely devoted to the sky, would not be enough for the investigation of so vast a subject… And so this knowledge will be unfolded only through long successive ages. There will come a time when our descendants will be amazed that we did not know things that are so plain to them… Many discoveries are reserved for ages still to come, when memory of us will have been effaced.”

What Seneca said then is still true today. Innovation will surely continue to amaze people. Forever. There’s no invention stagnation happening now nor will it happen in the future. The idea advanced by some that the pace of innovation is slowing down is deeply misguided. Innovation that is distributed is harder for some people to see, but it is far more substantial when considered in the aggregate. Seneca is saying that there is no fixed supply of innovation. Seneca also wrote: “For many men, the acquisition of wealth does not end their troubles, it only changes them.” and “Wealth is the slave of a wise man. The master of a fool.” He is saying that the best approach is to view wealth as one would any form of optionality. Nassim Taleb’s view on Seneca is as follows:

“Seneca was about being long options. He wanted to keep the upside and not be hurt by the downside. That’s it. It’s just how to set up his method. Seneca was the wealthiest man in the world. He had 500 desks, on which he wrote his letters talking about how good it was to be poor. And people found inconsistency. But they didn’t realize what Seneca said. He was not against wealth. And he proved effectively that a philosopher can have wealth and be a philosopher. What he was about is dependence on wealth. He wanted the upside of wealth without its downside. And what he would do is–he had been in a shipwreck before. He would fake like he was a shipwreck and travel like he was a shipwreck once in a while. And then he would go back to his villas and feel rich. He would write off every night before going to bed his entire wealth. As a mental exercise. And then wakes up rich. So, he kept the upside. In fact, what he had, my summary of what Stoics were about is a people who really had, like Buddhists, an attitude. One was to have the last word with fate. And my definition is a Stoic Sage is someone who transforms fear into prudence, pain into transformation, mistakes into initiation, and desire into undertaking. Very different than the Buddhist idea of someone who is completely separated from worldly sentiments and possessions and thrills. Very different. Someone who wanted the upside without the downside. And Seneca proved it. He understood the hedonic treadmill that Daniel Kahneman rediscovered 2,000 years later. He understood it very well. And he understood wealth, debt from others or from fortune. And he wanted to write off debt from fortune and he wanted to remove his dependence on fate, on randomness. He wanted to have the last word–with randomness. And he did.” – EconTalk

2. “We let go the present, which we have in our power, and look forward to that which depends upon chance, and so relinquish a certainty for an uncertainty.”

It is in the domain of uncertainty that the greatest financial returns can be obtained by a venture capitalist or any investor for that matter. I have cited Richard Zeckhauser’s work several times on 25IQ on this point: “the wisest investors have earned extraordinary returns by investing in the unknown and the unknowable (UU)” writes Zeckhauser. Embracing uncertainty is essential. Nassim Taleb writes “I want to live happily in a world I don’t understand. You get pseudo-order when you seek order; you only get a measure of order and control when you embrace randomness.” There are greater financial returns where the crowd does not follow since contrarian bets with odds substantially in your favor can be found in just such a place.

3. “Delay not; swift the flight of fortune’s greatest favors.”

The successful pursuit of an idea is sometimes time dependent. For example, if Bill Gates had not left Harvard and started Microsoft with Paul Allen and had instead waited to graduate, the opportunity would most probably have been lost. It is not possible to re-run history and prove that point, but the idea of carpe diem seems hard to dispute. Many ideas and businesses are time stamped with an expiration date. Do you need to be first especially in every case?  No. Google’s success proves that.  But you do need to “be.” Talking ain’t doing. “Real artists ship,” famously said Steve Jobs.

4. “Courage leads to heaven; fear leads to death.”

“There are more things to alarm us than to harm us, and we suffer more often in apprehension than reality.”

Again and again you hear venture capitalists talk about their desire for missionary founders. Missionary founders are far more likely to be courageous and to persevere when things inevitably get hard. Leaders in other spheres of life think the same way. Sheryl Sandberg has said: “Your life’s course will not be determined by doing the things that you are certain you can do. Those are the easy things. It will be determined by whether you try the things that are hard.” and “Ask yourself: What would I do if I weren’t afraid? And then go do it.”

In venture capital courage matters. Being carried back from battle on your shield is neither shameful nor the end of the world. No one “bats a thousand.” People get too hung up on frequency of success, when it is magnitude of success that they should focus on.

Nassim Taleb writes about Seneca:

“Recall that epic heroes were judged by their actions, not by the results. No matter how sophisticated our choices, how good we are at dominating the odds, randomness will have the last word…..There is nothing wrong and undignified with emotions—we are cut to have them. What is wrong is not following the heroic or, at least, the dignified path. That is what stoicism truly means. It is the attempt by man to get even with probability…..stoicism has rather little to do with the stiff-upper-lip notion that we believe it means…..The stoic is a person who combines the qualities of wisdom, upright dealing, and courage. The stoic will thus be immune from life’s gyrations as he will be superior to the wounds from some of life’s dirty tricks.”

5. “There is no genius without a touch of madness.”

“It is pleasant at times to play the madman.”

Marc Andreessen has said that he “is looking for the big breakthrough. Ideas that are unpredictable and seem crazy at first. (Black Swans)” and “You are investing in things that look like they are just nuts.” Michael Moritz has a similar view: “What they don’t say is that at the very beginning there was great uncertainty and a great lack of clarity…. We just love … people who perhaps to others look unbackable.” The reason why venture capitalists like a touch of madness is that this is where optionality can be found. If the idea was not somewhat nuts, big companies would be pursuing it. A good dose of nuttiness scares away the people who would rather “fail conventionally than succeed unconventionally.”

6. “The less money, the less trouble.”

What Seneca is saying here is quite clear, but for many people it is still puzzling. Bill Gurley likes to say: “more startups die of indigestion than starvation.” When you don’t have “enough” money you are forced to get innovative and to solve problems with a better culture rather than money. Of course, you don’t want to run out of money either since as Seneca also said: “Economy is too late when you are at the bottom of your purse.” When it comes to how much money to have on hand at a startup there is a level like Goldilocks that is “just right.” My post on Rolef Botha addresses this issue.

7. “It is quality rather than quantity that matters.”

“Love of bustle is not industry.”

Focus matters for an entrepreneur. What Bill Gurley calls “death from indigestion” also applies to startups that try to do too much. Fred Wilson has said: “You need more than a lean methodology, you need a lean culture….To me, lean is a state of mind that a founder and his/her team needs to have across all aspects of the business. The specific product and engineering approaches that are at the core of the lean startup movement are paramount for sure. But if you can apply lean to hiring, sales, marketing, customer service, finance, and everything else, you will be rewarded with a fast, nimble company.”

8. “Fidelity that is bought with money may be overcome with money.”

Keith Rabois has pointed out: “Many entrepreneurs are raising more money than they need and it can cause derivative consequences down the road that are not healthy.” Solving hard problems with just money does not scale. (Clinkle. Color. Fab. ) If a business is going to overcome mercenary behavior by employees it must offer employees much more than just a paycheck.

9. “Associate with those who will make a better man of you.”

Mark Zuckerberg has said: “I will only hire someone to work directly for me if I would work for that person. And it’s a pretty good test.” Keith Rabois puts it this way: “First principle: The team you build is the company you build.” Nothing is quite as much fun than learning from other smart and hard-working people when building something important. This point is the inverse of what George Bernard Shaw once said: “I learned long ago, never to wrestle with a pig. You get dirty, and besides, the pig likes it.”  In contrast, wrestling with people who will make you a better person is wise.

10. “To err is human, but to persist (in the mistake) is diabolical.”

It is important to make mostly new mistakes in life. Charlie Munger has famously said: “Forgetting mistakes is a terrible error if you’re trying to improve cognition. Reality doesn’t remind you. Why not celebrate stupidities?” One of the best ways to learn from mistakes is to conduct a post mortem on a significant mistake. And, of course, to learn vicariously from the mistakes of other people. I am writing a post now on Charlie Munger’s views on mistakes that will appear in September when my book on him is out. Munger says: “Forgetting your mistakes is a terrible error if you are trying to improve your cognition. Reality doesn’t remind you. Why not celebrate stupidities in both categories?” and “It’s important to review your past stupidities so you are less likely to repeat them, but I’m not gnashing my teeth over it or suffering or enduring it.” and “It’s a good habit to trumpet your failures and be quiet about your successes.”

11.  “Our plans miscarry because they have no aim. When a man does not know what harbor he is making for, no wind is the right wind.”

A startup executing a pivot may be wise or not. But executing a pivot is not the first choice of an entrepreneur and certainly not if they are mostly clueless about where they want to go. I wrote in my post about Eric Ries: “A decision to pivot shouldn’t be taken lightly. Some founders pivot their way right into bankruptcy. Failing is not a good thing. Instead, having the ability to fail and then possibly still recover is a good thing.”

12.  “Leisure without books is death, and burial of a man alive.”

“Welcome those whom you yourself can improve. The process is mutual; for men learn while they teach.”

People who teach others get more than they give if they are doing it right. Teaching others and writing helps you think things fully through. If you can’t teach it, you don’t know it. Yes, Charlie Munger is right that: “The best thing a human being can do is to help another human being know more.” But teaching and writing are also selfish activities in many respects. As for the benefits of reading, Charlie Munger points out:

“We read a lot.  I don’t know anyone who’s wise who doesn’t read a lot.  But that’s not enough: You have to have a temperament to grab ideas and do sensible things.  Most people don’t grab the right ideas or don’t know what to do with them.” & “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero. You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.”

Notes:

The Complete Works of Seneca

Antifragile on Amazon

A Dozen Things I’ve Learned about Value Investing from Jean Marie Eveillard

Jean-Marie Eveillard “started his career in 1962 with Societe Generale until relocating to the United States in 1968. Two years later, Mr. Eveillard began as an analyst with the SoGen International Fund. In 1979, he was appointed as the portfolio manager of the Fund, later named the First Eagle Global Fund. He then went on to manage the First Eagle Overseas and First Eagle Gold Funds at their inception in 1993 as well as the First Eagle U.S. Value Fund in September 2001. After managing the Funds for over 30 years, Mr. Eveillard now serves as Senior Adviser and Board Trustee to First Eagle Funds and as a Senior Vice President of Arnhold and S. Bleichroeder Advisers, LLC.”

1. “Benjamin Graham’s book The Intelligent Investor has three lessons. The first is humility, that the future is uncertain. There are people on Wall Street who will predict the Dow will be at a certain level, but that is nonsense. The second thing is that because the future is uncertain, there’s a need for caution. The third thing was especially important. Graham values the idea that securities can be more than just paper. You should try to figure out the intrinsic value of a business. In the short term, the market is a voting machine where people vote with their dollars, but in the long term, it’s a weighing machine that measures the realities of business.” 

“You need humility because you know you can be wrong, and when you admit that you stress caution by assigning a margin of safety to your investments so that you don’t overpay for them.” 

“I focused mainly on stocks that were trading at 30 to 40 percent below my intrinsic value calculations.”

This passage is a distillation of many key points about value investing. The Great Depression made Ben Graham humble as an investor. As a result of that experience he developed his value investing system. This system is only appropriate for people who can take a long term viewpoint and sometimes underperform a benchmark in the short term. Many people can’t do these things for psychological or emotional reasons, or won’t do the work required to actually understand the business underlying each security.

Value investing is not the right investing system for everyone, but it is unique in that can potentially be successfully implemented by an ordinary investor with slightly above average intelligence and a sound work ethic. The limitation of the system is that very few people actually have the full set of skills and personal attributes required to be successful in implementing the system. Value investing is simple but not easy.

As for the 30-40% discount to intrinsic value which creates the margin of safety, Matthew McLennan (one of Jean-Marie Eveillard’s colleagues at First Eagle) notes:

“We’ve typically looked to buy 70 cent dollars. I think the mental model of paying 70 cents for a business makes great sense; if the normal equity is priced for 7% returns, and you’re going for 70 cents on the dollar, you’re starting with a 10% ROI. Closing that valuation gap over five to ten years may generate a low-teens return. If it’s a great business, there’s an argument to be made, not necessarily for paying 100 cents on the dollar, but for paying 80 to 85 cents on that dollar. As Charlie Munger would say, it’s a fair price for a great business. Your time horizon’s long enough that you’re capturing less spread day one, but if the business has a drift to intrinsic value of 4-5% a year, held for a decade, you may potentially reclaim that and then some. The more patient you are, the more you’re potentially rewarded for holding good businesses.”

2. “By being a value investor you are a long-term investor. When you are a long-term investor, you accept the fact that your investment performance will lag behind that of your peers or the benchmark in the short term. And to lag is to accept in advance that you will suffer psychologically and financially. I am not saying that value investors are masochists, but you do accept in advance that your reward, if any, will come in time and that there is no immediate gratification.”

“I think one of the reasons I didn’t enjoy growth investing was because it assumes the world to be perfect and certain, which it is not! Becoming a value investor allowed me to acknowledge the fact that I am uncertain about the future.”

What Jean Marie Eveillard is talking about here is something that you either understand and embrace or you don’t.  It is also something that you are comfortable with or not. People who are not humble about their ability to predict the future or who need immediate gratification are not good candidates to be successful value investors. These people should put value investing in the “too hard” pile and move on.

3. “We don’t buy markets. We buy specific securities.”

“An investor who buys a building or an entire corporation gives a great deal of attention to the price to be paid for the asset. So does the buyer of a car or even a bathing suit. They all seek value. What’s so different with equities? Are they just pieces of paper to be traded in and out of on the basis of psychology, sentiment, herd instinct?”

“The search for undervalued stocks beings with the idea that stocks are not just pieces of paper that are traded in the market. Every stock represents a business, which has its own intrinsic value. To determine that value, you have to estimate what a knowledgeable buyer would be willing to pay for the business in cash. It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions. Because you have to revise your assumptions from time to time to reflect business and market conditions, intrinsic value fluctuates over time, and it can go up or down.”

The best value investors are people who have significant experience in business. This allows the investor to successfully answer a key question: What would a private market buyer pay in cash for the business in question? The point made by Jean Marie Eveillard about intrinsic value not being precise is important. The future is always uncertain and a future business result is not an annuity.

One other important thing about determining intrinsic value is knowing that it is not always possible to determine intrinsic value in a given case. If you can’t reliably determine intrinsic value for a specific business, just move on (put it in the “too hard” pile). In other words, the value investor will try to find another security to buy which allows them to easily determine intrinsic value. Jean Marie Eveillard is also pointing out that a fuzzy intrinsic valuation result can be OK for a value investor since the investor is protected to a significant degree by a margin of safety. First Eagle’s approach as described by Matthew McLennan is as follows:

“There’s a willingness to pay higher multiples for franchise businesses. By going in at 10x – 12x EBIT, you could get a 6%normalized free cash flow yield that can potentially grow 4-5%sustainably over time, and thus you may achieve the prospect of a double digit return. If it’s a businesses that is more Graham in nature, with no intrinsic value growth, we may be inclined to go in at 6x – 7x EBIT, where we get our potential return through a low double digit normalized earnings yield.”

4. “We invest, if in the end we think we understand the business, we think we like the business and we think the investors are mispricing the business.” 

“We try to determine what a knowledgeable buyer expecting a reasonable return would be willing to pay today, in cash, for the entire business. Our approach requires us to understand the business – its strengths and weaknesses – rather than just the numbers. As investors have learned, the numbers can’t always be trusted.”

“Buffett says that value investors are not hostile to growth. Buffett says that value and growth are joined at the hip – value investors just want profitable growth and they don’t want to pay outrageous prices for future growth because, as Graham said, the future is uncertain.” 

As Howard Marks points out, investing is “the search for mistakes by other investors.” Sometimes a security is offered for sale at a bargain price that represents a 30% discount to the intrinsic value of the business. This will happen rarely, but when it does there will often be several opportunities available at the same time. In other words, the arrival of opportunities for value investors will tend to be lumpy.

5. “If one is wrong in judging a company to have a sustainable competitive advantage, the investment results can be disastrous.” 

A “sustainable competitive advantage” is another name for a “moat.”  Sometimes even the best value investors fail to see that the business has no moat or that the moat is about to disappear. For example, Warren Buffett found in buying Dexter Shoes that “What I had assessed as durable competitive advantage vanished within a few years.”  Warren Buffett also thought the UK retailer Tesco had a moat at one point. Other investors thought at an inopportune time that Kodak had a moat, or Blackberry or Nortel. Without a moat a business has no pricing power. 0Matthew McLennan of First Eagle puts it this way:

“Unfortunately, asset-intensive businesses often lack pricing power. What sometimes occurs is a need to reinvest during a time of weak pricing power, and this results in balance sheet deterioration and reduced earnings power. Also, asset-intensive businesses tend to have longer tail assets. With those come management teams that promote their desire to reinvest and grow the business. As a result, there’s less return of capital.”

6. “Value investing is a big tent that accommodates many different people. At one end of the tent there is Ben Graham, and at the other end of the tent there is Warren Buffett, who worked with Graham and then went out on his own and made adjustments to the teachings of Ben Graham.” 

“Over the past almost 30 years, we have sort of floated between Ben Graham and Buffett. We began with the Graham approach which is somewhat static and less potentially rewarding than the Buffett approach, but less time consuming. So as we staffed up, we moved more to the Buffett approach, although not without trepidation because the Buffett approach – yes, you can get the numbers right, but there is also a major qualitative side to the Buffett approach.”

“Having more people allowed us to spend a lot of time trying to find out the major characteristics of businesses and their sustainable competitive advantage – what Buffett calls a ‘business moat.’”

There are many ways to be a value investor as long as the four bedrock principles of value investing are adhered to – 1. a security is partial stake in a business, 2. margin of safety, 3. Mr. Market is your servant and not your master, 4. be rational. Value investing styles can vary when it comes to issues like the level of diversification, whether quality of the business is taken into consideration, and the amount of the margin of safety. Some value investors diversify their investments more than Warren Buffett. Other value investors are numbers-driven cigar-butt investors who do not consider the quality of the business. Other value investors are “focus investors” (they concentrate holdings rather than diversify) and do consider quality of the company in question.

7. “I have a great belief that everything is cyclical in life, particularly in the investment world. Value investors are bottom-up investors. But when we establish intrinsic values and update them, we do not assume eternal prosperity but accept that there is a business cycle.”

Other people I have written about in this series like Howard Marks , Fred Wilson, and Bill Gurley also believe that cycles are inevitable in all types of businesses.  That cycles are inevitable does not mean that their timing is predictable with certainty.

8. “I think the secret of success of most value investors is that when times became difficult they stuck to their guns and did not capitulate.”

It is easy to talk about being “greedy when others are fearful and fearful when others are greedy,” but actually doing so is harder than people imagine. It is warm and comforting for many people to sit inside a herd. Being genuinely contrarian is a lonely thing to do at times. Especially when fear of missing out is strong, people can do nutty things.

9. “Both closet indexing and shooting for the stars are exposing financial planners’ clients to undue risk. Both are a result of benchmark tyranny.”

“The knock on diversified funds is that they’re index-huggers, which given the geographic breadth of where we invest, is not at all the case for us. I know the argument that you should only own your best 30 or 40 ideas, but I’ve never proven over time that I actually know in advance what those are.”

“I think a concentrated portfolio is more of a bull market phenomenon. In a bear market, if you are too concentrated, you never know what can happen to your stocks. Some people have asked me whether I just invest in my best ideas, but the truth is that I don’t know in advance what my best ideas will be, so I’d rather diversify. Besides, the beauty of our global fund was that we could invest internationally, which helped to minimize country-specific risks. With that in mind, I am not saying that you should diversify the portfolio to the extent of creating a quasi-market index.”

“How come we don’t have more concentrated portfolio? Number one, because I’m not as smart as Warren Buffett. And number two, because truly, people say, “Well, why don’t you just invest in your best ideas?” But I don’t know in advance what will turn out to be my best ideas. So, that’s why we’re diversified.” 

Some value investors own only six stocks, some 30 and some hundreds. The degree of diversification an investor uses is a choice that fits within value investing as long as it does not rise to the level of closet indexing (“index huggers”). Charlie Munger points out that “[With] closet indexing, you’re paying a manager a fortune and he has 85% of his assets invested parallel to the indexes.  If you have such a system, you’re being played for a sucker.”

10. “By definition there are two characteristics to borrowing. Number one: borrowing works both ways. So you are compromising the idea of margin of safety if you borrow. Number two: borrowing reduces your staying power. As I said, if you are a value investor, you are a long term investor, so you want to have staying power.”

You can’t stay invested and participate in rising markets caused by a growing economy if you are out of the process since leverage has wiped out your equity stake. Howard Marks says: “Leverage magnifies outcomes, but doesn’t add value.”  Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad.  When you are leveraged you can run into volatility that impairs your ability to stay in an investment or investing in general which can result in “a permanent loss of capital.”

11. “Sometimes in life, it’s not just about what we buy, but what we don’t buy.”

“A value investor doesn’t need to be constantly in touch with every security in every market in the world.”

This is consistent with Charlie Munger’s idea that instead of focusing all your energy on trying to be smart, a person should also focus on not being dumb.  It is important to have a “too hard pile” and to limit decisions to areas in which we are competent. By focusing your research on a smaller number of businesses that fall within your circle of competence you can do a better job on your research. Risk goes down when you know what you are doing.

12. “Contrary to many mutual fund managers, we do not believe we have to be fully invested 100% of the time.”

“Our cash balance is purely a residual of whether or not we’re finding enough to invest in.”

Some people think that because value investors tend to have cash to invest when markets are near bottom, value investor are “timing” markets. Value investors tend to have cash near market bottoms since they stop buying securities when markets are near the top of the cycle due to individual company valuations that do not provide a margin of safety.  If a value investor focuses on the micro aspect of individual businesses on a bottoms up basis, the macro tends to take care of itself. Matthew McLennan of First Eagle said recently: “We had our greatest cash levels in early 2009, not because we correctly timed the market bottom.”  Value, not price determines how much cash a genuine value investor has in the portfolio at any given time since that cash is a residual of a disciplined buying process.

Notes:

Staying Power: Jean-Marie Eveillard – Graham And Doddsville  http://www.grahamanddoddsville.net/…/an_interview_with_jeanmarie_eveillar

Eveillard: A value maestro’s encore   http://archive.fortune.com/2007/06/19/pf/funds/eveillard.fortune/index.htm

Morningstar http://corporate.morningstar.com/us/asp/subject.aspx?xmlfile=174.xml&filter=PR4061

Ivey Lecture: http://www.bengrahaminvesting.ca/Resources/Video_Presentations/Guest_Speakers/2014/Eveillard_2014.htm

Consuelo Mack: https://www.youtube.com/watch?v=Nd9MIJasr8I   http://www.gurufocus.com/news/147599/full-transcript-and-video-of-jeanmarie-eveillards-interview-with-consuelo-mack

Interview:  https://www.youtube.com/watch?v=i46Gt7ZT6yQ

Columbia Directory: https://www8.gsb.columbia.edu/cbs-directory/detail/je2402