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

A Dozen Things I’ve learned from Julian Robertson about Investing

1. “Smart idea, grounded on exhaustive research, followed by a big bet.”

“Hear a story, analyze and buy aggressively if it feels right.”

A colleague of Robertson once said: “When he is convinced that he is right, Julian bets the farm” George Soros and Stanley Druckenmiller are similar.  Big mispriced bets don’t appear very often and when they do people like Julian Robertson bet big. This is not what he has called a “gun slinging” approach, but rather a patient approach which seeks bets with odds that are substantially in his favor. Research and critical analysis are critical for Julian Robertson. Being patient, disciplined and yet aggressive is a rare combination and Robertson has proven he has each of these qualities.

2. “Hedge funds are the antithesis of baseball.  In baseball you can hit 40 home runs on a single-A-league team and never get paid a thing. But in a hedge fund you get paid on your batting average. So you go to the worst league you can find, where there’s the least competition. You can bat 400 playing for the Durham Bulls, but you will not make any real money. If you play in the big leagues, even if your batting average isn’t terribly high, you still make a lot of money.”

“It is easier to create the batting average in a lower league rather than the major league because the pitching is not as good down there. That is consistently true; it is easier for a hedge fund to go to areas where there is less competition. For instance, we originally went into Korea well before most people had invested in Korea. We invested a lot in Japan a long time before it was really chic to get in there. One of the best ways to do well in this business is to go to areas that have been unexploited by research capability and work them for all you can.”

“I suppose if I were younger, I would be investing in Africa.” 

What Julian Robertson is saying is that there is profit for an investor in going to where the competition is weak. Competing in markets that are less well researched give an investor who does their research an advantage. Charlie Munger was once asked who he was most thankful for in all his life. He answered that he was as most thankful for his wife Nancy’s previous husband.  When asked why this was true he said:  “Because he was a drunk. You need to make sure the competition is weak.”

Warren Buffett makes the point that the way to beat Bobbie Fisher is to play him at something other than chess. Buffett adds: The important thing is to keep playing, to play against weak opponents and to play for big stakes.” And “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”  Some investors try to find a market or a part of a market where you aren’t the patsy if you want to outperform an index.

3. “I believe that the best way to manage money is to go long and short stocks. My theory is that if the 50 best stocks you can come up with don’t outperform the 50 worst stocks you can come up with, you should be in another business.”

The investing strategy being referred to here is a so-called “long-short” approach in which long and short positions are taken in various stocks to try to hedge exposure to the broader market which makes gains more associated with solid stocking picking. This approach is actually involves an attempt to hedge exposure to the market, unlike some hedge fund strategies that involve no real hedging at all. When Julian Robertson started using this this long-short approach it was less used and short bets especially were more likely to be mispriced than they are today. Many of Julian Robertson’s so-called “Tiger Cubs” continue to do long-short investing. A recent report claims that $687 billion is currently invested in long-short equity hedge funds.

4. “Avoid big losses. That’s the way to really make money over the years.”

Julian Robertson believes that hedge fund should make it a priority to “outperform the market in bad times.” That means adopting a strategy where the hedge fund actually hedges. As previously noted, the long-short strategy helps achieve that objective.  Another way to avoid big losses is to buy an asset at a substantial discount to its private market value. When the right entry point is found in terms of price, an investor can make a mistake and still come out OK financially. This, of course, is a margin of safety approach.

5. “For my shorts, I look for a bad management team, and a wildly overvalued company in an industry that is declining or misunderstood.”

When an investor shorts a company with a bad management team it is a safer bet since a business with a good management team is far more likely to fix problems. In other words, if a shorted business has a bad management team it is insurance that the real business problem problem underlying the short will continue. Julian Robertson is also saying that the overvaluation must be “wild” rather than mild for him to be interested in a short, and that he likes shorts in an industry in secular decline so the wind is at his back.

6. “There are not a whole lot of people equipped to pull the trigger.”

“I’m normally the trigger-puller here.”

The system used by Julian Robertson may decentralize the research and analysis function but it concentrates the trigger pulling with him. The newsletter Hedge Fund Letters writes:Managers oversaw different industries and made recommendations but Robertson had final say. The firm made large bets where they had conviction and each manager commonly covered less than ten long and shorts. Positions were continuously revisited and if things changed there were no holds – positions were either added to or removed.”  Someone can be a great analyst and yet a lousy trigger puller. Successful trigger pulling requires psychological control since most investing mistakes are emotional rather than analytical.

7. “I’ve never been particularly comfortable with gold as an investment. Once it’s discovered none of it is used up, to the point where they take it out of cadavers’ mouths. It’s less a supply/demand situation and more a psychological one – better a psychiatrist to invest in gold than me.”

“Gold bugs, generally speaking, are some of the craziest people on the face of the globe.”

On gold, Julian Robertson agrees with Warren Buffett, who has said:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, [favored by investors] who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow.”

To buy gold is to speculate based on your predictions about human psychology. That is not investing, but rather speculation. A gold speculator is engaged in a Keynesian Beauty contest: “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).

8. “When you manage money, it takes over your whole life. It’s a 24-hour-a-day thing.”

This is a quote from the book Hedge Fund Masters on the Rewards, the Risk, and the Reckoning by Katherine Burton. Julian Robertson is not alone in this way since many financial and tech billionaires only turn to things like philanthropy after a career change. This is also a statement about how competitive and constantly changing the investing world is. Only an academic like Bob Gordon who is not involved in the real world can make a claim that the pace of innovation is slowing. The pace of innovation is increasing and its impact is brutal. With regard to innovation and the level of competition in hedge funds, Roberto Mignone, head of Bridger Management said once: “You’ve got a better chance surviving as a crack dealer in Chicago than lasting four years in the hedge fund business.”

9. “The hedge fund business is about success breeding success.”

One of my favorite essays was written by Duncan Watts and is entitled: Is Justin Timberlake a Product of Cumulative Advantage? The concept of cumulative advantage is so important in understanding outcomes in life and yet it is so poorly understood. The basic idea is that once a person or business gains a small advantage over others, that advantage will compound over time into an increasingly larger advantage. This is sometimes called  “the rich get richer and the poor get poorer” or the Matthew effect based on a biblical reference. Merton used this cumulative advantage concept to explain advancement in scientific careers, but it is far broader in it application. Cumulative advantage operates as a general mechanism which increases inequality and explains why wealth and incomes follow the power law described by Pareto. Part of what Robertson is saying is that the more money you raise, the more money you can raise [repeat] the more talent you can attract, the more talent you can attract [repeat].

10. ” I remember one time I got on the cover of Business Week as “The World’s Greatest Money Manager.” Everybody saw it and I was kind of impressed with it, too. Then three years later the same author wrote the most scathing lies. It’s a rough racket. But I think it’s a good thing in human narcissism to realize you go from highs and lows based on your views from the press – really, it shouldn’t matter.”

Letting the views of the press on you impact your view of yourself or what you do is folly. Criticism is hard to take for most anyone, but considering the source is helpful in getting past that. The only thing that everyone likes is pizza. My uncle who recently passed away liked to say ‘Illegitimi non carborundum’ which is a mock-Latin aphorism meaning: “Don’t let the bastards grind you down.” This saying was popularized by US General Vinegar Joe Stillwell during World War II, who is said to have borrowed it from the British army.

11. “[In March 2000] This approach isn’t working and I don’t understand why. I’m 67 years old, who needs this? [In March 2000] There is no point in subjecting our investors to risk in a market which I frankly do not understand. After thorough consideration, I have decided to return all capital to our investors. I didn’t want my obituary to be ‘he died getting a quote on the yen’.”

Sometimes the world changes so much that it is time to either take a break or hang up your cleats – especially if you are already very rich. Some people do this successfully. Others ride old methods to their financial doom. Druckenmiller and others decided to mostly retire when they saw that their methods were no longer working. In 1969, Warren Buffett wrote a letter to his partners saying that he was “unable to find any bargains in the current market,” and he began liquidating his portfolio. That situation of course changed and Warren Buffett emerged with a new competitive weapon in the form of the permanent capital of a corporation rather than the panicky capital of a partnership.

12. “[At the age of six.] I still remember the first time I ever heard of stocks. My parents went away on a trip, and a great-aunt stayed with me. She showed me in the paper a company called United Corp., which was traded on the Big Board and selling for about $1.25. And I realized that I could even save up enough money to buy the shares. I watched it. Sort of gradually stimulated my interest.”

If you want a child to be interested in investing it is wise to introduce key ideas to them early in life in real form. No matter how small the stake, the impact of real money at work in a market means the experience is meaningful and memorable. Mary Buffett writes in her book that Warren Buffet believes that whether a person will be successful in business is determined more by whether a person had “a lemonade stand as a child than by where they went to college. An early love of being in business equates later in life to being successful in business.”

Notes:

Bloomberg Interview: http://www.marketfolly.com/2009/10/julian-robertson-interview-bloomberg.html

CNBC Interview: http://www.cnbc.com/id/101092813

Business Week:  http://www.bloomberg.com/bw/stories/1996-03-31/fall-of-the-wizard

Graham and Doddsville Newsletter: http://www8.gsb.columbia.edu/rtfiles/Heilbrunn/Graham%20%26%20Doddsville%20-%20Issue%2015%20-%20Spring%202012.pdf

Forbes Article: http://www.forbes.com/sites/schifrin/2013/06/05/julian-robertson-hedge-funds-are-the-antithesis-of-baseball/

UNC Blog: http://blogs.kenan-flagler.unc.edu/2010/09/27/hedge-fund-pioneer-julian-roberston-on-his-investment-philosophy/

The New Investment Superstars http://www.amazon.com/gp/search?index=books&linkCode=qs&keywords=9780471403135

Hedge Hunters: http://www.nytimes.com/2007/12/19/your-money/19iht-MCOLUMN22.html?_r=0

A Dozen Things I’ve Learned from Irving Kahn about Value Investing and Business

Irving Kahn was the chairman of the investment firm Kahn Brothers Group. He was born in 1905 and prior to his recent death was one of the oldest active professional investors.  The New York Times in its obituary of Irving Kahn wrote: “A disciple and later partner of Benjamin Graham, the contrarian advocate of value investing, Mr. Kahn would go on to work at Abraham & Company and Lehman Brothers, which he left in 1978 to open Kahn Brothers Group with two of his sons, Alan and Thomas.” Jason Zweig wrote in his tribute to Kahn: “He [was] Mr. Graham’s teaching assistant in the classes on security analysis that the great investor taught at Columbia Business School. Mr. Kahn also assisted Mr. Graham and Columbia professor David Dodd in researching their classic book, ‘Security Analysis,’ published in 1934.”

1. “In the Thirties, Ben Graham and others developed security analysis and the concept of value investing, which has been the focus of my life ever since. Value investing was the blueprint for analytical investing, as opposed to speculation.” 

“Very few people have Ben Graham’s ability to take a subject very complex and boil it down to something simple.” 

“Value investing is an art, not a science.”

“Between the ultra-depression-conservatism of Ben Graham and the brilliance of monopoly investor Warren Buffett, there are ample levels [of value investing] that should fit your own pattern of risk to reward, suitable for your capital needs and lifestyle.”

In these few sentences Irving Kahn identified many important points about value investing. First, value investing is a system. Second, the system is simple, but not easy to implement since certain aspects of value investing are an art. Third, by following the value investing system’s analytical approach you can invest rather than speculate. Fourth, the value investing system created by Ben Graham in the Thirties has evolved since times have changed. Fifth, there are variants of the value investing system that can be created on top of certain bedrock principles which will be discussed below. You can always find an approach that meets your unique needs.  For example, after you retire, certain aspects of your approach to value investing can change.

2. “[Always] know much more about the stock I’m buying than the man who’s selling does.”

“The gambling nature of Wall Street has little or no interest in the serious, underlying nature of businesses.”

A value investor treating an investment security as a partial interest in an actual business is the first bedrock principle of value investing. If a share of stock does not represent an actual interest in a real business, what the hell is it? To understand that business requires research about the business not investor psychology. Irving Kahn is also pointing out in this set of quotations a truism that for every seller there is a buyer and vice versa. Daniel Kahneman writes: “There is always someone on the other side of a transaction; in general, it’s a financial institution or professional investor, ready to take advantage of the mistakes that individual traders make.” You must work hard to understand the underlying business and its markets better than other investors to generate an investing edge.

 
3.  “Prices are continuously molded by fears, hopes, and unreliable estimates, capital is always at risk unless you buy better than average values.”

“There are always good companies that are overpriced. A disciplined investor avoids them. As Warren Buffett has correctly said, a good investor has the opposite temperament to that prevailing in the market. Throughout all the crashes, sticking to value investing helped me to preserve and grow my capital.” 

That an asset should be purchased at a sufficient discount to intrinsic value (which provides the investor with a margin of safety) is the second bedrock principle of value investing. Irving Kahn is saying that price is a very different concept than value since prices are determined in the short term by the emotional state of investors and speculators. There is always a risk that price will be less than value just like there is always the opportunity that price will exceed value. Irving Kahn is also saying that you can pay too much even for a quality company and that avoiding conventional wisdom is wise. Seth Klarman points out that “value investing is a marriage between a contrarian and a calculator.”

4. “Security prices are as volatile as ocean waves – they range from calm to stormy.”

“No one knows when the tide will turn. Those who are leveraged, trade short-term and have bought at a high prices will be exposed to permanent loss of capital. I prefer to be slow and steady. I study companies and think about what they might return over, say, four or five years. If a stock goes down, I have time to weather the storm, maybe buy more at the lower price. If my arguments for the investment haven’t changed, then I should like the stock even more when it goes down.”

That Mr. Market should be treated as a servant rather than a master is the third bedrock principle of value investing. When J. P. Morgan was asked for a market prediction he said: “It will fluctuate.” Business cycles are inevitable due to wildly gyrating emotions of the people who make up a market. As large numbers of people follow each other due to their herding instinct they will inevitably sometimes underestimate and sometimes overestimate the actual intrinsic value of a business. Markets cycling back and forth between fear and greed present a rational investor with an opportunity to benefit, if the investor purchases assets based on intrinsic value and doesn’t try to time market prices .  This is a hard concept for many people to grasp. Buying at a discount to intrinsic value seems like timing to some people, but it isn’t because you are not predicting the future price of the asset in the short term. You wait for an attractive price rather than predict its timing. The bet is that you know something will happen in the future, but you do not know when.  If you are having trouble with this idea, I suggest you read Seth Klarman’s book Margin of Safety.  They key word for me is “wait.” When you are waiting you are not predicting when something will happen, just that it will very likely happen sometime. Irving Kahn is essentially saying that good things come to he or she who patiently waits for a bargain purchase to become more valuable.

5. “You must have the discipline and temperament to resist your impulses. Human beings have precisely the wrong instincts when it comes to the markets.”

“The Depression taught me what frugality means and the importance of not losing money.”

That an investor must make rational decisions is the fourth bedrock principle of value investing. This fourth principle is by far the hardest part of value investing. The battle humans constantly fight to make rational decisions is never ending.  You will never stop making some boneheaded mistakes, but you can, with work and attention, reduce both their frequency and magnitude. learning from mistakes, especially the mistakes of others which is less personally painful, is wise. Many value investors like to read biographies since it is a great source of stories about mistakes and successes of all kinds. The way to acquire good judgment is often through bad judgment.

6.  “We basically look for value where others have missed it. Our ideas have to be different from the prevailing views of the market. When investors flee, we look for reasonable purchases that will be fruitful over many years.”

“Lemmings always lose.”

Irving Kahn thought like a contrarian in order to identify mispriced assets. Howard Marks says investing is a search for the mistakes of other people. Market inefficiency is a fancy academic term for mistakes. That people often acting like lemmings is an opportunity for the rational investor. It is mathematically impossible to follow the crowd and outperform the crowd. Charlie Munger noted at the 2015 Berkshire Annual Meeting that “If people weren’t often so wrong, we wouldn’t be so rich.”  You must “think differently” and be right about what you are thinking differently about to outperform a market. In seeking to be contrarian, one must avoid what some people call “the hipster paradox” (attempts to be different often end up with people making the same decisions).

7. “Our goal has always been to seek reasonable returns over a very long period of time. I don’t know why anyone would look at a short time horizon. In my life, I invested over decades. Looking for short-term gains doesn’t aid this process.”

Because most people are impatient, a smart, rational and patient investor is able to arbitrage time and generate outperformance. Value investing is a process in which you get rich not only slowly but in a lumpy fashion. If you can’t handle a slow process, irregular returns and occasional periods of underperformance, you are not a candidate to be a successful value investor.

8. “Remember the power of compounding. You don’t need to stretch for returns to grow your capital over the course of your life.”

Vanguard has an example which illustrates the power and value of compounding. How reinvesting can pay off over time:

“Let’s say you begin with two separate $10,000 investments that each earn 6% a year (keep in mind this is a hypothetical example, and actual returns would likely be different and a lot less predictable). In one $10,000 investment, you withdraw your investment earnings in cash each year, and the value of your account stays steady, as you see with the flat line in the chart below. In the other investment, you don’t cash out your earnings—they get reinvested. The curved line below shows the power of compounding and time. If you keep reinvesting the earnings (and again, we’re assuming a steady hypothetical return of 6% each year) after 20 years your investment will have grown by more than $20,500. And if you’ve got an even longer time frame—for example, if you’re in your 20s and saving for retirement—after 40 years, your investment will have grown by more than $92,000.”

9. I don’t watch [the stock market every day], because I’m not a trader.” 

“The public is spellbound by daily price moves. Less noticed are long-term economic changes that ultimately set future prices.”

“Investors must remember that their first job is to preserve their capital. After they’ve dealt with that, they can approach the second job, seeking a return on that capital.” 

“If the art of investing were actually easy, or quickly achieved, no one would be in the lower or middle classes.”

If investing was easy everyone would be rich. For some people one of the hardest things to do as an investor is to not be overly focused on daily price variations. Watching prices wiggle back and forth can be mesmerizing. But watching prices move all the time can make people do nutty things. Unfortunately, many investors seem to think there is some sort of a financial prize for hyperactivity when it is in fact a penalty because of fees, costs and the potential for more mistakes. The best way to prevent mistakes from ruining performance is to have something that is a cushion against mistakes.  One analogy I like is the safety driving distance between your car and the car ahead of it on the freeway. Even if the car ahead of you stops unexpectedly, you have build in a margin of safety. If you are building a bridge as the engineer you want to make sure that it is significantly stronger than necessary to deal with more than the very worst case.  Preserving capital as an investor is best achieved by buying at a margin of safety since even if you make a mistake things can still work out well due to the cushion against error. And if the investment goes well you can earn an even bigger return obviously if you buy the asset at a bargain price.

10. “I stick to the 20 odd stocks that I hold.”

Irving Kahn was a focus investor who liked to hold only a relatively small number of stocks. Whether one concentrates stock holdings as a value investor like Irving Kahn or diversifies their investments is a personal choice. Both approaches can be successful in their own way.  As was mentioned above, an investor’s choice regarding diversification is a variable in the value investing system.

For example, the value investor Joel Greenblatt has chosen diversification for his most recent fund. He has done so because he does not believe the  people who invested in his fund have the courage to stay in the fund if they underperform for a significant period of time. Ben Graham was also relatively diversified as an investor but for different reasons. Famous value investor Walter Schloss was also someone who diversified his portfolio. In comparison, Charlie Munger and others believe in concentrating their investments. For example, in the fall of 2014 Bill Ackman’s Pershing Square International fund owned only six stocks.

11. “You don’t have to be fully invested all the time. Have patience, keep your standards.”

“You gain much more by slow investing and concentrating on what you know, than on fast investing, which is nothing more than gambling.”

Patience is an essential attribute of a Ben Graham-style value investor. And sometimes being patient means holding significant amounts of cash and not being fully invested.  This cash position for a value investor is usually just a natural product of not finding businesses selling at prices that allow for a  margin of safety. “Concentrating on what you know” is what is called staying with a circle of competence in value investing circles. The way to lower risk is to know what you are doing and the way to know what you are doing is to stay focused on areas where you have genuine knowledge and skills. “Getting rich slow” is too hard for most people to do.

12. “From some of the financial history books I read that discussed the market cycle, I learned that stocks in certain industries were especially volatile, and copper was one. I looked at the stock index list, and decided to short a copper company called Magma Copper. Because I had little money, I had to ask my brother-in-law, who was a lawyer, to open a brokerage account for me. With $50, I shorted the stock in the summer, and my brother-in-law said it wouldn’t be long before I lost all my money because the market was going up, and I was telling it to go down. In October 1929, when the stock market crashed, my $50 became nearly $100. That was the first trade of my life.”

“I’m a passionate reader. That’s why being an investor is the perfect job for me.”

“To be a successful investor learning is essential.” 

“Net-net stocks were easy to find in the early days. All I had to do was to look over annual reports and study balance sheets. I tried to find companies that had dependable assets such as cash, land, and real properties. Then I made sure they didn’t have too much debt and had decent prospects. If these stocks traded at below their net working capital, then I would be interested in buying them.

I understand that net-net stocks are not too common anymore, but today’s investors should not complain too much because there were only a handful of industries in which to look for stocks in the old days. Now there are so many different types of businesses in so many different countries that investors can easily find something. Besides, the Internet has made more information available. If you complain that you cannot find opportunities, then that means you either haven’t looked hard enough or you haven’t read broadly enough.” 

The best investors read a lot. It’s that simple. They also take time to think about what they have read. It is amazing how many people who don’t read. Particularly amazing to me are people who think buying books without reading them creates any value. They must imagine that the ideas in the unread books travel magically into their brains as they sleep or watch television. What Irving Kahn is also talking about here is the fact that value investing has evolved over the years. As time passed after the Great Depression, it became harder and harder to find publicly traded stocks trading at less than liquidation value. Some value investors started looking outside the major markets, others went looking in private markets and others started considering quality in the analysis of value. Charlie Munger points out that despite this evolution the value investing system continues to work well.

Notes:

Telegraph – 108-year-old investor, “I’m Still Winning”
WSJ – Jason Zweig on Irving Kahn

NPR – The 100 Year Old on Wall Street

A Dozen Things I’ve Learned from Roelof Botha about Venture Capital and Business

Roelof Botha is a partner at the venture capital firm Sequoia Capital. He has been involved in many businesses. He also writes: “Some democratize technology access (Square, Eventbrite, Unity); some create global user communities (YouTube, Tumblr, Instagram, Whisper, QuizUp); and others disrupt markets through innovative business models (Evernote, Weebly, Xoom).” In 2000, prior to his graduation from Stanford Graduate School of Business, he was a director of corporate development for PayPal. He was named CFO in September 2001 and after the PayPal IPO joined Sequoia in 2003.

1. “The key characteristic [of a founder] is the desire to solve a problem for the customer. That is the driving passion, not ‘I think this is going to be a billion-dollar company and I want to hop in because I can get rich.’”  

“I look for the personal passion of the entrepreneur, their ability to describe the problem articulately, and the clarity with which they can explain why they have a unique and compelling solution to the problem.”  

“The most successful entrepreneurs tend to start with a desire to solve an interesting problem—one that’s often driven by personal frustration.”

If a business is not solving a genuinely valuable problem for customers nothing else matters and failure is inevitable. Founders who are thinking about revenue models, term sheets and lots of peripheral issues when the business is not yet solving an important and valuable customer problem are missing the boat. In making these statements Roelof Botha is expressing a desire for missionary founders over mercenary founders. Botha’s partner Doug Leone also favors missionary founders. John Doerr of KPCB also feels the same way about missionaries being preferable to mercenaries. For the same reason, Brian Chesky of AirBnB once said: “in a war, missionaries outlast and endure mercenaries.”

On a related point, Roelof Botha has said that he thinks many great companies sell out too early. He has said that Sequoia “loves being in business with entrepreneurs that want to build something enduring.”

2.  “There is a 50% mortality rate for venture-funded businesses. Think about that curve. Half of it goes to zero. There are some growth investments—later stage investments—which makes things less drastic. Some people try for 3-5x returns with a very low mortality rate. But even that VC model is still subject to power law. The curve is just not as steep.” 

Venture capital requires outsized tape measure home runs to be successful because of the failure rate. A few giant winners must make up for many failures. Basic mathematics dictates this requirement. You can’t have failure rates that reflect a power law without huge returns from so-called “unicorns.”  The need for unicorns drives the selection process of venture capitalists. This fact of life in the venture business means focusing on big markets and businesses that have the potential to grow revenues and profits at nonlinear rates. Most businesses that are formed are not candidates for venture capital. That’s OK.  The best way forward for a business which will never have revenue above $100 million may be bootstrapping with internally generated cash, business loans or investments from friends and family.

3. “Entrepreneurship is much more than what VCs participate in.” 

Many businesses described by founders as needing venture capital are really just small businesses looking for what amounts to small business finance. The people who start these businesses are genuine entrepreneurs. Often they are better off with bootstrap financing or borrowing money in the form of a loan. The businesses created by these entrepreneurs are very important businesses, and a key part of building an economy and creating jobs. But they are not the sort of businesses that are suitable for venture investing. Again, that’s OK.  the total amount of venture financing is overall a relatively small part of an economy. Because of its impact on innovation and productivity venture capital punches far above its weight in terms of impact, but the absolute dollar amount invested per year is relatively small.

4. “Think of yourself as the central point of a network.”

The best way to scale a business is to create flywheels, which is another name for a self-reinforcing phenomena. And in the center of any flywheels benefitting any startup are the founders and their team. To make a flywheel happen they must create a network that is mutually reinforcing. The tricky part of any flywheel is overcoming the chicken and egg problem. How does the business generate initial momentum before all the pieces are in place. Usually the jump start takes the form of a free chicken or a free egg.

5. “The answer [to creating a flywheel] lies in two essential variables: the size of the market and the strength of the value proposition. Any growth goes through an exponential curve, then flatters with saturation. If the ceiling of the market opportunity is $200 million, even if you get a flywheel, it will take you from twenty to sixty or seventy, then peter out because you saturated the available space.

The bigger the market the more runway you have—so if you hit that knee of the curve, you can grow exponentially and keep going for a long time. Doubling a business of material size for three to four years leads to a really large, important company. That’s a key element in the flywheel idea.”

To achieve the sort of growth needed by venture capital it is best to be surfing on a phenomenon that is nonlinear. Moore’s law is one such phenomenon especially when the business also benefits from network effects. Sometimes a flywheel is created in a really small markets and that is not so interesting to a venture capitalist given the need for unicorn style returns.

6. “Companies can end up with too much cash. They might have a 15-month runway. They get complacent and there’s not enough critical thinking. Things go bump at 9 months and it turns into a crisis. And then no one wants to invest more.”

Josh Kopelman of First Round Capital has a great post about raising cash in which he said: “You should target 18 to 24 months of runway post Series Seed.” He also makes important notes about how much harder it is to raise an A round than seed stage capital. The amount of Series A capital available is not much bigger and the number of seed funded startups competing for the money is larger than has been the case in the past. One suggested rule is that a startup that has 12 months of cash should be thinking about raising more cash, and should definitely have started raising by the time they have only 9 months of cash, and should be nervous if they only have six months of cash on hand.

7. To achieve a big success, many things must come together. In some cases, what looked like smooth sailing from the outside was more like a near death experience; a few small changes and the outcome would have been dramatically different. There is always a mixture of skill and luck involved.”

“You have to put yourself in a position to be lucky.”

When considering the difference between luck and skill is it always best to refer to the work of Michael Mauboussin: “There’s a quick and easy way to test whether an activity involves skill; ask whether you can lose on purpose. In games of skill, it’s clear that you can lose intentionally but when playing roulette or the lottery you can’t lose on purpose.” My friend Craig McCaw said to me more than once that a ship as viewed from the dock may look pretty with the captain smiling from the upper deck in a resplendent uniform — but under the decks there is inevitably some ugliness associated with the travails of actually running something.

8. “Problem companies can actually take up more of your time than the successful ones.”

Time is the scarcest resource of a founder or venture capitalist. And the biggest time sink is a business that has lots of problems. When problems arise, that is when the value of a great board, advisers and mentors kicks in and the reason why when given a choice a startup always wants to raise more than money. Investors who bring expertise and helpful relationships to the business are always preferable to purely financial investors.

9. “It’s important to choose initial investors who are not twitchy and rushing for an exit.” 

“Who are you getting in business with? You really have to get to know the [VCs] you might be working with. You’re essentially entering a long-term relationship.”

“Consider a simple 2 x 2 matrix: on one axis you have easy to get along with founder, and not.  On the other, you have exceptional founder, and not. It’s easy to figure out which quadrant VCs make money backing.”

When you are potentially entering into a relationship with people who will be in your life for many years, why would you make a choice to involve people in your business who are hard to get along with? Not only do poor relationships with key people substantially lower your chance of success, the process will make you miserable. Why be miserable? Life is short.

10. “Think about private investing. It’s very different from hedge-fund investing or public investing; you can take advantage of market psychology and short term mismatches because you can exit. We don’t have that luxury in venture capital. We can’t bet this trend will be fashionable for the next three years. By definition we need to have a long term stance. Maybe the company goes public or is acquired in three years, five years, ten years— who knows …We like long runways.”

The length of time it takes for a venture capital investment to pay off drives many aspects of the venture capital industry. Sequoia is rather famous for saying to its portfolio companies: “if you don’t have cash for a long runway, you better have a revenue model that gets you to cash-flow positive quickly.” The better option is to have enough cash and cash flow to last a long time. Warren Buffett treats cash as a call option with no expiration date, an option on every asset class, with no strike price. As an analogy, venture capital funds lock up capital from the limited partners during the life of the fund for that reason.  Buffett again says “Cash combined with courage in a crisis is priceless.” It is during a downturn that the hiring gets easier and cheaper, so building a company then can ironically be very attractive.

11.  “Since the distribution of startup investment outcomes follows a power law, you cannot simply expect to make money by simply cutting checks. That is, you cannot simply offer a commodity. You have to be able to help portfolio companies in a differentiated way, such as leveraging your network on their behalf or advising them well.”

Every startup and its founders, employees, business and markets are unique. Startups need hands-on help with finding product market fit, recruiting, finance, team building and other aspects of building a business. If the venture capitalists involved in a startup are not assisting with things like recruiting early engineers and closing big sales, the startup has the wrong venture capitalists. Venture capital is a service business, not just a way to make money via finance.

12. “There is a subtle benefit of actuarial science which I didn’t appreciate when I joined the profession. Professor Robert Dorrington at UCT once quipped, ‘Actuaries are trained to think 30 years into the future and accountants are trained to think a year in arrears.’ Part of what actuarial science enforces in you is long-term thinking and that frame of mind influences the work that I do today. We invest in companies that employ three people and we have to imagine what the company might turn out to be in 10 or 15 years.”

Roelof Botha was actually trained as an actuary. He points out that a successful venture capitalist must able to imagine what something might be a 10-15 years later. Of course, since it is magnitude of success and not frequency of success that will determine outcomes, a venture capitalist only needs to be really right about what they imagine in a few cases.

Imagining the future is not a science but an art. This description from Botha about what he is looking for is qualitative: “The key to start-up success is purity of motivationIf they can weave a believable story with a compelling value proposition, they’ll have us hooked.”

 

 

Notes:

Nothing Risked Nothing Special Gained (video)

What does Roelof Botha look for in a founder? (video)

This Week in Startups (video)

Roelof Botha: Entrepreneurship is Not Synonymous With Founder (video)

Peter Thiel’s Startup Class 7 Notes (Blake Masters)

AllThingsD – Kara Visits Sequoia’s Roelof Botha

Roelof Botha on startups: Ditch the polish, it’s about ‘raw authenticity’

TechCrunch Disrupt 2012 – Sequoia’s Botha on Entrepreneurship

Reuters: IPO? No thanks, say Silicon Valley CEOs

The Actuary Interview: Roelof Botha

A Dozen Things I’ve Learned from Ben Carlson about Investing

Ben Carlson is one of my favorite finance writers. He is a CFA and has been managing institutional investment portfolios since 2005. He is both a writer and a teacher. His book on investing entitled A Wealth of Common Sense is out soon (you should pre-order it).

What I like best about Ben Carlson is that he is young and very savvy about not only investing but the tools of social and other forms of modern media like Twitter and Tumblr.  Too many of the people I write about who are able to teach others about investing are, well, either old or very old. People like  Ben Carlson, Patrick O’Shaughnessy, Morgan Housel, James Osborne and Josh Brown (the Magnificent Five) represent the next generation in financial writing. They are fearless in confronting financial advice poseurs of all kinds. That they all are moving swiftly into media formats like video makes me hopeful they can successfully combat more of the hucksters pushing “easy wealth in seven steps” style schemes. I am rooting for them, especially when they go after people like constantly self-promoting old coots flogging their financial flim-flams that hurt ordinary investors. The way they attack promoters of high sales loads and hidden fees with these new tools inspires me. When these Magnificent Five go after the “bad guys” I am always cheering  them on.

 

1. “The all-time great investors –Buffett, Marks, Dalio, Klarman, Munger and even Gundlach – have the ability to translate their ideas into simple terminology. Not only are they brilliant, but they all simplify their message when explaining their process.”

Teaching other people helps you think through your own ideas. If you can’t reduce your ideas and investing process to something you can describe simply to others, it is less likely that you have a sound investing process or at least your investing process is not as good as it might be. Teaching about investing has another benefit in that limited partners who understand your investing process are much more likely to stay with you when you are under-performing the market. Simply put, having investors who understand your investing process is a competitive advantage. Seth Klarman puts it this way: “At the worst possible moment, when your fund is down because cheap things have gotten cheaper, you need to have capital, to have clients who will actually love the phone call and – most of the time, if not all the time – add, rather than subtract, capital.” And finally, teaching others about investing is good for the teacher’s brand. A strong personal brand buffed to a shine via teaching makes raising money from limited partners easier.

2. “If you study Buffett, Marks, Soros, Lynch, Dalio, etc. you will find that even though their strategies differ, they all share the ability to control their emotions and make clear, probability-weighted investment decisions based on past experiences.”

The psychological aspects of investing are by far the biggest challenge for any investor. Getting control of yourself is a key part of getting control of your finances and investments. Humans will never stop making emotional mistakes. Focusing a significant portion of your time and energy on reducing those mistakes pays big dividends. On Ben Carlson’s second point Michael Mauboussin describes how to make wise, probability-weighted decisions: “Expected value is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price ) for a given outcome by the probability that the outcome materializes.”

If you can think probabilistically while controlling your emotions, investing gets far easier. Studying great investors helps with that learning process. Famous value investor Irving Kahn said once: “millions of people die every year of something they could cure themselves: lack of wisdom and lack of ability to control their impulses.”

3. “Everyone is conflicted in some way. It’s impossible to avoid conflicts of interest in the financial services industry. It is a business after all. The trick is to understand how incentives drive people’s actions and look for those firms and individuals that are up front and honest about any potential conflicts.”

The phrase “everyone is talking their book, all the time” has been seared in my brain ever since I heard it first from my friend Bill Gurley. It’s such a simple way to capture an important idea. An old German proverb says: “whose bread I eat, his song I sing.” And a lot of the time you are eating your own bread. Daniel Kahneman puts it this way: “Facts that threaten people’s livelihood and self-esteem — are simply not absorbed. The mind does not digest them.”  Warren Buffett advises people to beware of asking your barber if you need a haircut for that reason.

Buffett’s partner Charlie Munger said recently: “If the incentives are wrong, the behavior will be wrong. I guarantee it.”  That adds to what he said many years earlier: “I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.”
4. “It’s easy to be a long-term investor during a bull market. Everyone’s making money and it feels like you can do no wrong.  It’s when things don’t go as planned that this group loses control.”

People panic. Not only do they panic, but they follow other people who have panicked, who are following other people who have panicked [repeat]. Being in a “thundering herd” is most often not a good thing.  And to outperform the market you must leave the confines of the herd and be right about your reason for leaving. No one is ever contrarian as an investor “just in time” on a consistent basis. Contrarians must inevitably endure periods of underperformance and sometimes even ridicule from the herd.  Of course, being too early is often indistinguishable from being wrong.
5. “It’s not enough to say you will buy when fear is high and stock prices are low. You also have to have the necessary funds available to make purchases during times of maximum pessimism.”

Jason Zweig did a wonderful interview of Charlie Munger in which he wrote: “Successful investing, Mr. Munger told me, requires ‘this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself, because in this world opportunities just don’t last very long.” Sitting on the sidelines in a rising market with cash earning just about nothing is a very hard thing to do. Lots of people may see a bargain during a downturn but may not have any dry powder at that time which allows them to act on that insight. Timing markets is folly, but having a long term attitude and only buying stock at prices that offer a margins of safety can help someone have cash available at a time like 2009.

6. “Understanding yourself and your own tendencies can be much more helpful to the investment process than knowing exactly what’s going on in the markets. You have no control over what’s going to happen in the markets, but you have complete control over your reactions to them.”

Most mistakes are psychological or emotional. Even Daniel Kahneman has said that after a lifetime of study of dysfunctional heuristics he still makes bonehead errors. Staying rational when making investment decisions is a life long struggle. You can never learn enough so that dysfunctional heuristics won’t potentially lead you to folly and error.

Everyone makes mistakes. The job of an investor is to make fewer new mistakes and to try to avoid being an idiot. Simply avoiding idiocy is highly underrated. My sister, a psychologist, said to me recently “what I think about in my practice is often not too different from what you write about on your blog.” This is of course true. Knowing yourself pays big dividends if you are an investor.

7. “Increased activity does not necessarily lead to better results.”

Investing by nature requires some activity. But not much. In other words, investing can never be completely passive. For example, you must allocate assets and chose an index fund/ETF if you are a passive investor. But there are aspects of investing where doing less through diversification improves performance since it decreases fees and lowers the adverse effects of performance chasing. As another example, an active investor who invests seldom but in a very aggressive way when the odds are substantially in their favor often experiences the best results. The market does not award prizes to investors who are hyperactive. Investors who are too concerned with always “doing something” are like horses wearing extra weight at a racetrack.

8. “All else equal, a talented sales staff will trump a talented investment staff when attracting capital from investors. There are organizations that can have both, but typically the firms with the best sales teams or tactics will end up bringing in the most money from investors. A well-thought-out narrative by an intelligent, experienced marketing department with the right pitch book can do wonders at persuading investors to hand over their hard-earned money. It’s difficult to admit we can be so easily persuaded but it’s true.”

Most investments are sold rather than purchased. Nothing else explains people still paying sales loads when purchasing an investment, when they are often easily avoided. There are people who can sell ice to Eskimos and many of them are selling investments. Howard Marks in a masterful recently published essay on liquidity skewers a few marketing strategies that are being foisted on people as an ‘investment free lunch’.

9. “Most investors will be immediately drawn to the marketing firms because people typically gravitate towards certainty, confidence and the latest fads.”

People love people who are confident. Daniel Kahneman writes: “Overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.” You’ve seen these supremely confident motivational speakers make their pitch to investors saying things like “Just follow these seven steps and you will be rich.” It’s bullshit, but as long as it is presented confidently large numbers of sheep, err people, will follow.

10. “Financial models are fairly useless if you take them at face value. I dealt with extremely complex Excel spreadsheet models on a daily basis. They were a thing of beauty for spreadsheet geeks. Complex formulas and macros, linked data, pro-forma financial statements — all with the analysis spit out in a neat summary page. Every tiny piece of company and industry data was meticulously estimated or tracked down to the nearest decimal point. 

Many of the analysts I worked with told me it was their modelling skills that really set them apart from their peers.  But what I found from navigating these models is that there was always one or two levers you could pull that would completely change your output (price target or earnings estimate). A minor change to a discount rate or future growth rate assumption could drastically change the end result by a wide margin.”

When someone delivers you a spreadsheet and makes an argument based on that spreadsheet, I suggest to travel right to the assumptions.  This approach saves great amounts of time and wasted energy. Contrary to that old proverb, the devil is actually making trouble in the assumptions rather than in the details. There are also angels lurking in the assumptions too since a lot of innovation has its source changing a commonly believed assumption. Scott Adams could have just as easily been talking about spreadsheets rather than slides when he said: “If you just look at a page and drag things around and play with fonts, you think you’re a genius and you’re in full control of your world.” People who believe their projections that run six years into the future are accurate are as common as leaves in New England.

11.”Sometimes negative knowledge by learning what not to do is just as important as figuring out the right way to do something.”

Getting ahead by avoiding stupidity, particularly if the activity can potentially result in a big mistake, is such a simple idea. No one personifies this idea more than Charlie Munger. “I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.” In learning what not to do, it is best if you learn through other people’s mistakes rather than your own. Avoiding stupidity is best done vicariously. There is no better way to see a lot of stupid behavior over a short time than reading.

You can learn so much just by watching people make mistakes in life, especially if you are genuinely paying attention. Charlie Munger’s ideas again come to mind: “Just avoid things like racing trains to the crossing, doing cocaine, etc.  Develop good mental habits…. A lot of success in life and business comes from knowing what you want to avoid: early death, a bad marriage, etc.” As I’ve said many times, it is best to avoid situations where you have a big downside and a small upside (negative optionality) and to seek the inverse (big upside small downside).

12. “The reason so many people don’t have their financial house in order is because they (a) become overwhelmed or (b) don’t care about finance because they find it boring.”

If you don’t find business interesting you should not be trying to outperform the markets. If actively investing in stocks is not about understanding individual businesses and business in general then exactly what is it about?  Most everyone should buy a diversified portfolio of low fee index funds/ETFs.  One trick that may help is to understand that business gets more interesting the more you learn about it. Once you get to critical mass in understanding basic principles, it all gets more interesting. Especially if you enjoy understanding how systems fit together and mutually reinforce each other, business can be very interesting. Andy Warhol said once: “Being good in business is the most fascinating kind of art. Making money is art and working is art and good business is the best art.”

But even then to be really good at understanding business and investing you must understand many disciplines. You must adopt what Charlie Munger calls a lattice of mental models approach. The best book on this is by Robert Hagstrom entitled: Investing: The Last Liberal Art.

Notes:

http://awealthofcommonsense.com/

A Dozen Things I’ve learned from Stanley Druckenmiller About Investing

“Stan may be the greatest moneymaking machine in history. He has Jim Roger’s analytical ability, George Soros’s trading ability, and the stomach of a riverboat gambler when it comes to placing his bets. His lack of volatility is unbelievable. I think he’s had something like five down quarters in 25 years and never a down year. The Quantum record from 1989 to 2000 is really his. The assets grew from $1 billion to $20 billion over that time and the performance never suffered. Soros’s record was made on a smaller amount of money at a time when there were fewer hedge funds to compete against.”  – Inside the House of Money

 

1. “I think David Tepper is awesome and if he’d take my money, I’d give him some but I think his fund is closed.”

I included this quote to make the point that even though a very small number of great investors do beat the market, it is very unlikely that they are going to be willing to invest your money. Even Stanley Druckenmiller does not believe he can get into David Tepper’s fund. In other words, you won’t be a limited partner in David Tepper’s fund anytime soon. It is also unlikely that you will be able to replicate the market outperformance of these great investors on your own. It would be much easier for me to write on this blog and elsewhere that no one ever beats the market even though I know it is not true. Some people might find the fib justifiable by the fact that it will encourage people to invest in a diversified portfolio of low fee index funds/ETFs. But that would not be truthful, so I just can’t do it.

But this truth has a cost since overconfidence will cause a significant number of people to think that they can do what David Tepper and Stanley Druckenmiller have achieved as investors.  And these overconfident investors will go out and inevitably underperform the market. For me, honesty trumps paternalism. Dishonesty, even if only a fib in one area with arguably benevolent intent, is a slippery slope and has other costs. As George Washington said: ‘I cannot tell a lie.” But I will say that it is *highly* unlikely that you can be as successful as David Tepper and Stanley Druckenmiller. The sooner you realize that, the better off you will be.  Having said that, everyone can benefit from learning to make better decisions in life including decisions about how to allocate assets.

2. “George Soros has a philosophy that I have also adopted: The way to build long-term returns is through preservation of capital..

If you look at other posts I have written in this series on my blog you will see a consistent view expressed: not losing money is a critical part of the investing process. The great investors say it in different ways, but the point is always the same. For example, Warren Buffett says: “Rule No. 1: never lose money; rule No. 2: don’t forget rule No. 1.″ Paul Tudor Jones puts it this way: “I think I am the single most conservative investor on earth in the sense that I absolutely hate losing money.”  Seth Klarman provides the fuller explanation his book Margin of Safety:

“Avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather “don’t lose money” means that over several years an investment portfolio should not be exposed to appreciable loss of capital. While no one wishes to incur losses, you couldn’t prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on losses when others are greedily reaching for gains and your broker is on the phone offering shares in the latest “hot” initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome.”

3. “Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular.”

“I’ve learned many things from [George Soros]  but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

As I noted in my blog post on Nassim Taleb, investing home runs come from finding mispriced optionality. “Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny).” Occasionally you can find a situation with a big upside and a small downside if you are patient and work hard to find it. When that happens if you can be brave and aggressive in your bet, you can hit a home run. Charlie Munger argues that hitting a few financial home runs in a lifetime is all you need for financial success. Unfortunately, being patient, brave and aggressive is not a typical combination of character traits for most people.

4. “My job for 30 years was to anticipate changes in the economic trends that were not expected by others, and, therefore not yet reflected in security prices.”

Fundamentally, the job of an investor is to find assets which are available for purchase that are mispriced by the markets. If a given trend is expected by others they will be reflected in security prices and there is not opportunity for the investor. In my post about George Soros I note that he once said: “Money is made by discounting the obvious and betting on the unexpected.” Like all great investors, Stanley Druckenmiller trained himself to be an intelligent contrarian when making a bet and only to do that when there was a big upside and a small downside. Phil Fisher put it this way: “Doing what everyone else is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do at all.”

Richard Thaler and Cass Sunstein do a fine job of relaying a Warren Buffett story here:  “Warren Buffett retells the story of the dead oil prospector who gets stopped at the pearly gates and is told by St Peter that Heaven’s allocation of miners is full up. The speculator leans through the gates and yells ‘Hey, boys! Oil discovered in Hell.’ A stampede of men with picks and shovels duly streams out of Heaven and an impressed St Peter waves the speculator through. ‘No thanks,’ says the sage. ‘I’m going to check out that Hell rumor. Maybe there is some truth in it after all.’”

5.  “I have always made big concentrated investments. I don’t believe in diversification. I don’t believe that’s the way to make money.”

“You are not going to make money talking about risk adjusted returns and diversification. You’ve got identify the big opportunities and go for them.”

“As far as Soros is concerned, when you’re right on something, you can’t own enough.”  

As Warren Buffett has pointed out many times: “diversification is protection against ignorance. It makes little sense if you know what you are doing.” Of course is that most people have no idea what they are doing when it comes to investing.  Most people don’t even understand the difference between speculating and investing. For this reason and others almost everyone should buy a diversified portfolio of low fee index funds/ETFs. Warren Buffett points out that by acknowledging that you are not smart money by putting a strategy in place that harnesses diversification you become the smart money.

Unfortunately any investor must still choose how to diversify, so they still must learn to make sound investing decisions (portfolio asset allocation requires that an investor actively make certain choices even if it is to buy low fee index funds/ETfs).

6. “Soros is the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.”  

Michael Mauboussin has no peer in explaining why great investors focus on creating sound investing processes rather than outcomes. Because investing is a probabilistic process, results in the short term do not always distinguish between good and lousy processes. David Sklansky wrote in The Theory of Poker: ‘Any time you make a bet with the best of it, where the odds are in your favor, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.” If your process is sound taking a loss in the short term shouldn’t bother you, as Druckermiller learned from George Soros.

7. “I particularly remember the time I gave (the research director) my paper on the banking industry. I felt very proud of my work. However, he read through it and said, ‘This is useless. What makes the stock go up and down?’ That comment acted as a spur. Thereafter, I focused my analysis on seeking to identify the factors that were strongly correlated to a stock’s price movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don’t know what makes their particular stocks go up and down.”

“Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.”

Stanley Druckermiller is referring here to the importance of identifying what Mario Gabelli calls a catalyst. Gabelli writes: “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.” Valuation is most, ahem, valuable when it can be combined with a catalyst. Buying at an attractive valuation gives you a margin of safety against mistakes and the catalyst can provide you will a turbocharged result on that basic foundation.

8. “I learned you could be right on a market and still end up losing if you use excessive leverage.”

“It takes courage to ride a profit with huge leverage.”

Leverage magnifies mistakes as much as any successes. But because wrong decisions when leveraged can take the investor or speculator completely out of the investing process, leverage is particularly destructive of financial returns. Howard Marks point out that “Leverage magnifies outcomes, but doesn’t add value.” Having said this it is clear that George Soros uses leverage and so has Stanley Druckenmiller. So the key word for Stanley Druckenmiller must be “excessive” when it comes to leverage. How much exactly is “excessive”? The answer it seems, from what I have read, is that it depends on the strength of your confidence in the bet. Druckenmiller did says once in The Wall Street Journal that “leverage at Soros’s Quantum rarely exceeds 3-to-1 or 4-to-1.” Needless to say I don’t think anyone playing along at home should think that investing in this way is applicable or appropriate for them.

9. “I only focus on what is black or white and kind of sift out the gray area in my investing style.”

Why invest in anything which you are unsure about when there are other options that you are more sure about? This is simple “opportunity cost” thinking. Michael Mauboussin puts it this way:  “We don’t have odds on the tote board [like in a horse race], but we have something called the stock price. So we reverse engineer the expectations built into that price. We say, ‘What has to happen for that to make sense?’ And then we look at how the fundamentals are likely to unfold.  It’s a probabilistic exercise. That would be the first piece. The second piece, analytically, is bet size, which is once you have an edge, how much do you bet in your portfolio? That’s a second key component which is often overlooked.”

Charlie Munger finishes the thought: “And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past. We look for a horse with one chance in two of winning and which pays you three to one. And the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced bet—that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”

10. “Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.”

Stanley Druckenmiller is talking about loss aversion here. Most people get conservative when they are winning. The best analogy for this bias happens in golf: “even the best golfers systematically miss the opportunity to score a “birdie” — when a player sinks a ball in one stroke less than the number of expected strokes for a given hole — out of fear of having a “bogey” — or taking one stroke more than what is expected. According to the researchers, for many, the agony of a bogey seems to outweigh the thrill of a birdie.”

Loss aversion can be found everywhere if you look. Venture capitalists investing “good money after bad” in the hope of saving a loss is just one example. Similarly, too much energy can be put into saving a business instead of devoting that energy to building one with greater potential. Daniel Kahneman describes loss aversion with a helpful example:  “In my classes, I say: ‘I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?…People want more than $20 before it is acceptable. And now I’ve been doing the same thing with executives or very rich people, asking about tossing a coin and losing $10,000 if it’s tails. And they want $20,000 before they’ll take the gamble.”

11. “I certainly made my share of mistakes over the years, but I was fortunate enough to make outside gains a number of times when we had different views and various central banks. Since most investors like betting with the central bank, these occasions provided our most outside returns and the subsequent price adjustments were quite extreme. I don’t know whether we’re going to end with a malinvestment bust, due to misallocation of resources. Whether its inflation, or whether the outcome will actually be benign. I really don’t. But neither does the Fed.”

Many people believe that the Fed has extraordinary ability to predict the economy. Stanley Druckenmiller is saying that the people at the Fed put their underwear on one leg at a time like everyone else. They are reacting to events like everyone else. I think Janet Yellen is a great choice as a Federal Reserve Chairperson.  But it makes me nervous when I see people write about how she predicted this or that. I remember when people thought Alan Greenspan was great too. I believe that Janet Yellen is smart enough to know what she can’t predict.

As for how Druckenmiller made his bets against central banks, my hat is off to him. I don’t know how he did it. He has talked about the importance of understanding how central banks impact liquidityThe story he tells about the decision to short the British Pound is incredible. My hat is particularly off to him when he admitted that in today’s environment the tools he developed probably wouldn’t work. Humility is essential in a money manager he says, as is a focus on mistakes. In my view, we are in a new abnormal.” Charlie Munger commented about this recently: “I think it’s highly likely that the people who confidently think they know the consequences – none of whom predicted this – now they know what’s going to happen next? Again, the witch doctors. You ask me what’s going to happen? Hell, I don’t know what’s going to happen. I regard it all as very weird. Anybody who is intelligent who is not confused doesn’t understand the situation very well. If you find it puzzling, your brain is working correctly.”

12. “This is insane. I’ve never owned a stock that goes from $40 to $250 in a few months.”

The Internet bubble was literally insane. I’ve never been involved in anything in my life that was more surreal. Fear of missing out (FOMO) caused the bubble to reach unprecedented levels. FOMO is driven by an innate human desire to avoid regret. Daniel Kahneman has counseled financial advisors to “try to prevent people from acting out of regret.” Investors and speculators who are prone to regret are more prone to change their mind at precisely the wrong time. Primarily you want to protect them from regret, you want to protect them from the emotions associated with very big losses.

They key takeaway from the Internet bubble, for me, is that when it happens is not predictable. If it is a bubble and it does bust, the day before is like any other day. One key “tell” that can give you a sense that something is up is looking around and seeing lots of companies that are unprofitable paying far too much to acquire customers. What is too much? If the customer over their lifetime is producing a return that is significantly net present value negative the business is paying too much. How much is too much? It depends. If this pattern of acquiring net present value negative customers is persistent and widespread hairs should be standing up on the back of your neck. The bigger the net present value deficit the bigger the risk. Can you predict when it will end? No. “You can’t predict, but you can prepare says Howard Marks, and I agree. And for the hundredth time: risk is not the same thing as valuation.

 

Notes:

Inside the House of Money (Amazon)

The New Market Wizards: Conversations with America’s Top Traders (Amazon)

Soros: The Life and Times of a Messianic Billionaire (Amazon)

Bloomberg Interview on Strategy, Shorting IBM

Finance Trends – Stan Druckenmiller Talks Trading

Speech Transcript at Alpha

 

The Wall Street Journal – May 22, 2000

CNBC – Delivering Alpha Speech

Bloomberg – Druckenmiller calls it quits after 30 years

ZeroHedge – Druckenmiller on China’s Future & Investing’s New Normal

CNBC Interview (video) & article