A Dozen Things I’ve Learned from Joel Greenblatt about Value Investing

Joel Greenblatt is a very successful value investor and the founder of Gotham Capital, which offers four diversified long/short equity mutual funds. He has written several books on value investing identified in the notes below.

1. “One of the greatest stock market writers and thinkers, Benjamin Graham, put it this way.  Imagine that you are partners in the ownership of a business with a crazy guy named Mr. Market. Mr. Market is subject to wild mood swings. Each day he offers to buy your share of the business or sell you his share of the business at a particular price. Mr. Market always leaves the decision completely to you, and every day you have three choices. You can sell your shares to Mr. Market at his stated price, you can buy Mr. Market’s shares at that same price, or you can do nothing.

Sometimes Mr. Market is in such a good mood that he names a price that is much higher than the true worth of the business. On those days, it would probably make sense for you to sell Mr. Market your share of the business. On other days, he is in such a poor mood that he names a very low price for the business.  On those days, you might want to take advantage of Mr. Market’s crazy offer to sell you shares at such a low price and to buy Mr. Market’s share of the business. If the price named by Mr. Market is neither very high nor extraordinarily low relative to the value of the business, you might very logically choose to do nothing.”

Joel Greenblatt is a genuine Graham value investor.  Benjamin Graham’s value investing system has only three essential bedrock principles. The first bedrock principle is:  Mr. Market is your servant and not your master. The value investor does not try to predict the timing of stock market prices since that would make Mr. Market your master. The value investor buys at a bargain and waits for the bipolar Mr. Market to inevitably deliver a valuable financial gift to them. This difference transforms Mr. Market into the investor’s servant.

For a value investor, value is determined using methods that produce a fuzzy but very important benchmark, which is called “intrinsic value.” It is perfectly acceptable that the result of an intrinsic valuation is fuzzy and that approaches can vary bit from investor to investor.  It is also acceptable that the intrinsic value of some businesses can’t be reliably determined since they can be put in a “too hard” pile to free up time for other things. There are many thousands of other businesses to invest in that are not in the too hard pile. Admitting that the intrinsic value of some businesses can’t be reliably determined is also very hard for some people to accept.

Joel Greenblatt makes a key point here: “Prices fluctuate more than values—so therein lies opportunity. Why do the prices fluctuate so widely when values can’t possibly? I will tell you the answer I have come up with: The answer is I don’t know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to happen. I just want to take advantage of it. We could sit there and figure it all out, but I like to keep it simple.  It happens; it continues to happen; the opportunities are there. 

I just want to take advantage of prices away from value.. If you do good valuation work and you are right, Mr. Market will pay you back.  In the short term, one to two years, the market is inefficient.  But in the long-term, the market has to get it right—it will pay you back in two to three years. Keep that in mind when you do your analysis. You don’t have to look at the next quarter, the next six months, if you do good valuation work—.. Mr. Market will pay you.”

Here again is this idea that predicting that prices will fluctuate, and that eventually they will rise to intrinsic value or above, is not to predict when that will happen. Gotham’s philosophy is: “We believe that although stock prices often react to emotion over the short term, they generally trade toward fair value over the long term. Therefore, if we are good at identifying mispriced businesses (a share of stock represents a percentage ownership stake in a business), the market will agree with us…eventually.”

The Mr. Market metaphor is hard for many people to grasp. For this reason some people are never really comfortable with the value investing system. This is not a tragedy, since value investing is not the only way to invest successfully. There are other successful investing systems. For example, there is factor-based investing, which calls itself value investing, but isn’t Graham value investing. There is also activist investing, which can be combined with value investing. There are other investing systems like merger arbitrage. Benjamin Graham style value investing is not for everyone, but anyone who is an investor can benefit from at least understanding the system.

2. “Buying good businesses at bargain prices is the secret to making lots of money.” 

“Graham figured that always using the margin of safety principle when deciding whether to purchase shares of a business from a crazy partner like Mr. Market was the secret to making safe and reliable investment profits.”

“Look down, not up, when making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.”

We use EBIT–earnings before interest and taxes–and we compare that to enterprise value, which is the market value of a company’s stock plus the long-term debt that a company has. That adjusts for companies that have different ratios of leverage, different tax rates, all those things. But the concept is still the same. We want to get more earnings for the price we’re paying. That was sort of the principles that Benjamin Graham taught, meaning that cheap is good. If you buy cheap, you leave yourself a large margin of safety. Warren Buffett had a twist on that and said, Gee, it’s nice to buy cheap things but I also like to buy good businesses.

So if I could buy good businesses at a cheap price, it’s better than just cheap… We rank all companies based on their return on capital and we also rank all companies based on how cheaply we can buy them relative to their earnings. The more earnings, the better. Then we combine those rankings. And the companies that have the best combination of that ranking go to the top. So we’re not looking for the cheapest company. We’re not looking for the highest return-on-capital company. We’re looking for the companies that have the best combinations of those two attributes.”

The second bedrock principle of Benjamin Graham’s value investing system is that assets should only be purchased when the price of the asset creates enough of a bargain that it providers the buyers with a “margin of safety.” What Joel Greenblatt means when he says “look down” is that you should think about Warren Buffett’s first and second rules on investing: don’t lose money and don’t lose money. The right amount of margin of safety will vary based on the investor involved, but it should be large enough to cover any mistakes. One common margin of safety is 25%. The margin of safety for a company for which intrinsic value can actually be calculated (i.e. not in the “too hard” pile) should be so big that a really smart person can do the valuation in their head.

In the quotes above Joel Greenblatt describes how it is possible for value investing to evolve over time, as long as the three bedrock principles stay the same. Charlie Munger convinced Warren Buffett that quality (a good business) when combined with a bargain price was even better than just a business bought at a bargain price. Value investors like Greenblatt spend a lot of time thinking about Return on Equity and Return on Capital. These are the concepts that allow them to differentiate the earnings power of one company versus another.  Determining value by only a database screen that sorts based on book value and price tells you nothing about the quality of the earnings power of a business.

3. “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

“Most people don’t (and shouldn’t) invest by buying stocks and holding them for only one month. Besides the huge amount of time, transaction costs, and tax expenses involved, this is essentially a trading strategy, not really a practical long-term investment strategy.”

The third bedrock principle of Ben Graham value investing system is that a security is an ownership interest in an actual business rather than a piece of paper to be traded based on person’s view about the views of other people, about the views of other people [repeat]. To value a stock, a value investor must understand the underlying business. This process involves understanding the fundamentals of the business and doing some relatively simple math related to the performance of the business.

“A number of years ago I was trying to explain to my son what I did for a living.  He is 11 years old.   I spoke about selling gum. Jason, a boy in my son’s class, sold gum each day at school.  He would buy a pack of gum for 25 cents and he would sell sticks of gum for 25 cents each.  He sells 4 packs a day, 5 days a week, 36 weeks or about $4,000 a year. What if Jason offered to sell you half the business today?  What would you pay?

My son replied, ‘Well, he may only sell three packs a day so he would make $3000 a year.’ Would you pay $1,500 now? ‘Why would I do that if I have to wait several years for the $1,500?’ Would you pay a $1?  ‘Yes, of course!  But not $1,500.  I would pay $450 now to collect $1,500 over the next few years, which would be fair.’

Now, you understand what I do for a living, I told my son.”

Joel Greenblatt is not thinking in all of this: “I think others will pay me more than $X for this business”, because that is trying to predict the psychology of potential buyers. Warren Buffett once described the stock market as a “drunken psycho.” The financier Bernard Baruch similarly said once that “the main purpose of the stock market was to make fools of as many people as possible.” Emotions and psychological errors are the enemy of the value investor.  Graham Value investors stay focused on the value of the business and only look at the stock market when they may want to have it be their servant.

4. “Periods of underperformance [make Graham Value Investing] difficult – and, for some professionals, impractical to implement.” 

“Over the long term, despite significant drops from time to time, stocks (especially an intelligently selected stock portfolio) will be one of your best investment options. The trick is to GET to the long term. Think in terms of 5 years, 10 years and longer. Do your planning and asset allocation ahead of time. Choose a portion of your assets to invest in the stock market – and stick with it! Yes, the bad times will come, but over the truly long term, the good times will win out – and I hope the lessons from 2008 will help get you there to enjoy them.”

The Ben Graham value investing system is designed to underperform during a bull market and outperform doing falling and flat markets. This is very hard for many people to handle so they are not candidates to be successful value investors. Seth Klarman, who is one of the very best value investors, writes: “Short–term underperformance doesn’t trouble us; indeed, because it is the price that must sometimes be paid for longer-term outperformance.” Few investors have the fortitude to endure this period of underperformance referred to by Joel Greenblatt.  Investment managers with a Graham value investing style work hard to attract the right sort of shareholders who won’t panic and ask to redeem their interest in a fund at the worst possible time. Value investors who manage funds typically spend a lot of time trying to educate their limited partners about how value investing works.

Warren Buffett has created the better solution in that the structure of Berkshire does not allow redemptions by limited partners. Berkshire investors can sell their shares to someone else but they cannot ask for their ownership interest to be redeemed for cash. Bruce Berkowitz said once about Berkshire Hathaway: “That is the secret sauce: permanent capital.  That is essential.  I think that’s the reason Buffett gave up his partnership.  You need it, because when push comes to shove, people run … That’s why we keep a lot of cash around…. Cash is the equivalent of financial Valium. It keeps you cool, calm and collected.”

5. “Companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.”

Benjamin Graham style value investors who have evolved their value investing system to include an optional quality dimension understand that a moat is necessary to maintain high returns on capital. To understand moats I suggest that you read this essay (the 2013 updated version especially) and even if you have read it already I suggest you read it again. The concept of a moat is the same concept that individuals like Michael Porter talk about when they refer to a barrier to entry or sustainable competitive advantage. If you do not have a moat, the supply of what you sell inevitably increases to a point where the price of your product drops to a point where there is no long term industry profit above the cost of capital of the business. Increased supply from competitors is a killer of value for a producer of goods and services. A moat is something that puts limits on that supply and therefore makes a business more valuable. Moats, like people, come in all shapes and sizes. Some moats are strong and some moats are weak.  Some moats protect things that are very profitable and some don’t.

6. “You have to know what you know—Your Circle of Competence.”

People get into trouble as investors when they do not know what they are doing. This idea is not rocket science and yet people ignore it all the time. This is true whether the situation involves any combination of risk, uncertainty or ignorance. There are a number of behavioral biases that contribution to this problem including overconfidence bias, over optimism bias, hindsight bias and the illusion of control.   The right approach for an investor is to find areas in which you are competent. Charlie Munger puts it this way: “Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent, and you have to allocate it smartly.”

The idea behind the Circle of Competence filter is so simple it is embarrassing to say it out loud: when you do not know what you are doing, it is riskier than when you do know what you are doing. What could be simpler?  And yet humans often don’t do this.  For example, the otherwise smart doctor or dentist is easy prey for the promoter selling cattle limited partnerships or securities in a company that makes technology for the petroleum industry. Really smart people fall prey to this problem. As another example, if you lived through the first Internet bubble like I did you saw literally insane behavior from people who were highly intelligent.

7. “Remember, it’s the quality of your ideas not the quantity that will result in the big money.”

Value investors understand that investment outcomes are determined by magnitude of success rather than frequency of success. This is the so-called Babe Ruth effect. This is one of the greatest essays on this investing principle ever written. Fail to read it at your peril. Michael Mauboussin writes: “being right frequently is not necessarily consistent with an investment portfolio that outperforms its benchmark…The percentage of stocks that go up in a portfolio does not determine its performance, it is the dollar change in the portfolio. A few stocks going up or down dramatically will often have a much greater impact on portfolio performance than the batting average.” Venture capital returns are especially driven by the Babe Ruth effect.

8. There is no sense diluting your best ideas or favorite situations by continuing to work your way down a list of attractive opportunities.”

The best investors who “know what they are doing” understand that investing decisions should be made based on an opportunity-cost analysis. And some investors, as a result, decide to concentrate their investments rather than diversify. Charlie Munger has his own take on this same idea: “Everything is based on opportunity costs. Academia has done a terrible disservice: they teach in one sentence in first-year economics about opportunity costs, but that’s it. In life, if opportunity A is better than B, and you have only one opportunity, you do A. There’s no one-size-fits-all. If you’re really wise and fortunate, you get to be like Berkshire. We have high opportunity costs. We always have something we like and can buy more of, so that’s what we compare everything to.”

Seth Klarman makes a point here that is similar to the one he made above: “Concentrating your portfolio in the most compelling opportunities and avoiding over diversification for its own sake may sometimes lead to short-term underperformance, but eventually it pays off in outperformance.” Having said this, Greenblatt has moved to a more diversified approach. Gotham’s web site explains: “Our stock positions, which generally include over 300 names on both the long and short sides, are not equally weighted. Generally, the cheaper a company appears to us, the larger allocation it receives on the long side. On the short side, the more expensive a company appears relative to our assessment of value, the larger short allocation it receives. We manage our risks by requiring substantial portfolio diversification, setting maximum limits for sector concentration and maintaining overall gross and net exposures within carefully defined ranges.”

Greenblatt explains his views on diversification in a recent interview with Consuelo Mack. My take on his view (starts at about minute 14:30): what comes with a concentrated portfolio, is outside investors in the fund who lose patience and leave the fund when there is a period of underperformance. If you are investing your own money and have the patience, concentration can work better. He now more focused on being “right on average” for outside investors instead of concentrated investing in about eight stocks.

9. “Even finding one good opportunity a month is far more than you should need or want.”

Fundamental to value investing is the idea that mispriced securities and other assets which fall within your circle of competence are rarely available to purchase at a price which reflects a margin of safety. For this reason, value investors are patient and yet aggressive, ready to act quickly whenever the opportunity is presented. Most of the time the value investor does nothing but read, think, and research businesses and industries. Actual buying and selling of securities and other assets happens rarely. Warren Buffett has a few thoughts on this point which are  set out below:

  • “You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”
  • “We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”
  • “I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”
  • “The stock market is a no-called-strike game. You don’t have to swing at everything–you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, ‘Swing, you bum!’”
  • “One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as`marketability’ and `liquidity,” sing the praises of companies with high share turnover… but investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pick pocket of enterprise.”

10. “If you are going to be a very concentrated investor, you should not use leverage. You can’t leverage because you need to live through the downturns and that is incredibly important.”

Being a successful value investor requires that you have staying power. When you use financial leverage your mistakes are as just as magnified as your successes, and those mistakes can be big enough to make you a non-investor since you may have no longer have funds to invest. Don’t just take it from me. Please listen to these three investors. First, Charlie Munger: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Second, James Montier: “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 which can result in a permanent loss of capital.” Third, Howard Marks: “Leverage magnifies outcomes, but doesn’t add value.”

11. “The odds of anyone calling you on the phone with good investment advice are about the same as winning the Lotto without buying a ticket.”

To be a successful value investor of any kind requires actual work. And since work is necessarily involved, many people will try to avoid it, since that is human nature. Relying on people who call you on the phone with investment advice to avoid work, doesn’t, ahem, work. One way to avoid some of the work is to rely on others, but finding reliable and skilled people to rely on requires work too. Taking the time and devoting the time necessary to get sound financial advice will pay big dividends. This topic reminds me of a man I know who once pleaded with his doctor: “You have to help me stop talking to myself.” The doctor asked: “Why is that?” The man responded: “I’m a salesman and I keep selling myself things I don’t want.”

12. “Almost everyone should have a significant portion of their assets in stocks. But here it comes – few people should put ALL their money in stocks. Whether you choose to place 90% of your assets or 40% of your assets in stocks should be based largely on how much pain you can take on the downside.”

Joel Greenblatt is talking about the “asset allocation” set of issues, which present a number of choices that both active and index investors must face.  Stock prices can drop by a lot, and that and that can cause people to panic. Charlie Munger points out: “You can argue that if you’re not willing to react with equanimity to a market price decline of fifty percent two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result that you’re going to get.”

The best way to acquire good judgment so that you don’t panic is to read widely so you are prepared for this sort of result. Unfortunately, many people only learn these lessons by panicking and then missing a subsequent stock market rally while they sit in an emotional foxhole too terrified to participate in stock or bond markets. Unfortunately, many people learn about this so-called behavior gap by actually touching a hot stove. Some people learn the lesson and others never recover fully.

Greenblatt’s books:

The Little Book That Still Beats the Market

You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits

The Big Secret for the Small Investor: A New Route to Long-Term Investment Success

Notes:

Market Folly – Joel Greenblatt on risk investment

Forbes – The Little Book That Beats the Market (Intelligent Investing)

Wealthtrack – Greenblatt’s Strategy Change

CBS – Greenblatt Class #1 Notes

The Little Book That Beats The Market: Review, Quotes, & Lessons Learned

A Dozen Things I’ve Learned from Chris Dixon About Venture Capital and Startups

1. “If everyone loves your idea, I might be worried that it’s not forward thinking enough.” 

Anyone thinking about starting a business should be searching for mispriced opportunities.  While markets are mostly efficient in eliminating opportunities for extraordinary profit, there are always areas of an economy in which there are significant uncertainty. These areas are excellent places for a startup to look for opportunities.

The best entrepreneurs have learned that large businesses are investing huge amounts of capital in areas in which extensive information is already available, and that it’s most advantageous to create new businesses where information is not available. In other words, the best opportunities for startups tend to be in areas that are overlooked and less well-known by others. What Chris Dixon is saying is that if everyone loves your idea, this may be a “tell” that there will not be opportunities for extraordinary profit. The venture investor Peter Thiel has said: “The best startups are good ideas that look like bad ideas. Good ideas that look like good ideas are already being worked on by big companies.”

Dixon also says in this insightful post that “you shouldn’t keep your startup idea secret.” He identifies a range of positive benefits that flow from sharing the idea and getting feedback, while pointing out “there are at best a handful of people in the world who might actually drop everything and copy your idea.”

While most businesses do not require a result that generates extraordinary profit to be a success, this is not the case for a startup that seeks to raise venture capital. Venture capitalists invest in a portfolio of startups, knowing that only one to three in every fund could likely be a massive success. Chris Dixon’s partner Marc Andreessen describes the approach of a venture capitalist more technically as ‘buying a portfolio of long-dated, deeply-out-of-the-money call options’. Entrepreneurs are in the business of creating those options and selling some of them to investors to fund the business.

Like a startup or any other investor, a venture capitalist is seeking a mispriced opportunity.  All intelligent investors seek mispriced assets and if you want to explore this topic you can do no better than reading Howard Marks.  Why do large businesses and others leave this opportunity in areas with significant uncertainty available for startups? Howard Marks traces the source to bias and closed mindedness, capital rigidity, psychological success, and herd behavior. Markets are not fully efficient. Private, emerging and obscure markets are especially inefficient.

 

2. “How do you develop a good idea that looks like a bad idea? You need to know a secret — in the Peter Thiel sense: something you believe that most other people don’t believe. How do you develop a secret? (a) know the tools better than anyone else; (b) know the problems better than anyone else; and/or (c) draw from unique life experience.”

“Founders have to choose a market long before they have any idea whether they will reach product/market fit. In my opinion, the best predictor of success is whether there is what David Lee calls ‘founder/market fit.’ Founder/market fit means the founders have a deep understanding of the market they are entering, and are people who ‘personify their product, business, and ultimately their company’.”  

Chris Dixon is saying that the people most likely to know the “a secret” about a business opportunity are people who have deep domain expertise. In other words, it is not nearly as likely that someone without deep domain expertise will be successful without understanding the technology, the best methods to create the product, the best ways to bring products to market or the needs of the customer. Another way to think about this point is in terms of a moat or sustainable competitive advantage. Founders and employees of the startup are themselves contributors to the moat of a company, both directly and indirectly.

People who work for the startup who have deep domain knowledge are a likely source of what is called “optionality” which I have explained in a previous blog post. When a team of people in a startup have what Dixon called “secrets” as a result of deep domain expertise, their ability to adapt and innovate gives the startup and the investors optionality. Teams that do not have this optionality usually can’t adapt to changing environments, and fail more often.

The other skill that people with deep understanding have is the ability to see a phenomenon that is emerging within a complex adaptive system. When something bigger than the sum of its parts is emerging in an economy, some people with deep domain expertise are going to see the potential (the secret) before other people.

 

3. “[The] business of seed investing, and frankly, early-stage entrepreneurship, is so much about getting good information. And almost all of that information, unfortunately, is not published.”

The fact that information about a business is hard to get is actually a great thing for a startup, since it can help create the mispriced opportunity they seek. Uncertainty in the early stages of a startup is the friend of the entrepreneur. As the team pushes forward to reduce technology risk, find product/market fit and discover methods to scale the business, uncertainty is retired and value is created. The job of a great venture capitalist is in no small part to provide entrepreneurs with an entry into networks that allows them to quickly and cost-effectively find this private information. The same principle applies to the venture capitalists themselves. Great venture capitalists are always trying to find good sources of information, particularly information that is not published.

 

4. “Ideas …matter, just not in the narrow sense in which startup ideas are popularly defined. Good startup ideas are well developed, multi-year plans that contemplate many possible paths according to how the world changes.”

“Characteristics of the best ideas: (a) powerful people dismiss them as toys; (b) they unbundle functions done by others; (c) they often start off as hobbies and/or (d) they often challenge social norms.” 

“The best ideas come through direct experience. …When you differentiate your direct experience from conventional wisdom, that’s where the best startup ideas come from.”

My deepest exposure to what Chris Dixon is talking about immediately above (direct experience) came during the time I worked for Craig McCaw, who without question is a savant when it comes to ideas that can be developed into great businesses.  In the very early days, the “cell phone” only offered enough value to be a commercial success to a very small number of users. In the beginning, the device was so big it required a suitcase or a car installation to be useful. I remember real estate agents and construction sites as the biggest users. On the infrastructure side, a city like Seattle could be served by radios on only three very tall towers.

Eventually mobile phones appeared, but they were very expensive, analog, heavy and large. During that time period, McKinsey famously predicted that no one would ever use a mobile phone if a land line phone was available. McKinsey placed little or no value on what Craig McCaw called the ability of people to be “nomadic.” The mobile phone had each of the attributes Chris Dixon noted above. Some people thought of the mobile phone as a toy. Since my first mobile phone cost more than $4,000 dollars I actually felt awkward using it in some social settings. Talking into a mobile phone in some pubic settings would cause people to frown at you.

To continue my example, Craig McCaw was also an enthusiastic personal user of what we then called “cellular” phones. Craig McCaw loved working out of the ‘mobile office’ – meaning cars, planes, boats and ships. Which meant he was a natural enthusiast for the product. When the time came to sell his cable TV business in order to double down on the mobile phone business, the choice was made easy by his love of the mobile phone.

 

5. “There is a widespread myth that the most important part of building a great company is coming up with a great idea.” “What you should really be focused on when pitching your early stage startup is pitching yourself and your team. Of course a great way to show you can build stuff is to build a prototype of the product you are raising money for. This is why so many VCs tell entrepreneurs to ‘come back when you have a demo.’ They aren’t wondering whether your product can be built – they are wondering whether you can build it.”

Great ideas matter, as the previous quotations noted. But the ability of a team to execute is a more important consideration than a clever idea. Most everyone has said more than once “I thought of that idea first” when they see a new business being formed. The best idea in the world without a team to make it happen, won’t amount to a hill of beans. Chris Dixon is saying that the best evidence that a team can actually execute, is actually executing on something like a demo. The best evidence that you can do something like create software, is actually creating software. As the old proverb points out, the proof of the pudding is in the eating.

 

6. “What the smartest people do on the weekend is what everyone else will do during the week in ten years.” “Hobbies are what the smartest people spend their time on when they aren’t constrained by near-term financial goals.”  Chris Dixon is not referring to smart people who play ping pong in their garage or pay fantasy baseball in their dorm rooms on weekends. He is referencing the smartest people that are building things like the first PCs, drones, or a better search engine.  The Homebrew Computer Club, an early hobbyist group which had it first meeting on March 5, 1975, is just one example. The critical element here is an advanced technology that is useful to very smart hobbyists but does not yet have obvious financial returns associated with its use. Inevitably, technologies driven by phenomena like Moore’s law drive costs to lower levels and performance to high enough levels so that what was once a hobby becomes a thriving business.

As an aside, it is easier to understand Moore’s law now. But I will say that although I am probably in the top few percent in the US who understand its power, I underestimate that power every single year.

 

7. “This era of technology, it seems to be the core theme is about moving beyond bits to atoms. Meaning technology that affects real word, and transportation and housing and healthcare and all these other things, as opposed to just moving bits around. And those areas tend to be more heavily regulated and, this issue is only beginning to be significant and will probably the defining issue of the next decade in technology.” 

I include this quotation since it is an example of something that I value, which is an ability of a person to make a genuine non-consensus prediction about the future rather than predicting the present. Too many venture capitalists are camp followers. They are moving into a trend when others have long since moved on to other opportunities. To outperform, a venture capitalist must think like Howard Marks described here: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Deviating from a consensus view for its own sake is suicidal, but doing it occasionally and being very right is what makes a great venture capitalist like Dixon.

 

8. “Anyone who has pitched VCs knows they are obsessed with market size.” “If you can’t make the case that you’re addressing a possible billion dollar market, you’ll have difficulty getting VCs to invest. (Smaller, venture-style investors like angels and seed funds also prioritize market size but are usually more flexible – they’ll often invest when the market is “only” ~$100M).  This is perfectly rational since VC returns tend to be driven by a few big hits in big markets.” 

“If you are arguing market size with a VC using a spreadsheet, you’ve already lost the debate.” For early-stage companies, you should never rely on quantitative analysis to estimate market size. Venture-style startups are bets on broad, secular trends. Good VCs understand this.” “Startups that fill white spaces [areas where there is latent demand without supply] aren’t usually world-changing companies, but they often have solid exits. They force incumbents to see a demand they had missed, and those incumbents often respond with an acquisition.”

It is not possible to make silk purse out of a pig’s ear.  For a startup to generate the necessary financial return for a VC, the potential market being addressed must be massive. The entrepreneur who pulls out a spreadsheet and tries to make the case that the market is large enough based on fake quantitative assumptions does little but destroy his or her credibility. Venture capitalists hate to see hockey stick shaped distribution curves based on unrealistic assumptions that don’t map to reality. Chris Dixon is saying that what they do want to see for markets that can’t be defined with much certainty is a strongly argued narrative which explains that the market has or will attain the required size. Yes, they want to see as many related facts as possible that support the narrative. No, they don’t want to hear wild guesses presented as facts.

 

9. “There are two kinds of investors: Ron Conways who try to create value by finding good people and helping them create something great, and others, who want a piece of someone else’s things. The builders and the extractors. Avoid the extractors.” 

“Founders too often view raising capital as a transaction, when it is actually a very deep relationship. They think of money as money, when there is actually smart money, dumb money, high-integrity money, and low-integrity money.”

Particularly in the United States, money is not the scarce resource in venture capital.  The scarce resource is fundable startups. The outcome for any startup will increasingly be determined by access to networks of people and resources.  If a startup has a choice between (1) just money and (2) money plus access to these networks, is it wise to choose the latter.  Because startups most compete in an Extremistan environment (i.e., winner-take-all or winner-take-most-all) even the smallest advantage can end up topping the balance of success and cumulative advantage to one company.  Perhaps some founders are cheered up by a venture capitalist who is mostly a cheerleader, but the smart entrepreneurs want someone who can directly help with tasks like recruiting and problems like pricing and distribution.

 

10. “VCs have a portfolio, and they want to have big wins. They’d rather have a few more lottery tickets.. while for the entrepreneurs, it’s their whole life, and let’s say you raised five million bucks, and you have a fifty million dollar offer, and the entrepreneurs are like, “Look, I make whatever millions of dollars. I’ll be able to start another company.” And the VCs are like, ‘Wait! We invested billions of dollars.’ That is usually where tension comes.”

Chris Dixon has been both a founder and a VC.  He has empathy for both venture capitalists and founders on this set of issues. He is most certainly correct that this type of situation creates tension. The wave of discussion about this topic is proof of that. The question is: what is the best way to resolve the tension in ways that are mutually beneficial?  First, a brief note about what is at stake. The economist Harry Markowitz called diversification the only free lunch investing. Warren Buffett discussed the issues involved as follows:

“Of course, some investment strategies require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry.  That investor should both own a large number of equities and space out his purchases.  By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.  Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.  I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential.  In the words of the prophet Mae West:  ‘Too much of a good thing can be wonderful.’ ”

The wisest outcome on founder and employee liquidity issues will depend on the facts and circumstances of each case. There is no connect-the-dots-formula that is right in all cases. Fred Wilson has written a very thoughtful post on this issue. He points out that even from the view of the VC there is an incentive to create some liquidity:providing some founder liquidity, at the appropriate time, will incentivize the founders to have a longer term focus and that will result in exits at much larger valuations because, contrary to popular belief, founders drive the timing of exit way more than VCs do.”

In addition to what Fred Wilson notes, it is one thing to concentrate your investments if you have a net worth measured in millions and quite another if you have little financial cushion if the business fails. The important point that Chis Dixon raises is that there is an issue here, and it can create tension if not dealt with intelligently. Founders are smarter and better informed than ever before and they want a venture capitalist who is empathetic and thoughtful.

 

11. “If you aren’t getting rejected on a daily basis, your goals are not ambitious enough. The most valuable lesson I had starting out in my career was when I was trying to break in the tech world and I applied to jobs at big companies and at startups, at VC firms. I got rejected everywhere. I had sort of an unusual background. I was a philosophy major, a self-taught programmer. It turned out to be the most valuable experience of my career because I eventually developed such thick skin that I just didn’t care anymore about getting rejected. And, in fact, I kind of turned it around and started embracing it. I eventually — that sort of emboldened me. Through those sort of bolder tactics, eventually landed a job that got my first startup funded. So every day to this day I try to make sure I get rejected.”

The ability to handle rejection in a sales process is something that has always fascinated me.  Why can some people knock on door after door and suffer rejection and after rejection and still maintain a positive attitude long enough to generate the eventual sale? For some people a single rejection turns them into a nervous wreck, while others power through to close a sale. It seem to me to be explained by a combination of innate personality and a learned skill.

In any event, starting a business and even building a successful career involves way more selling than people who have never done it before imagine. Entrepreneurs are constantly selling themselves, their business and its products to potential employees, suppliers, distributors, investors and customers. If you can’t sell, starting a business is probably unwise.

 

12. “Before I started my first company, an experienced entrepreneur I know said, ‘Get ready to feel sick to your stomach for the next five years.’ And I was, ‘Eh, whatever.’ Then later, I was, ‘Shoot, I should listen to the guy.'” 

“You’ve either started a company or you haven’t. ‘Started’ doesn’t mean joining as an early employee, or investing or advising or helping out. It means starting with no money, no help, no one who believes in you (except perhaps your closest friends and family), and building an organization from a borrowed cubicle with credit card debt and nowhere to sleep except the office. It almost invariably means being dismissed by arrogant investors who show up a half hour late, totally unprepared and then instead of saying ‘no’ give you non-committal rejections like ‘we invest in later stage companies.’ It means looking prospective employees in the eyes and convincing them to leave safe jobs, quit everything and throw their lot in with you. It means having pundits in the press and blogs who’ve never built anything criticize you and armchair quarterback your every mistake. It means lying awake at night worrying about running out of cash and having a constant knot in your stomach during the day fearing you’ll disappoint the few people who believed in you and validate your smug doubters.”

I was the third employee of a company founded by Craig McCaw, and although I wasn’t a founder it was nevertheless a life changing experience.  It was a particularly notable day since I received two job offers the very same day. One job was a very safe position with an established company. The other was with the startup. What tipped the decision was that I wanted to have the life experience of being part of a startup. I wanted the experience more than the immediate monetary rewards that the other position offered.

From a post by Chris Dixon on climbing the wrong hill in your career“People tend to systematically overvalue near-term over long-term rewards.  This effect seems to be even stronger in more ambitious people.  Their ambition seems to make it hard for them to forgo the nearby upward step.”

There were lots of times I thought that I had made a mistake in not taking the safer and better-paying job. I experienced all the things Chris Dixon talks about in that post, including attacks from armchair critics. I worried often about other employees and how my family would cope with failure if that happened. The tale of this startup is actually one of the great untold stores in business history. It resulted in a 4X return for early investors which was not terrible, but not great either. That’s a story for another time.

 

 

Notes:

Chris Dixon – Why you shouldn’t keep you startup idea secret 

Github – Startup School 2013

 

Chris Dixon – The idea maze

Chris Dixon – What the smartest people do on the weekend

 

Chris Dixon – Founder Market Fit 

Chris Dixon – Size markets using narratives, not numbers

 

This Week in Startups – Chris Dixon, General Partner at a16z (video)

Chris Dixon – Size markets using narratives, not numbers

 

9 inspirational startup quotes from Chris Dixon

Chris Dixon – Pitch yourself, not your idea

 

Gigaom – Why the VC Model is Broken

Chris Dixon – Climbing the Wrong Hill

Chris Dixon – If you are not getting rejected

A Dozen Things I’ve Learned from Tom Murphy About Capital Allocation and Management

Some people, particularly those that are in the early stages of their career, may ask: who was Tom Murphy?  He is the sort of person that industry hall of fames write about in this way: He began his broadcasting career as the first employee of a bankrupt television station in Albany, New York. Acquisition by acquisition, he built the company.” “Tom, who became President of Cap Cities, gradually built the company into a telecommunications empire. In 1985 he engineered the purchase of ABC with the backing of his long-time friend Warren Buffett, and the company became Cap Cities/ABC. He describes it as ‘the minnow that ate the whale’. Ten years later, Tom sold Cap Cities/ABC to Disney for approximately $19 billion.”

In 1985, Fortune wrote: “Under Murphy and Burke, Capital Cities has turned in an exceptional performance in its principal businesses: broadcasting, which produced 51% of the company’s 1984 operating profits, and publishing (48%). Without much show of effort, Capital Cities’ per-share earnings growth since 1974 has averaged 22% annually, compounded. Return on shareholders’ equity, a key measure of performance, averaged a splendid 19.2% during the period.”

Warren Buffett is one of Tom Murphy’s biggest admirers. For Warren Buffett to say this is high praise indeed: “Tom Murphy and Dan Burke were probably the greatest two-person combination in management that the world has ever seen, or maybe ever will see.” Similarly, Warren Buffett once told Lawrence Cunningham, the author of the book Berkshire Beyond Buffett:  “Most of what I learned about management, I learned from Murph. I kick myself, because I should have applied it much earlier.” He has also said it as directly as possible: “I think (Murphy) is the top manager in the U.S.”

When you study what Warren Buffet has said and written about managing a business, in many cases you are learning indirectly from Tom Murphy. That is a good thing since Tom Murphy did not say or write very much in comparison to Buffett. Like many great operators and managers Tom Murphy mostly let his business results speak for themselves, and did not spend any significant time seeking to be noticed by the public.

1. “There’s no substitute for being a good business, and there are not many of them.” “There are not many great businesses that come along in a lifetime.” Warren Buffett and Tom Murphy see eye-to-eye on this point, with the Berkshire chairman famously saying: “When a management team with a reputation for brilliance joins a business with poor fundamental economics, it is the reputation of the business that remains intact.” Without a moat, any business will inevitably see the price of their company’s products reduced to a point equal to the opportunity cost of capital – even if the business has managers who have great operational skills. Yes, you definitely want great managers and occasionally you might find one as talented as Tom Murphy or Ajit Jain. But that does not mean you should invest in a business without a moat if you think it has great management.

The forces of competition are relentless, and the ability to copy the operational effectiveness of a competitor is a constant problem for businesses that do not have a moat. Tom Murphy is making the point above that businesses which have a moat are rarer than most people imagine. In other words, a good moat is truly hard to find. And contrary to what Peter Thiel would have you believe, moats come in all sizes with varying strengths and weaknesses.

The width and depth of a given moat shifts constantly. There is no binary phase transition between moat and no moat. I do find it a bit ironic given the Buffett/Berkshire connection that Tom Murphy once said: “I loved the business I was in, and I loved going to work every morning. If it had been the railroad business, it would not have been as much fun.”

2. “The goal is not to have the longest train, but to arrive at the station first using the least fuel.” This quote is a great setup to contrast the management style of Tom Murphy with William Paley, who ran the competing CBS television network.  Tom Murphy was not a fan of a business getting bigger for its own sake or diversifying into unrelated businesses to achieve “synergy” or diversification. Unlike William Paley, Tom Murphy did not buy businesses like a baseball team or a toy company. When Tom Murphy bought a business it was to generate additional benefits for the core media business.

As we discussed, Tom Murphy thought that a business with a moat is very hard to find and for this reason alone he preferred to put capital to work in the business where he had the greatest advantage. When Tom Murphy allocated capital he preferred a focused approach rather than diversification, since he was investing in a business he knew very well and that had very attractive characteristics.

3. “We just kept opportunistically buying assets, intelligently leveraging the company, improving operations and then we’d … take a bite of something else.” One of the great skills that any investor or businessperson can have is a talent for capital allocation. And Tom Murphy, like Warren Buffett, was a master at capital allocation.  When Tom Murphy bought a business he used debt or cash generated by the business rather that diluting equity by issuing stock. In this way, he acted a lot like John Malone or Craig McCaw as they rolled up business after business so as to benefit from demand and supply-side economies of scale.

William Thorndike, the author of the popular business book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, believes that the best CEOs have an “investor’s mind set.” When they consider a business decision like an acquisition or the purchase of capital equipment, “they viewed it as investment and when it had attractive returns they did a lot of it.”

4. “The business of business is a lot of little decisions every day mixed up with a few big decisions.” A great business is built brick-by-brick on a daily basis. The job of a CEO is to make a few really important decisions that set strategic direction, and then find ways to enable the rest of the company to achieve their goals. Dan Burke, Murphy’s long-time business partner, said in an interview that the process is simpler than people imagine. You gather the facts and then you make decisions based on good judgment. Of course, having good judgment is easier said than done. It is certainly easier if your business itself is sound.

On Warren Buffett’s company, Tom Murphy wrote in the forward to Berkshire Beyond Buffett: “From afar, it may look like Berkshire’s wide-ranging businesses are very different from one another. In fact … while they span industries, they are united by certain key values, like managerial autonomy, entrepreneurship, frugality and integrity.” Dan Burke was fond of a quotation attributed to a Chinese philosopher: ”A leader is best when people barely know he exists, not so good when people obey and acclaim him — worse when they despise him. But of a good leader who talks little when his work is done and his aim is fulfilled, they will say: We did it ourselves.”

5. ”Decentralization is the cornerstone of our management philosophy.” “[Warren Buffett and I] are both proponents of a decentralized management philosophy: of hiring key people carefully; of pushing decisions down the organization; and of setting overall principles and resisting temptation to be involved with details. In other words, don’t hire a dog and try to do the barking.” 

“Decentralization, though, is not a magic bullet….  In the wrong environment, chaos and anarchy sit side-by-side with decentralization.” Warren Buffett has said his strength is his weakness: delegation to the point of anarchy. What Tom Murphy taught him was that if you (1) hire the very best people and (2) don’t delegate the critical job of capital allocation, you can create what Buffett’s partner Charlie Munger calls a ‘seamless web of deserved trust’. It is tremendously cost efficient to have a culture that is based on trust, since you don’t have the cost or the inefficiency associated with layers of management that try to act as a substitute. When Tom Murphy bought the ABC Television network, the Capital Cites headquarters consisted of only 36 people. Of course, this seamless web of deserved trust system does not work if you do not hire great people, allocate capital wisely, and delegate authority. Fortune magazine pointed out: “The great exception to the local-autonomy principle is a rigorous annual budgeting process that Burke personally oversees.”

6. “We expect a great deal from our managers.” The flip side to Tom Murphy’s aggressive delegation of authority was that he held his managers accountable for performance.  If you have delegation without accountability it is an absolute recipe for disaster. For example, accountability for sales targets was not something that was casually considered at Capital Cities.  As another example, in the television broadcast industry feedback is quick. Someone once quoted Murphy as saying: “Every day you wake up and get a report card on how you’re doing.”

In the Berkshire context, Jim Weber, the CEO of Brooks Running, has pointed out that Buffett and Munger “fall in love with a business that has great management in place, so that they don’t have to run it [but] I’ve never felt more responsible and accountable.” Murphy’s #2 Dan Burke put the process at Capital Cities this way:  ”We sit everybody down in the dark once a year and show them what they said they were going to do for the year and what they actually did. Then we look at what they say they’re going to do next year. It’s sort of compelling to know that a year from now you’re going to be back in that same slot.”

7. “Cost control was the baseline of our company culture.” “We worked to make cost-consciousness a part of our company’s DNA. Budgets, which are set yearly and reviewed quarterly, originate with the operating units that are responsible for them.”  Tom Murphy was famously frugal. One story often told is about Tom Murphy only painting the two sides of a building Capital Cities owned that faced the road. But when it came to buying assets that produced excellent financial returns, Tom Murphy did not hesitate to spend money. If he was cheap, it was on expenditures that he felt did not produce an adequate financial return.

A producer for ABC said once that if your programs went over budget “you would be invited to seek employment elsewhere.” In The Outsiders William Thorndike wrote: “Murphy, however, was a cab man and from very early on showed up to all ABC meetings in cabs. Before long, this practice rippled through the ABC executive ranks, and the broader Capital Cities ethos slowly began to permeate the ABC culture. When asked whether this was a case of leading by example, Murphy responded, Is there any other way?”  Focus on cost control meant that Murphy’s stations had the highest margins in the business, north of 50% compared to an average of 30%.”

8. “Gauge performance over the long haul.” Tom Murphy was famously patient when it came to acquisitions and he adopted the same view when it came to the performance of his managers. Like Warren Buffett, he was willing to accept results that could be lumpy if that higher volatility improved long-term overall performance. The process was rigorous: “Murphy’s method of deal sourcing … involved staying out of the public eye, and spending years developing relationships with potential prospects. He never financed with equity, either generating cash internally, or using debt which was nearly always paid off within three years. All his major deals were through direct contact with sellers; they were never hostile, and never through an auction. He had strict return requirements: a double-digit after-tax return over 10 years, without leverage.”

9. “There’s no substitute for people with brains who are willing to work hard.” “One wrong hiring decision at a senior level can really hurt hiring decisions down the line.” “If you hire mediocre people, they will hire mediocre people.”

“In terms of culture, we told our employees that we hire the smartest people we can find and that we have no more of them around than necessary.” For Murphy, no partner was more important than Dan Burke who “shaped the culture of the company, with an emphasis on accountability, directness, irreverence and community service.” [Dan Burke had] a “wicked sense of humor that made every day more fun.” Tom Murphy and Dan Burke preferred to hire someone with brains rather than experience. Tom Murphy once said that his company “doesn’t like to have more personnel than it needs. Too many people with too little to do leads to office politicking and other behavior that’s destructive for an organization.”

10. “One of the most uncommon things in life is common sense. It’s very hard to notice whether people have common sense.” Judgment and common sense are among the hardest things to teach. I think everyone can get better at making decisions, but some people have more common sense than others it seems.  In many respects, making better decisions and having more common sense is a trained response. In my view, the first rule on this point is to read as much about Charlie Munger’s views on the psychology of human misjudgment and worldly wisdom as you possibly can. The second rule is to not forget the first rule.

11. “As an entrepreneur you don’t want to run out of cash. You don’t want to borrow any more money than you absolutely need.” This point is so obvious, and yet some people forget it and seal their doom. Running out of cash is an unforgivable sin in business.  If you have enough cash, you can even go through bankruptcy and survive as a business. Holding the right amount of cash is an art, especially if you are being financed with debt. I plan to write a post on Michael Milken at some point which will deal with this set of issues.

12. “Don’t spend your time on things you can’t control. Instead, spend your time thinking about what you can.” Carl Richards has a wonderful graphic that makes this same point on a napkin-like sketch.

Things that matter, Things you can control

Notes:

Amazon – Berkshire Beyond Buffett

Amazon - The Outsiders

QZ – The man who taught Warren Buffett how to manage a company

Fortune – “The Best Advice I Ever Got”

Tom Murphy, Harvard Business School notes

Tom Murphy Interview (video)

Smart Company – Warren Buffett: How a rowboat beat an ocean liner 

Fortune – Capital Cities Capital Coup

A Dozen Things I’ve Learned from Doug Leone About Startups & Venture Capital

Doug Leone is the Managing Partner of Sequoia Capital, where he has been a partner since 1993. Prior to joining Sequoia in 1988 he worked at Sun, HP and Prime in sales and sales management positions.

1. “We want to be partners with entrepreneurs from day one… We know after many, many years that your DNA is set in the first 60 to 90 days.”  

Doug Leone would prefer to be the “first outside dollar” in a new business. He believes it is easier to train people about the right approach than to change what has already been established. The cynic might say he is saying this because valuations are lower for the “first dollar in” venture capitalist. The non-cynic would reply that the probability of success goes up when a business gets a great start, since investing early helps retire risk and uncertainty.

Doug Leone makes a reference to genetics in the quote. What is the DNA of a business?  In my view it is culture and values, plus a range of best practices. Best practices can’t be reduced to a formula since every business is different, but there are ways to learn from others. Many posts on this blog have been about best practices and company culture. I learned most of what I know about optimal company culture and best practices mostly during one magical period in my life when I would sit in on meetings as Craig McCaw met various captains of industry as they came to visit him. A parade of executives like Charlie Ergen, Alan Mulally and Jeff Hawkins passed through my life during that period, and what I learned in those meetings was magical. I tried to be a sponge for knowledge and best practices, and to make the best parts of their DNA part of my DNA.

It is important to break at least a few rules in creating a startup, since you can’t outperform a market by simply copying others. BUT, not taking the time to learn from others about best practices is a huge mistake. A group called the Startup Genome team created this “avoid-to-achieve-success” list, which is instructive rather than complete:

  • Spending too much on customer acquisition before product/market fit and a repeatable scalable business model
  • Overcompensating missing product/market fit with marketing and press
  • Building a product without problem/solution fit
  • Investing into scalability of the product before product/market fit
  • Adding “nice to have” features
  • Raising too little money to get thru the valley of death
  • Raising too much money. It isn’t necessarily bad, but usually makes entrepreneurs undisciplined and gives them the freedom to prematurely scale other dimensions. I.e. over-hiring and over-building. Raising too much is also more risky for investors than if they give startups how much they actually needed, and waited to see how they progressed.
  • Focusing too much on profit maximization too early
  • Over-planning, executing without regular feedback loop
  • Not adapting business model to a changing market
  • Failing to focus on the business model and finding out that you can’t get costs lower than revenue at scale.

2. “[In venture] big is completely the enemy of great. You want very small, tight teams, same thing with running an engineering department.”

Doug Leone believes that small teams of people making decisions make better decisions (too many cooks spoils the broth). The Startup Genome team also makes a few points on small team failures:

  • Hiring too many people too early
  • Hiring specialists before they are critical: CFO’s, Customer Service Reps, Database specialists, etc.
  • Hiring managers (VPs, product managers, etc.) instead of doers
  • Having more than 1 level of hierarchy

3. “We’re happy to help recruit the first 3, 4, 5 engineers but we firmly do believe that recruiting is a core competency that companies should learn.”

A repeated theme of successful VCs in this series of blog posts has been that the composition and chemistry of the team will determine the success of the business. Since great people attract other great people in a nonlinear way, getting a strong early start with recruiting is essential. Doug Leone is also saying that if the company can’t recruit its own people after getting an assist from the venture capitalist, they are in trouble. If great people aren’t being attracted to the startup something is wrong.

Because hiring the right people is so important Sequoia has in house recruiters to help companies. If a startup if not able to attract great employees that is a “tell” for an investor that something is wrong with the business or its culture. By contrast, a startup that punches above its weight in attracting great employees is a sign that the business is on the right track. If you think to yourself: “How did they hire someone of her or his caliber” that’s a good indicator that the startup will be successful.

4. “There are three types of start-ups: 1) Ones that are so young that it’s difficult to tell if the dogs are going to eat the dog food. 2) Ones where there’s clear evidence of market pull.  3) Ones that are unfortunately stuck in a push market or have a very difficult product to sell. The trick is to say away from #3.  You only go to #1 if you are a domain expert and you have an informed opinion on a product/market, but this is a rare trait. The real trick is to end-up in #2.”

When he said this, Doug Leone was giving advice to salespeople about joining a startup. In the best case for the salesperson, product/market fit has been found and there is at least some sales traction. In other words, dogs are eating the startup’s dog food and want more. Doug Leone is pointing out that if the business has not yet established product/market fit (ie., it’s still difficult to tell if the dogs are going to eat the dog food) it is best for the salesperson to leave the opportunity to others who have special skills and aptitudes. A different breed of employee is required when it is unclear whether the dogs will eat the dog food (type 1).

5. “Little companies have really two advantages: stealth and speed. You [Arrington] come from the world of speed and no stealth. The best thing for little companies do is to stay away from the cocktail circuit.”

As my blog post on LinkedIn’s Reid Hoffman pointed out, startups need feedback when developing a product or service. Having said that, a startup need not spend a lot of time promoting the offerings until the time is right. There is a big difference between developing a product and finding product/market fit, and promoting a product in ways that do not relate to product/market fit.  Attending parties is not what creates great companies. Typically you are not interacting with customers at a party. Having said that, as I wrote in my post on Nassim Taleb: “Living in a city, going to parties, taking classes, acquiring entrepreneurial skills, having cash in your bank account, avoiding debt are all examples of activities which increase optionality.” A balance is required in all things, and the level and intensity of party attendance and socializing is a part of that.

6. “Don’t confuse the cost to start a company [with] the cost of building a company.”  Creating a product or service and finding product market fit are only small steps toward success. Unless the business finds sales, marketing and distribution approaches that scale, a startup will not find success. There is a huge gap between finding product market fit and scaling a company. Bill Gurley of Benchmark Capital points out: “If you want to get to 50 to 100 employees (unless you’ve discovered the next Google AdWords) you’re going to need outside funding, but that doesn’t mean VC investment is the path for everyone.”

There are many attractive business opportunities that do not require and should not raise venture capital. Ben Horowitz of a16z writes: “Building modern companies is not low risk or low cost: Facebook, for example, faced plenty of competitive and market risks, and has raised hundreds of millions of dollars to build their business. But building the initial Facebook product cost well under $1M and did not entail hiring a head of manufacturing or building a factory.”

7. “Hire the guy who has something to prove.” “We want people who come from humble backgrounds and have a need to win.”

Especially since he came from humble beginnings economically, Doug Leone is a big fan of hiring people who are hungry for success. His partner Michael Mortiz explains: “Every time we invest in a little company, it’s a battle against the odds. We’re always outgunned by companies that are far larger than us, who have threatened us and the founders with extinction.”

The best VCs prefer missionaries to mercenaries, and people who have something to prove tend to be missionaries. I certainly have met people who were driven by the fact that they started with literally nothing before building a business. I’ve have found in my own life that many people who come from comfortable financial backgrounds are also driven to find success. Bill Gates and Craig McCaw are just two examples. Of course, some people from affluent backgrounds are also growing organic vegetables in a commune (not that there is anything wrong with that if it makes them happy).

8. “Be incredibly, ruthlessly selfish with your equity.”

Entrepreneurs who are not careful about dilution often learn a hard lesson about selling equity too cheaply.  The founders will need shares to compensate key people and to keep themselves motivated to stay “all in.” Bill Gurley has said that he’s “seen companies take one or two angel rounds and wind up giving away half their company.” There is a relevant old saying in the venture capital business: “There are three phenomena that can wreck even the best of investments: Dilution, Dilution, Dilution.”

A16z points out that there are many tradeoffs involved: “The easiest way to think about valuation is the tradeoff it provides relative to dilution: As valuation goes up, dilution goes down. This is obviously a good thing for founders and other existing investors. However, for some startups there’s an added wrinkle; they may face an additional tradeoff, of valuation versus “structure.” Which reminds us of the old adage that ‘You set the price, I’ll set the terms.’

Lots of people like Sam Altman  and Wealthfront have also written thoughtful, informative posts on this topic.

9. “What differentiated knowledge does the angel bring? . . . Don’t just do an angel round with people whose money is thrown your way.”

Given a choice between Angels who add both money & other contributions, or Angels with only money to contribute, choose the former. Especially circa 2015, raising money is not a problem if you have a great team and an offering under development with significant optionality. Founders increasingly realize that they need more than money from an investor. For this reason you see more and more venture capitalists blogging and using social media to convey to founders that they have more to contribute to a business than money. When is raising money from Angels a good idea? Ben Horowitz writes: “If you are a small team building a product with the hope of “seeing if it takes” (with the implication being that you’ll try something else if it doesn’t), then you don’t need a board or a lot of money and an angel round is likely the best option.”

10. “There are [venture] firms that have never generated a positive return or have not even returned capital in 10 years that are raising money successfully. And that surprises the heck out of me. People talk about the top quartile — it’s not about the top quartile, it’s barely about the top decile, or even a smaller subset than that.”

Pension funds and universities have ~ 8% return assumptions, and hope for some sort of justification that they will deliver magical returns via the venture capital asset class. In other words, they invest in the way that Doug Leone describes, since it enables the investment committee of the pension or endowment to defer the pain of reducing the return assumption – and that makes the underfunding problem the job of someone else in the future. No one associated with an endowment or pension likes to cut spending or raise contributions, so they pretend that certain returns are possible. This results in more money coming into the VC asset class than would otherwise be the case.

What this also causes is for money to chase performance in the venture capital asset class, and for this to be true: “Venture Capital has long been a trailing indicator to the NASDAQ. Venture capital is a cyclical business.” (quote from Bill Gurley)

11. “Just keep in mind that we are in a venture capital business. It’s called venture capital because nothing is certain. But if you look at our portfolio, it doesn’t include Twitter. It doesn’t include Pinterest. We have made many, many errors over the last 40, 50 years. But I’ll also tell you we’ve got many, many right.”

Venture capital is a business in which you are guaranteed to make mistakes, since it is all about buying mispriced optionality. It is magnitude of success and not frequency of success that matters in the end. The greatest venture capitalists, just like Babe Ruth, strike out a lot, but hit massive “tape measure home runs”. It is worth emphasizing that Doug Leone talked about “uncertainty” rather than risk. Uncertainty is actually the investor’s friend since it is the primary cause of mispriced assets. I discuss the difference between risk and uncertainty in my post on Vinod Khosla of Khosla Ventures. Without mispriced assets (i.e., the mistakes of other people), you can’t outperform the market, and it is when there is uncertainty that assets most often get attractively mispriced.

12. “If you’re in Cleveland, we cannot help you.”

Doug Leone said this in 2011. Unfortunately, physical location matters even with the Internet as a powerful tool to distribute expertise. My late friend Keith Grinstein used to say that “you can’t milk a cow over the phone.” Physical location still matters, which is why there are cities that benefit from agglomeration effects. Smart cities embrace this fact and create their own positive feedback loops.

If the venture capital firm is too far away from the startup, it is hard for the venture capitalist to provide much more than money. Without more than money, Doug Leone does not feel the company has the same probability of success. Since Doug Leone has helped established Sequoia branches overseas, he must believe that the Sequoia VCs in overseas city X can help startups in city X. Doug Leone obviously feels other cities can have agglomeration effects while investing in, or Sequoia would not have such big investments in China and India.

Don Valentine (the Founder of Sequoia), who I will write about soon, said once about his firm: “In 30 years we haven’t convinced ourselves to set up a presence in Boston. It’s a very difficult business to be good at consistently over a long period of time, and it requires a lot of thoughtful and integrated decision-making… We make enough mistakes on investments we make here (in Silicon Valley), that we’re not comfortable we can (be successful) 3,000 miles away, never mind 8,000 miles away.” If a city is a just a couple of hours away from a venture capitalist, I would argue that the rule doesn’t apply. Lots of venture capitalists from San Francisco have been successful investing in Seattle and vice versa, especially if they have strong venture partners in the other city. A firm like Benchmark Capital benefits immensely from having a partner like Rich Barton in Seattle.

Notes:

PEHub – Sequoia’s Doug Leone to Mike Arrington: Why You Want to Be a VC is Beyond Me

Forbes – Douglas Leone, Sequoia Capital’s secrets to success and PR for venture firms

Medalia – So you want to sell a startup? QA with Leone

WSJ – Sequoia Capital’s Leone: In Venture, Big Is the Enemy of Great

Kedrosky – Infectious Greed

Adweek – Are Startups Thinking Too Small?

Upstart – Sequoia’s Doug Leone

Techcrunch – Disruptive Tendencies

A Dozen Things I’ve Learned from Steve Jobs about Business

Before writing this blog post I decided to apply one of Steve Jobs’ ideas: “Deciding what not to do is as important as deciding what to do.” [1997] This is not a post about Steve Jobs as a person, so I have tried hard in this post to not discuss his personality. I try to limit the discussion to what I have learned from him about business. Of course, you are perfectly free to write a blog post or article about what he taught you about business. You can write a post about how his personality was a key part of his success in business too. You can also write a post and say: “That isn’t what Steve Jobs meant when he said X.” You could even be right, but that would not be what Steve Jobs taught me.

Dates of quotes are important in trying to understand Steve Jobs so I have included them in this post. A good friend of mine, who knew Steve Jobs very well, said to me: “He was a chameleon. And a really good one.” So when Steve Jobs said something really does matter in understanding what he meant.

1. “The difference between the best worker on computer hardware and the average may be 2 to 1, if you’re lucky. With automobiles, maybe 2 to 1. But in software, it’s at least 25 to 1. The difference between the average programmer and a great one is at least that. The secret of my success is that we have gone to exceptional lengths to hire the best people in the world. And when you’re in a field where the dynamic range is 25 to 1, boy, does it pay off.” [1995]

“The problem is, in hardware you can’t build a computer that’s twice as good as anyone else’s anymore. Too many people know how to do it. You’re lucky if you can do one that’s one and a third times better, or one and a half times better… Then it’s only six months before everybody else catches up. But you can do it in software. As a matter of fact, I think that the leap that we’ve made is at least five years ahead of anybody.” [1994] This phenomena described by Steve Jobs, when combined with supply-side economies-of-scale and demand-side economies-of-scale, creates a lollapalooza. The existence of lollapaloozas in an environment where scaling happens digitally over networks means that digital businesses are nonlinear in terms of its outcomes. This point is so fundamental to any digital business today that the Jobs quotes above must come first in my list. Once the offering of a business is digital, even small advantages tend to lead to a “few winners-take-most-all” result.

The power law distributions that exist in business flow from this “few winners-take-most-all” phenomenon. The great wealth of a tiny number of technology business founders is one outcome of this phenomenon. As another example, both (1) the power law distribution inside a venture capital firm’s portfolio and (2) the power law distribution of financial returns between venture capitalists, are driven by digital businesses being part of Extremistan. That financial outcomes tend to produce an unequal distribution of income is not a new phenomenon. The rich get richer phenomenon is at least as old recorded history. What is new is that digital systems are an accelerant of the Matthew effect (rich get richer) phenomenon.

This isn’t a post about technology but it is worth noting that the second quote above about hardware was made by Steve in 1994. NeXT had just exited the hardware business the previous year, and Steve Jobs’s grand vision was reduced to a software objects company. The iPhone was introduced in 2007. Did Steve prove himself wrong with iPhone or is there a way to square the circle? A very smart friend of mine points out:

“The irony about this quote is that the things that really made the iPhone special were all hardware. Large touchscreen with way more sensors for touch than anyone had done before. Screen twice the size of any cell phone. Tons of custom integrated chips. Multitouch and IOS would’ve made no sense without the innovative hardware to enable this.”

Would Steve Jobs say that, nevertheless, it is the software and other factors that maintain Apple’s moat for a longer period? To square the circle, one can argue that hardware still provides considerable advantage. I believe Steve Jobs is saying the advantage is not nearly as big as is the case with software, so hardware innovation must be constant. In other words, is Steve Jobs saying that hardware based moats are more precarious and require continual innovation? Hardware that is “a third times better or one and a half times better” is still an advantage. Wouldn’t it be fantastic if we could still ask him?

 

2. “If we don’t cannibalize ourselves, someone else will.” [Isaacson biography, 2013]

In an Extremistan environment, the same powerful nonlinear phenomenon that built you up, can tear you down just as quickly. If you go into denial, mistakes you make years before can end up causing severe financial pain. Bill Gates said to me many years ago that the potential downside of the power of network effects “is what makes me work so hard and worry so much.”

 

3. “Stay hungry. Stay foolish.” [2005]

Nassim Taleb wrote in his book Antifragile: “the idea present in California, and voiced by Steve Jobs at a famous speech: “Stay hungry, stay foolish” probably meant “Be crazy but retain the rationality of choosing the upper bound when you see it.” Any trial and error can be seen as the expression of an option, so long as one is capable of identifying a favorable result and exploiting it…” I have written previously that financial returns are created in the venture capital industry by harvesting optionality. To “stay hungry” is to be alert for opportunity, patient but ready to act aggressively when the time is right. To “stay foolish” is to be willing to buck conventional wisdom when there is a massive potential upside, and a relatively small downside (optionality).

 

4. “I have always wanted to own and control the primary technology in everything we do.” [2004]

“Because Woz and I started the company based on doing the whole banana, we weren’t so good at partnering with people. I think if Apple could have had a little more of that in its DNA, it would have served it extremely well.” [2005]

“We have to let go of this notion that for Apple to win, Microsoft has to lose. We have to embrace the notion that for Apple to win, Apple has to do a really good job. And if others are going to help us, that’s great.” [1997]

People like Steve Jobs, John Malone and Elon Musk understand the business problems associated with wholesale transfer pricing power as well as anyone in technology. Simply put: Wholesale transfer pricing = the bargaining power of company A that supplies a unique product XYZ to Company B, which may enable company A to take the profits of company B by increasing the wholesale price of XYZ. The way Steve Jobs used the iPod/iTunes business model even before iPhone to avoid the wholesale transfer pricing power of music owners was masterful.

 

5. “The cure for Apple [when it was down] is not cost-cutting. The cure for Apple is to innovate its way out of its current predicament.” [2004]

“A lot of companies have chosen to downsize, and maybe that was the right thing for them. We chose a different path.” [2010]

You can’t cut your way to success in the technology business. To stop investing in research and development means inevitable, usually nonlinear, decline. There are many current examples of companies paying the price of doing stock buybacks rather than investing aggressively in research and development. Eating your corn seed in a technology business is suicidal and spectacular in its negative consequences at scale.

 

6. “Even a small thing takes a few years. To do anything of magnitude takes at least five years, more likely seven or eight.” [1995]

Too many founders are unaware of the commitment that they are making when they start a business. To create something truly great takes years. Yes, a truly tiny number of people have flipped a SaaS business in a few years, but that is (1) not common and (2) not an Apple, Microsoft of Google class dent in the universe. The converse of this point is that not every business needs to make a dent in the universe. Owning a small but profitable business can be a very good thing. Not every business should raise venture capital.

 

7. “My model of management is the Beatles. The reason I say that is because each of the key people in the Beatles kept the others from going off in the directions of their bad tendencies…. They sort of kept each other in check. And then when they split up, they never did anything as good. It was the chemistry of a small group of people, and that chemistry was greater than the sum of the parts. And so John kept Paul from being a teenybopper and Paul kept John from drifting out into the cosmos, and it was magic. And George, in the end, I think provided a tremendous amount of soul to the group. I don’t know what Ringo did.” [2003]

This is a puzzling quote. He did say it so it is worth thinking about. A good friend who knew Steve Jobs said that he sought “control” like Paul and yet idolized John. The situation with the Beatles was not really comparable to Steve’s interaction with others. To truly understand what Steve Jobs meant here would require asking for clarification. It seems more likely that Jobs was referring to the fact that every person on Earth has strengths and weaknesses and that different personalities can balance each other and create a stronger team. By having a diverse team with complementary skills and talents the whole of the output of the team can be far greater than the sum of the parts, if you get the mix right. This lollapalooza outcome can be positive or negative. The venture capitalist Bruce Dunlevie once said to me that every once in while a team comes along that is truly special and magic things happen. Bruce said to me that the chemistry is never exactly the same, but there is something familiar about the pattern.

8. “Creativity is just connecting things. When you ask creative people how they did something, they feel a little guilty because they didn’t really do it, they just saw something. It seemed obvious to them after a while.” [1996]

“Being a beginner again… freed me to enter one of the most creative periods of my life.” [2005]

There are many heuristics that can get in the way of creativity. Sometimes it is hard to see what is right in front of your face. As just one example, Steve Jobs said once:

“The last few years at NeXT, I’ve gotten a little better glimpse of what I really saw at Xerox PARC [in 1979], which was two things. One blinded me to the other because it was so dazzling. The first, of course, was the graphical user interface. The second thing I saw–but didn’t see–was the elaborate networking of personal computers into something I would now call ‘interpersonal computing.’ At PARC, they had 200 computers networked using electronic mail and file servers. It was an electronic community of collaboration that they used every day. I didn’t see that because I was so excited about the graphical user interface.

It’s taken me, and to some extent the rest of the industry, a whole decade to finally start to address that second breakthrough– using computers for human collaboration rather than just as word processors and individual productivity tools.” [1991]

One of the things I have found in my writing is that people love and learn well from metaphors. Not only is connecting things in different ways a driver of creativity, it is a great way to convey knowledge. I am compelled to quote Charlie Munger yet again: “you can progress only when you learn the method of learning. Nothing has served me better in my long life than continuous learning.” When Steve Jobs refers to being a “beginner again” I strongly suspect he is referring to Shunryu Suzuki-roshi’s ideas including: “In the beginner’s mind there are many possibilities, but in the expert’s there are few.”

9. “I think part of what made the Macintosh great was that the people working on it were musicians and poets and artists and zoologists and historians who also happened to be the best computer scientists in the world.” [1996]

This sort of thinking is consistent with Charlie Munger’s “lattice of mental model’s” philosophy: “What is elementary, worldly wisdom? Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ‘em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form….You must know the big ideas in the big disciplines, and use them routinely — all of them, not just a few. Most people are trained in one model—economics, for example—and try to solve all problems in one way.” Many professionals often think only about their own discipline and think that whatever it is that they do for a living will cure all problems. A nutritionist may feel as if she can cure anything for example. Or a chiropractor may believe he can cure depression. These are examples of “man with a hammer” syndrome since to such a person “everything looks like nail” even though it may not be a nail. In the language of Philip Tetlock, it is better to be a “fox” (knows a little about a lot) rather than a “hedgehog” (knows a lot about very little).

10. “People think focus means saying yes to things you’ve got to focus on. But that’s not what it means at all. It means saying no to the hundred good ideas that there are. You have to pick carefully.” [2004]

“Innovation is saying no to a thousand things. That’s true for companies, and it’s true for products…. We’re always thinking about new markets we could enter, but it’s only by saying no that you can concentrate on the things that are really important.” [1998]

Focus is tremendously helpful. Focusing on what a business can do that is unique not only creates a sense of mission but is more likely to result in the creation of a moat. This is the same point made by Bill Gurley (tipping his mat to Howard Marks) when he points out: “Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.”

11. “Apple’s market share is bigger than BMW’s or Mercedes’s or Porsche’s in the automotive market. What’s wrong with being BMW or Mercedes?” [2004]

This quote pre-dates the iPhone, which changed everything for Apple. But it is interesting nevertheless since this approach is part of the path that took Apple to where it is now. In any event, really big markets create really big opportunities. When I write my post on Don Valentine of Sequoia (who was an original investor in Apple) I will discuss that point in some detail. Don Valentine said once: “I like opportunities that are addressing markets so big that even the management team can’t get in its way.” My post on Andy Rachleff address this point as well.

12. “I’m convinced that about half of what separates successful entrepreneurs from the non-successful ones is pure perseverance.” [1995]

In several of my blog posts I have talked about the difference between missionary and mercenary founders. Missionaries tend to have more perseverance and are much more likely to create a company with massive impact (i.e., put a dent in the universe). Bill Gates said once; “we were kind of naively optimistic and built big companies. And every fantasy we had about creating products and learning new things — we achieved all of it. And most of it as rivals.” If I was able to be a fly on the wall of one meeting between two people who put actually a dent in the technology business it would have been the last meeting between Bill Gates and Steve Jobs. I can’t resist adding that Don Valentine once said to Regis McKenna (who had sent Steve Jobs to talk to him): “Why did you send me this renegade from the human race?” My friend Craig McCaw uses the word “renegade” and similar terms in the same positive way to describe someone who can break the mold and create new value for the world.

Notes:

Steve Jobs – The Lost Interview

The Playboy Interview

1993 Rolling Stone Interview

2003 Rolling Stone Interview

Several Steve Jobs interviews

Steve Jobs biography

HBR Article

CBS News – Steve Jobs in his own words

 

Wired – Steve Jobs commentary

FastCompany – Steve Jobs wisdom

A Dozen Things I’ve Learned From Comedians About the Business of Life

1. “Wealth is not about having a lot of money; it’s about having a lot of options.” Chris Rock.

“The only thing money gives you, is the freedom of not worrying about money.” Johnny Carson.

The best thing about having money is having good choices in life. An essential challenge if you are poor is having terrible choices. Having terrible choices feeds back in a self-reinforcing negative way. People who think that the best thing about wealth is that it allows you to have material things are, well, bonkers.

How far this faulty thinking can go is best illustrated by a story. A successful businessman parked his brand-new Porsche in front of his office so his colleagues could see it. As he stepped out of the new car, a truck passed too close and ripped off the door on the driver’s side. A bystander dialed 911 and within a few minutes a policeman arrived. Before the officer could ask any questions, the business man began screaming hysterically that his new Porsche was now completely totaled.  It was only after a half hour of ranting that the officer was able to talk to the man. “I can’t believe how materialistic you are,” the police officer said. “You are so focused on your possessions that you don’t notice anything else.” The businessman was clearly offended: “How can you say such a thing?” The policeman replied: “Don’t you know that your left arm is missing from the elbow down? It must have been torn off by that truck.” “My God!” screamed the man. “My Rolex!”

2. “If you’re an average layperson, your grasp of high finance consists of knowing your ATM code.” Dave Barry. The average person is an idiot when it comes to spending and investing money. There is no getting around this fact and sugarcoating the problem does not help anyone. The skills that allowed humans to survive in a more primitive world do not naturally provide the skills necessary for a human to prosper as a consumer or investor in a modern word. In other words, evolution did not equip humans to spend and invest wisely.

The good news is: you can learn to spend and invest better since it can be trained response. The bad news is: the need to train yourself never ends, requires hard work and is contrary to the desire of most humans to enjoy present moment consumption. People who have not trained themselves to be investors need help. The best sort of help is self-help in the form of reading and paying attention. Yes, you may be able to find a trustworthy advisor to help you but you still must work and educate yourself and find an adviser who adds value – and then properly take their advice.

Unfortunately, most people don’t even know where to begin. So the result is predictable. As just one example, on the savings side of the house: Adults under age 35 (millennials) currently have a savings rate of negative 2%, according to Moody’s Analytics. That compares with a positive savings rate of about 3% for those age 35 to 44, 6% for those 45 to 54, and 13% for those 55 and older.” Bankrate reports that “26 percent of Americans have no emergency savings and 41 percent say their ‘top financial priority’ is simply staying current with their expenses or getting caught up on their bills.”

3. “About 15 years ago, I saw an Oprah show where she said, ‘Always be the only person who can sign your checks.” At the time, I had no money. I was at Second City in Chicago. I came to New York in 1997 to work on Saturday Night Live. I realized I have no head for business. And it would have been very easy for me to let someone take control of my money – for me to say, ‘Here, sign my checks…whatever.’ But that line from Oprah has always been a reminder. Today, as much as it makes me super sleepy, I have to pay a lot of attention when my business manager talks to me about money. He talks to me about taxes, and I get really, really sleepy. But I listen.” Tina Fey. I’m old enough to have seen misplaced trust go wrong many times. A classic example happens when a child is managing money for a parent and spends it on themselves in ways that the parent is unaware of (e.g., gambling, travel, toys). The person who breaks trust will often try to justify the spending by saying to themselves that they will pay it back with interest. Systems that promote trust are fundamental to commerce. For example, the invention of the cash register was an important development in spreading commerce. Another system for not having your life ruined by someone who breaks your trust is “signing your own checks.”

4. “A fool and his money are soon partying.” Steven Wright

“Cocaine is God’s way of saying that you’re making too much money.” Robin Williams.  I’m unfortunately old enough to have seen people literally kill themselves because they had too much money and took their love of stimulating substances to an early grave.  The number of lives and families I have seen ruined by alcoholism is too big to count. I’m not saying don’t drink, but I am saying you should be very careful – especially if you have a family history of alcoholism. Chris Rock points out that substance abuse can dissipate money fast: “Wealth is passed down from generation to generation. You can’t get rid of wealth. Rich is some shit you can lose with a crazy summer and a drug habit.” 

5. “Liz Lemon (as played by Tina Fey): “I have got to make money and save it and I have to do that thing that rich people do where they turn money into more money. Can you teach me how to do that?” Jack: ““With my eyes closed.” The Mathew effect (i.e., the rich get richer) is one of the most powerful forces at work in society today. It explains a lot about many things, including income and wealth inequality. Both success and failure have always fed back on themselves, but in a digital economy that process is accelerated and creates what Nassim Taleb calls Extremistan. Edgar Bronfman said once: “To turn $100 into $110 is work. To turn $100 million into $110 million is inevitable.”

Comedians know all too well that incomes in their industry reflect a power law. Acting is similar: “‘If you’re [a big star], you’re getting well paid’” says one top agent, ‘but the middle level has been cut out.’ As an example, Leonardo DiCaprio made $25 million for The Wolf of Wall Street, while co-star Jonah Hill was paid $60,000. According to the most recent Screen Actors Guild statistics, the average member earns $52,000 a year, while the vast majority take home less than $1,000 a year from acting jobs.”

6. “When people are getting richer and richer but they’re not actually producing anything, it can’t end well.” Louis CK.  During the portion of the Internet bubble that lasted from 1999 to 2000, the thing that troubled me the most was that it seemed like everyone I knew was too rich. It was possible to go out to lunch and come back $500,000 richer on paper.  This paper wealth wasn’t real but yet it drove extreme “fear of missing out” which drove the bubble to ever-higher levels. If loads of people in society are not producing anything but they are getting richer nevertheless, it is what poker players call a “tell.” When the tide eventually goes out, it is easy to spot who has been swimming naked. It’s like the story about the man who walked by a table in a hotel and noticed three men and a dog playing cards. “That is a very smart dog,” said the man. “He’s not that smart,” replied one of the players. “Every time he gets a good hand, he wags his tail.”

7. “Credit and debt is the root of all evil.” Chris Rock. If you borrow money to invest, the outcome of your successes will be magnified, but so will the outcome of your mistakes. If you are investing, compounding is a tailwind, but if you are borrowing, compounding is a headwind. Few people have trained themselves to understanding the power of compounding. There is a story that is relevant: “The king was a big chess enthusiast and had the habit of challenging wise visitors to a game of chess. One day a traveling sage was challenged by the king. To motivate his opponent, the king offered any reward that the sage could name. The sage modestly asked just for a few grains of rice in the following manner: the king was to put a single grain of rice on the first chess square and double it on every consequent one.

Having lost the game and being a man of his word, the king ordered a bag of rice to be brought to the chessboard. He started placing rice grains according to the arrangement: 1 grain on the first square, 2 on the second, 4 on the third, 8 on the fourth and so on. Following the exponential growth of the rice payment, the king quickly realized that he was unable to fulfill his promise. On the twentieth square the king would have had to put 1,000,000 grains of rice. On the fortieth square, the king would have had to put 1,000,000,000 grains of rice. And, finally on the sixty fourth square the king would have had to put more than 18,000,000,000,000,000,000 grains of rice which is equal to about 210 billion tons – allegedly sufficient to cover the whole territory of India with a meter thick layer of rice.

The king should have responded in the following way: “Before you receive the rice, just to be sure you are getting what you asked for, I’d like you to count each and every grain.” It takes one second to count a grain of rice. To count the number of grains he’d been promised, it would have taken the sage a half-trillion years.

8. “A bank is a place that will lend you money if you can prove that you don’t need it.” Bob Hope. There is a related joke on the topic of collateral:  A man drives into a new city in an expensive Porsche and visits a prominent bank. While there he asks for a loan of $1000 since forgot his wallet. The banker says” “OK, but you have to leave your Porsche and the keys here as collateral”.  The man agreed and at the end of the week he returned the $1000 plus interest of $4 for a short term loan plus processing fee. Curious, the banker asks why he didn’t just get a wire transfer and the man replied “Where else could I park my car for $4 for a week?”

9. “My bank is the worst. They are screwing me. You know what they did to me? They’re charging me money for not having enough money. Apparently, when you’re broke, that costs money.”

“I had five dollars [in the bank] that I couldn’t have for three days until they charged me another 15. Leaving me with -10. What does that mean? I don’t even have no money any more. I wish I had nothing… I have not ten. Negative ten. I can’t afford to buy something that doesn’t cost anything. I can only afford to get something that costs, you-give-me-ten dollars.” Louis CK.  One way to get to negative money is to have an overdraft protection agreement with a bank. This arrangement allows the consumers spend more money than is in their accounts for a fee that averages $34 per transaction. This is essentially a loan, and the effective interest rates are massive.

Overdraft loans are not the only problem. There are now more than 20,000 payday lenders in the United States. The mean payday loan borrower earns $22,476 a year and is paid $458 in fees. The median amount borrowed from a payday lender was $350, for a 14-day term. Median fees amount to $15 per $100, which is an APR of 322%. Borrowers with payday loans on average are in debt to their lenders for 199 days during a year.

10. “Wealth – any income that is at least one hundred dollars more a year than the income of one’s wife’s sister’s husband.”  H. L. Mencken. Envy has zero upside. None whatsoever. If you can learn to turn off the envy, your life gets better. To the extent you are successful, you will hopefully be happier and you will make better decisions. But, of course, it is easier to say than do.  Joan Rivers said once: “Don’t expect praise without envy until you’re dead.” If what she said wasn’t a little true, it wouldn’t be funny!

Warren Buffett put it this way: “As an investor, you get something out of all the deadly sins—except for envy. Being envious of someone else is pretty stupid. Wishing them badly, or wishing you did as well as they did—all it does is ruin your day. Doesn’t hurt them at all, and there’s zero upside to it. If you’re going to pick a sin, go with something like lust or gluttony. That way at least you’ll have something to remember the weekend for.”

11. “There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.”  Mark Twain. There is arguably nothing more fundamental to investing than the difference between a speculator and an investor. John Maynard Keynes defined speculation as “the activity of forecasting the psychology of the market.” Speculating is about trying to forecast price. Investing, by contrast, is about trying to buy an asset at a discount to its value. The semantics on this set of issues are tricky and both Robert Hagstrom and Howard Marks have nuanced and well thought through views that are worth reading.

The key to understanding the difference is determining whether a given activity is net present value positive or negative. Which reminds me or a story. A friend of mine once went into a butcher shop and said, “I will bet you $500 that you can’t reach that bit of meat,” pointing to a cut of beef hanging above him on a hook. The butcher looked up and said, “No way I will take that bet.” My friend asked, “Why not?” And the butcher answered, “The steaks are too high!”

12. Navin R. Johnson: [played by Steve Martin] “’I’ve already given away eight pencils, two hoola dolls, and an ashtray, and I’ve only taken in fifteen dollars.’ Frosty: “Navin, you have taken in fifteen dollars and given away fifty cents worth of crap, which gives us a net profit of fourteen dollars and fifty cents. Navin R. Johnson: “Ah… It’s a profit deal. Takes the pressure off.”  This dialogue from the movie The Jerk has always appealed to me, since so many people in life don’t understand the difference between revenue and profit.  People will often say that X “makes” a lot of money.  What the heck does “make” mean?  Counterfeiting? The idea that revenue and profit are not the same thing escapes too many people. Whether a business creates value and whether a business captures value are independent outcomes.  Too many people have an understanding of business that is similar to the “Underpants Gnomes” in the South Park episode in which the following business plan is presented:

  1. Collect Underpants
  2.  ?
  3. Profit

This problem is made worse by certain financial practices invented by creative CFO’s. Jim O’Shaughnessy points out that many investors “argue that earnings can be easily manipulated by a clever chief financial officer, using an old joke as an example: A company wants to hire a new chief financial officer. Each candidate is asked just one question. ‘What does two plus two equal?’ Each candidate answers four, with the exception of the one they hire. His answer was: ‘What number did you have in mind?’”

Here’s the scene from the Jerk & the Louis CK bank story.

A Dozen Things I’ve Learned from Marissa Mayer about Business, Management, and Innovation

 

 

  1. “Technology companies live and die by talent. That’s why when people talk about the talent wars…when you see the best people migrating from one company to the next, it means that the next wave has started.” “Really in technology, it’s about the people, getting the best people, retaining them, nurturing a creative environment and helping to find a way to innovate.”  “I definitely think what drives technology companies is the people; because in a technology company it’s always about, what are you going to do next?” “It’s really wonderful to work in an environment with a lot of smart people.”  “I realized in all the cases where I was happy with the decision I made, there were two common threads: Surround myself with the smartest people who challenge you to think about things in new ways, and do something you are not ready to do so you can learn the most.” Among the most common themes in my series of posts is exactly what Marisa Mayer identifies in these quotes.  It is not possible to be successful in business without great people. Great people attract more great people in ways that are mutually reinforcing creating a positive feedback loop. Whether great people are arriving or departing is something a CEO must make a top priority. Marissa Mayer, through “talent acquisitions” and otherwise, has clearly been very focused on improving the talent base at Yahoo. Marissa Mayer understands that in a technology business, when a fire alarm goes off, the most important assets of the business leave the building. Lee Iacocca once astutely said: “I hire people brighter than me and I get out of their way.” Jack Welch has similarly said: “The essence of competitiveness is liberated when we make people believe that what they think and do is important – and then get out of their way while they do it.”

 

  1. “Every organization has a drawback. There are some companies that go back and forth between a functional and divisional organization.  In the end, it doesn’t matter. It’s important to know what those drawbacks are and work around them. But you shouldn’t spend too much time reorganizing.” Anyone who has worked at a big company has experienced reorganizations. The classic move in any reorganization is between a divisional organization and a functional organization.  Each organizational structure has certain benefits and drawbacks.  For example, in a divisional organization, each group within the company is responsible for its own each product(s) as well as its own profit-and-loss results. GE is often cited as a classic example of a divisional organization. Supporters of the divisional organization argue the structure creates clearer accountability for results and less dependencies on other groups.  If a functional structure is adopted, each group is organized by function(s). Supporters of a functional organization argue that the system prevents a “warring tribes” culture in which groups fail to cooperate. They also argue that when products must be tightly integrated, functional structure works more effectively. Motorola of 20 years ago is often cited as a company where a “warring tribes” culture was actually encouraged by management. Apple is often cited as an example of a company with a functional organization. Marissa Mayer isn’t saying don’t ever reorganize. What she is saying is that: (1) a CEO and their board should carefully chose a structure and not be jumping back and forth between functional and divisional choices and (2) once the structure is chosen, the CEO’s task is to exploit the strengths of the structure chosen and “work around” the weaknesses.

 

  1. “I don’t know a lot about genetics, but I understand some of it and I think that what you really want are the genes that are positive to hyper-express themselves in culture. Take the elements of fun, take the elements that are really motivating and inspiring people, and amplify them and ramp them up. And take some of the negative genes that are getting in the way and shut them off, and figure out what’s causing those and shut them off… When you’re coming into a company, and you know you have to do a transformation, what you really want to do is look at the company and say, ‘Okay, here are the parts that the company does well. How do we get those genes to hyper-express? The genes that are getting in the way, how do you turn those off?’” The importance of culture is another theme in this series of blog posts. Mayer’s analogy to genetics is a great one when thinking about culture. Culture is something that when done right is almost automatic, as is the expression of a gene. A culture that has gone off the tracks is a genuinely hard problem to solve.  Bill Gates said once that he admired what Lee Iacocca did at Chrysler since turning around a culture is such a very hard thing to do.  For the same reason Warren Buffett once said “turnarounds seldom turn” a CEO who wants to create cultural change must put a lot of effort into the process and deserves applause if they do it successfully.

 

  1. “The interesting thing about being CEO that’s really striking is that you have very few decisions that you need to make, and you need to make them absolutely perfectly. …you can delegate a lot of the decisions, but there are a few decisions, and sometimes it’s not obvious, that you need to really watch, and that can really influence the outcome. [As a CEO you must watch] for those decisions every day wondering to yourself, ‘Is this one of them or is this one where it doesn’t really matter what the decision ends up being?’” “Eric Schmitt would always say this very humbling thing that’s really true, which is that good executives confuse themselves when they convince themselves that they actually do things. He would say, look, it’s your job as leadership to be defense, not offense. The team decides we’re running in this direction and it’s your job to clear the path, get things out of the way, get the obstacles out of the way, make it fast to make decisions, and let them run as far and fast as you possibly can.” Marissa Mayer is making two important points here. The first relates to the importance of a CEO setting a direction by making a small number of pivotal decisions. The second relates to making sure that people have the freedom and resources necessary to get things done. Someone I really admire who has been a senior executive for decades puts it this way: “I think far too many people think ‘management decisions’ or ‘leadership = decisions’” – I agree. If the CEO is constantly dropping down into the organization and making decisions for people, processes inevitably bog down, the CEO inevitably makes many poor decisions since he or she is not close enough to the situation and the teams involved become dispirited and less confident since they are being second-guessed.

 

  1. “Product management really is the fusion between technology, what engineers do – and the business side.” Striking the right balance between “the business side” and “what engineers do” is a core function of the CEO. The focus of my own career has been on what Marissa Mayer calls “the business side.” But if everyone limits their scope to just one side, the business is going to have a huge problem. I’m a fan of this Mike Maples, Jr definition of a business model: “The way that a business converts innovation into economic value.” To make this happen you need strong talents on both the business and technology sides, but at least a few key people need to understand how to link the two sides. Call these people spanners or whatever, they perform a necessary and even critical function. As an example of Marissa Mayer understanding this need and taking action to create a class of people who can span the two sides, she was the founder of Google’s Associate Product Manager Program. Wired magazine wrote once about this innovative program as follows: “Google would hire computer science majors who just graduated or had been in the workplace fewer than 18 months. The ideal applicants must have technical talent, but not be total programming geeks — APMs had to have social finesse and business sense. Essentially they would be in-house entrepreneurs. They would undergo a multi-interview hiring process that made the Harvard admissions regimen look like community college. The chosen ones were thrown into deep water, heading real, important product teams ‘We give them way too much responsibility,’ Mayer once told me, ‘to see if they can handle it.’ ” This sort of cross disciplinary training is invaluable for both businesses and the individuals involved since the skills learned can help a company avoid “man with a hammer syndrome.” The best solutions always involve tools and approaches from multiple disciplines.

 

  1. “The beauty of experimenting … is that you never get too far from what the market wants. The market pulls you back.”  “If you launch things and iterate really quickly people forget about those mistakes and they have a lot of respect for how quickly you build the product up and make it better.” Innovation, not instant perfection. ..when we launch something people immediately say, “Well, it’s so rough it’s not very good”. …But the key is iteration. When you launch something, can you learn enough about the mistakes that you made and learn enough from your users that you ultimately iterate really quickly? I call this my Max and Madonna theory. We look at, like, Apple, Madonna. They were cool in 1983, they’re still cool today, 2006, 23 years later. And that’s really amazing to look at, and people think of them as very innovative and very inventive. How do they do it? And the answer is, they don’t do it being perfect every single time. You know, there’s lots of mess-ups along the way. Apple had the Newton, Madonna had The Sex Book. There’s been all kinds of controversies and mistakes made. But the answer is, when they make a mistake, you re-invent yourself. And I think that’s ultimately the charge that we have, is to launch these innovations and then make them better.” Marissa Mayer has a “New Product Development” class on Udemy.  The syllabus notes: “Marissa Mayer, Google’s Vice President of Search Products & User Experience, by which the company bases its decisions. Google’s approach is the take the guesswork out of product design, from functionality to shades of color, and they believe in the science of well-monitored and frequent A/B testing.” Marissa Mayer is talking in this set of quotes about the iteration process that that I wrote about in my post on Eric Ries and Lean Startup. In that post I explained that there are tradeoffs involved in a lean process, and the right choice depends on the nature of the business, the opportunity and how much cash is available. Applying the scientific method to business can reap big rewards. As an aside, readers of this blog know that I recently wrote a post on Bill Murray who starred in the greatest movie ever created on A/B testing: Groundhog Day.

 

  1. “When you can make a product simpler, more people will use it.” “When you see that notion in a product where you’re just like ‘wow this helps me do something I didn’t think I could do or helps me do something I didn’t think I could this easily; that’s the mark of a great consumer product.”  “I think a great product is something where you see an acute user need and you solve it in a way that is frictionless and beautiful. You really hope there’s an element of personality and delight there. But I do think it’s identifying the need and then finding an easy way to solve it. Sometimes you can solve it straight and head on….sometimes you solve it in an interesting way….sometimes it’s about innovation, sometimes it’s about coming at the product very much head on, but it’s really about having an eye for design and eye for the user need. How to not get in the users way. How can you just help someone immediately get something done especially if they’re doing something every day, multiple times per day, you really want it to be something that is easy and fast and simple with nothing in the way.” There is no doubt that what Marissa Mayer describes is hard. And that some people are better at this process than others. And that a very small number of people are savants in creating great products. And that some people create great products “once in a row.” I would also add that there are way more strikeouts than tape measure home runs in this process. And that the results are very often winner take all. It is tricky stuff. Most things fail. The products that do succeed, regardless of whether they were created by skill or luck, or a measure of both, move society forward.

 

  1. “You can’t have everything you want, but you can have the things that really matter to you.” “Innovation is born from the interaction between constraint and vision.” “People think of creativity as this sort of unbridled thing, but engineers thrive on constraints. They love to think their way out of that little box: ‘We know you said it was impossible, but we’re going to do this, this, and that to get us there.” “Constraints can actually speed development. For instance, we often can get a sense of just how good a new concept is if we only prototype for a single day or week. Or we’ll keep team size to three people or fewer. By limiting how long we work on something or how many people work on it, we limit our investment. In the case of the Toolbar beta, several key features (custom buttons, shared bookmarks) were tried out in under a week. In fact, during the brainstorming phase, we came up with about five times as many “key features.” Most were discarded after a week of prototyping. Since only 1 in every 5 to 10 ideas works out, the strategy of limiting the time we have to prove that an idea works allows us to try out more ideas, increasing our odds of success.” Many of my own formative years were spent in the wireless business. One things I learned in that business is that almost everything has tradeoffs, and that there are constraints everywhere. As an example, “Shannon’s law, which basically defines how much data can be sent over wireless links, considering the amount of spectrum, number of antennas, amount of interference, etc. To increase capacity could increase the amount of spectrum, or you could also increase the number of antennas, as done with MIMO (multiple input multiple output) or utilize small cells.” In my way of thinking, MIMO is a classic example of engineers facing the sort of constraint Marissa Mayer talks about (e.g., laws of physics are laws and not guidelines) and nevertheless innovating. As Sir Ernest Rutherford, the famous New Zealand physicist once said: “We haven’t got the money, so we’ve got to think!”

 

  1. “We believe that if we focus on the users, the money will come. In a truly virtual business, if you’re successful, you’ll be working at something that’s so necessary people will pay for it in subscription form. Or you’ll have so many users that advertisers will pay to sponsor the site.” “If you’re really successful and you get used a lot, there’s usually a very easy and obvious way to figure out how to monetize it.” This approach to business model creation is founded in optionality. I have written about optionality many times in this blog series. You want to find situation where an investment has a small potential upside and a massive potential upside. The optionality-based thesis in this case is: get unique users and data about those users, and the odds are excellent that a way can later be found to a profitable business model (or a sale of the company which needs to play defense). This process can work in a spectacular fashion but can also fail both in a spectacular way and in quiet obscurity. This business model development based on optionality process works best if the business  happens to have a moat. Extrapolating the Google experience to startups is not fully applicable or realistic, since Google owns the AdWords platform and startups can’t easily use new services as loss-leaders to feeder into something like that which has a moat.

 

 

  1. “There’s a myriad of different places that ideas come from, and what you really want to do is set up a system where people can feel like they can contribute to those ideas and that the best ideas rise to the top in sort of a Darwinistic way by proof of concept, a powerful prototype, by demonstrating that’s it’s going to fill a really important user need, and so on and so forth.” Marissa Mayer has worked hard to stamp out a “not invented here” mentality when it comes to ideas many times on her career. She believes systems to float new ideas and filters that enable truly worthy ideas to be acted upon are essential. This is particularly hard to do once a company reaches significant scale. Her Udemy class includes this description of her views on ideas: “Both the enterprise and the end users are better served by a culture that revolves around rewarding great ideas, rather than the self-promotion of getting others to acknowledge the contributions of an individual. Marissa Mayer… believes that if you fill a room with smart people and give them access to information, brilliant ideas will flourish, and the need for a strict management hierarchy dissolves. A platform for the free-form sharing of ideas promotes an open culture and a flat organization.”

 

  1. “I think threats are always opportunities…and I think the opportunity for us is to focus on the users and innovate.” There are two important ideas at work here. First, most positive most things in life have a negative flip side. I have a friend who likes to say about these situations arising in business: “You can’t eat ice cream all the time without getting fat.”  I will avoid the ever-present and often debunked reference to Chinese characters having double meanings. You may have encountered a version of this saying in an episode of the Simpsons: Lisa: “Look on the bright side, Dad. Did you know that the Chinese use the same word for ‘crisis’ as they do for ‘opportunity’? Homer: Yes! Cris-atunity.” But the essence of the story is true. In engineering and life, there are often inevitable tradeoffs.  And one of those tradeoffs is that what is most challenging is usually a huge opportunity. The other important point that Marissa Mayer is making here is that she is focused on innovation which benefits users. There are many types of innovations but not all of them benefit users. If they are not reminded of this engineers can often end up working on innovations that to do not translate into customer value. These innovations that do not benefit users may be quite interesting problems, but they do not drive the business forward.

 

  1. “We have this great internal list [at Google] where people post new ideas and everyone can go on and see them. It’s like a voting pool where you can say how good or bad you think an idea is. Those comments lead to new ideas.” Mayer discusses her approach to this opportunity in some detail in the Udemy Class linked to above. At Yahoo, she has launched an effort known as “PB&J” which is designed to rid Yahoo of dysfunctional “processes and bureaucracy and jams.”  Yahoo has created online tools to collect employee complaints and voting process which that stack rank PB&J problems so they can be addressed in an order which will produce the greatest impact. One consistent theme of these twelve quotations is that great ideas do not only come from the top of company management. As was specifically noted above, the job of a CEO is in no small part about clearing the way so other people in the business can get things done.

 

Notes:

Stanford Lecture

Wired – Mayer’s Secret Weapon

Disrupt interview

Davos (video)

Charlie Rose (video)

Vanity Fair – Marissa Mayer of Yahoo & Google

A Dozen Things I’ve Learned From Mark Suster About Venture Capital and Startups

Mark Suster blogs at Both Sides of the Table, which describes him as follows. “Mark Suster is a 2x entrepreneur turned VC. He joined Upfront Ventures in 2007 as a General Partner after selling his company to Salesforce.com.”

Writing this post on Mark Suster has been relatively easy since he writes and speaks clearly, thinks rationally and is generous with advice. He is also fearless in terms of the positions he takes on issues even if they are contrarian, which makes what he says quite interesting.

Coming up with twelve solid quotes from a public figure is not as easy as you might think. There are a lot of people I would *love* to write about but they are private and don’t say much in public about business or investing. Some people who would otherwise have a lot to teach about investing or startups work very hard to stay out of the press. Mark Suster is, by contrast, such a prolific source of material that instead of struggling to find quotes to include, I had to figure out what to cut out.

1. “If it’s your first time getting funding, you shouldn’t over-raise. Take whatever the right amount of money is for you, whether that’s $1 million, $5 million, or $10 million.” “Try to raise 18-24 month capital.” “When the hors d’oeuvres are passed, take two.… But, put one in your pocket.”

“What I like about raising less money is it allows you to move slower, and with a new company, you don’t really know what the demand [for your startup] will be. If you realize ‘holy crap, we’re on to something here,’ then you can always raise more money. “If you raise, say, $7 million off the bat, you’re on the express train. It’s either a big outcome or nothing if you assume investors are expecting 4X their money. Keep in mind that companies aren’t regularly bought for $100 million+ either.”

“VC’s want meaningful ownership … and the ‘fairway’ is 25-33% of your company.” “Be careful about ever dipping below 6 months of cash in the bank. You start fundraising when you have 9 months left and begin to panic if you get down below 3 months.” The only unforgivable sin in business is to run out of cash. But raising too much cash can also cause significant pain due to dilution. Getting the mix right between these two states is an art and not a science.  Of course, these are general rules, and the right amount to raise & to have on hand in any given case will depend on factors like

– the nature of the business (e.g., is it capital intensive; is customer acquisition cost high, how high is the burn rate) and

-the current state of the business cycle, which is constantly in flux. Venture capital is a very cyclical business.

As just one data point, Wharton recently quoted Pitchbook as saying: “in the past, Series A rounds meant entrepreneurs would give up roughly 33% of their company. This year, the average is around 27.7%.” That is after a seed round, and in today’s world you can get an extreme situation where startup has raised as much a $5 million in convertible debt before they do a Series A round. Bill Gates famously wanted enough cash in the bank to cover a full year of expenses in the early years of Microsoft, but (1) that was a different time and place with very different business models and (2) the business was generating that cash internally. Microsoft raised no venture capital, except for a small amount near the IPO to convince a specific investor to join the board of directors. Many people forget that when Microsoft went public Bill Gates owned about 50% of the company, which is a very rare thing. In contrast, some founders today have diluted themselves down to a few points of the equity by chasing fast growth in a cash consuming business model.

Finally, raising too much money can cause a lack of discipline and focus. Benchmark Capital’s Bill Gurley points out that “more startups die of indigestion than starvation.” Someone pointed out this week that too much money also means that issues and problems that should be dealt with by company culture are resolved instead by money which can mean that long term stability is threatened.

 

2. “There is no “right” amount of burn. Pay close attention to your runway.” “Your value creation must be at least 3x the amount of cash you’re burning, or you’re wasting investor value. Think: If you raise $10 million at a $30 million pre ($40 million post) that investor needs you to exit for at least $120 million (3x) to hit his/her MINIMUM return target that his/her investors are expecting. So money spent should add equity value or create IP that eventually will.” “Raising venture capital is like adding rocket fuel to your company… — which leads to a lot of bad behavior.” There is a big difference between a cash burn rate that is too high and valuations that are too high. The press has a huge tendency to transform a comment about burn rates being too high into a comment about valuations being too high. I suspect this happens because the concept of wealth is both easier to understand and a topic that readers are fascinated with.

Valuation and burn rate are not the same. Businesses can be spending too much cash in an environment where valuations are reasonable. Spending too much cash is a fast ticket to dilutionville or a broken capitalization table, which is an ugly place to be. Having some cash in reserve can come in very handy when markets essentially stop providing new cash for a period of time. Bill Gurley has told a great story about how OpenTable had to cut its cash burn rate severely when the ability to raise new cash dried up in the early 2000’s (when the Internet bubble popped) and the company was able to hang on for many years until growth resumed. Since market disruptions in the short term can’t be predicted with certainty, some amount of cash cushion has positive optionality. The question is not whether a cash reserve is needed, but how much. Danielle Morrill has a great post on burn rates which includes a $200K fully burdened cost-per-employee.

 

3. “The average VC – traditional VC – does 2 deals per year… from maybe 1,000 approaches.” Don’t take it personally if a VC does not want to invest in your startup. There are many reasons that potential investors say no. Also, try not to forget that the numbers cited by Mark Suster obviously mean that the top 100 VCs (individuals not firms) only make ~200 investment a year. Given that about 4,000 startups want to get funded in a given year, not all of them will be funded by a top 100 VC. The scarcest asset a VC has is time, and as a result they can only be he helpful to so many portfolio companies and on so many company boards. In other words, a great VC is more time-limited than capital-limited. If you do get funded, it will likely be after making a significant number of unsuccessful approaches and actual pitches. Some people can get funded quite quickly because of their reputation but they are the exception and not the rule. The venture capital firm Bessemer has a nice page that lists all the startups they rejected.

 

4. “You have to ask for the order.” Success in the venture business is way more dependent on sales skills than people imagine. VCs, founders and startup executives are constantly selling. The range of things that must be sold is long. Selling the prospects of the business to potential new employees is a huge part of what must be done for a startup to be a success. They are selling services and products, but also to potential investors and employees. If you don’t want to spend time and effort selling these things, starting a company is not something you will be much good at. And to sell successfully, you need to “ask for the order” since if you don’t do this you will never close a sale. The best product or service does not always win if the team does not learn how to sell it. As John Doerr said once: “Believe me, selling is honorable work — particularly in a startup, where it’s the difference between life and death.”

 

5. “Tenacity is probably the most important attribute in an entrepreneur. It’s the person who never gives up—who never accepts ‘no’ for an answer.” “what I look for in an entrepreneur when I want to invest? I look for a lot of things, actually: Persistence (above all else), resiliency, leadership, humility, attention-to-detail, street smarts, transparency and both obsession with their companies and a burning desire to win.” There are times in the life of every successful startup when they seem to be flying inches from disaster and close to death. If the founders and leadership of the company lose their nerve the outcome is very seldom pretty. Jane Park (the founder of e-commerce startup Julep) tells a great story about how the 2007 financial crisis took her company to the brink of running out of cash, and how she had to borrow $100,000 from her parents to save the business. That was courageous not only on her part but her parents, given that it was 50% of the money they had saved at that point in their lives toward retirement. The other great part of the story is how she used analytics to save her business. The data told her that people were not coming in as often, but were spending just as much when they did visit. By creating a loyalty program, Julep was able to get though the crisis. That’s a fantastic example of tenacity.

 

6. “I hate losing. I really hate losing. But you need to embrace losing if you want to learn. Channel your negative energy. Revisit why you lost. Ask for real and honest feedback. Don’t be defensive about it—try to really understand it. But also look beyond it to the hidden reasons you lost. And channel the lessons to your next competition.” “I think the sign of a good entrepreneur is the ability to spot your mistakes, correct quickly and not repeat the mistakes. I made plenty of mistakes.”

“The excuse department is now closed.” “There are a lot of people with big mouths and small ears. They do a lot of talking; they only stop to listen to figure out the next time they can talk.” Learning from your mistakes is such a simple idea. There is nothing like rubbing you nose in a mistake to force yourself to confront what needs to be changed. The best founders actually change rather than merely talking about change. One way to identify mistakes is to have people you can trust to tell you things they see from a different perspective. If you have someone who is loyal and trustworthy, who listens well and has good judgment, you truly have something that is invaluable. People like Coach Bill Campbell have these qualities, which explains their popularity as advisors.

 

7. “It’s the down market that real entrepreneurs are formed.” The best time to form a business is often in a down market. People are easier to recruit and there is less competition. The poseur founders and employees tend to run for safety during a down market, so that is helpful too since there is transparency on who’s willing to take risks and bet big. One of Warren Buffett’s most famed quotes is on this point: “Be greedy when others are fearful, and fearful when others are greedy.” Google was founded in September 1998 and when the Internet bubble popped a few year later, their ability to hire great people was enhanced by the downturn.

 

8. “If you have options in life, you won’t get screwed.” Getting to Yes by Roger Fisher became one of the best-selling books of all time based on this simple idea. In that book, Roger Fisher taught readers about the importance of having a BATNA (Best Alternative To a Negotiated Agreement). When you have an alternative, you can get a better set of terms and price. That Fisher’s insight was a big enough revelation to turn into his book a massive bestseller is, well, amazing, but then there it is. He developed the book at Harvard and that did help put an academic gloss on what anyone paying attention in life should know. As a simple example of this principle in operation, you should never say you will buy anything before agreeing on terms – including price. As another example it is wise to have multiple suppliers, unless they are selling a commodity.

 

9. “You can read lots of books or blogs about being an entrepreneur, but the truth is you’ll really only learn when you get out there and do it. The earlier you make your mistakes the quicker you can get on to building a great company.” “If you’re going to lead an early stage business you need to be on top of all your details. You need to know your financial model. You need to be involved in the product design. You need to have a details grasp of your sales pipeline. You need to be hands on.”

“The skill that you need to be good at to be effective as an entrepreneur is synthesis.” “Don’t let your PR get ahead of product quality.” “Your competitors have just as much angst as you do. You read their press releases and think that it’s all rainbows and lollipops at their offices. It’s not. You’re just reading their press bullshit.” “Do not be dismissive of your competition.” Successful founders tend to have a big bag of skills which are the result of a mix of real world experience and natural aptitude. Everyone makes mistakes but some people have an ability to make a higher ratio of new mistakes to repeated mistakes. Successful founders pay attention and learn. They naturally know how to multitask. In addition, they are almost always readers. And they surround themselves with smart people who also confront their own mistakes. One good test of whether you are looking at your mistakes is: have you changed your mind on any significant issues over the past year? If you have not, how deep are you digging? How much are you thinking?

 

10. “Entrepreneurs don’t “noodle,” they “do.” This is what separates entrepreneurs from big company executives, consultants and investors. Everybody else has the luxury of “analysis” and Monday-morning quarterbacking. Entrepreneurs are faced with a deluge of daily decisions – much of it minutiae. All of it requiring decisions and action.” I was in a meeting with a group of VCs once on Sand Hill road in the 1990s, and someone referred to a particular executive as “Mr. Ship.” This was meant as a compliment. What the person meant was this executive shipped promised product on time. Getting things done is an underrated skill. People who can generate a few months of publicity and look swell gazing off into the distance in a cover photo of a tech publication is an overrated skill. For a look at the things a founder must do to succeed, I suggest you read my post on Bill Campbell.

 

11. “Don’t hire people who are exactly like you.” “When I see a CEO who takes 90% of the minutes of a meeting I assume that as a leader that person probably doesn’t listen to others’ opinions as much as they should. Either that or he/she doesn’t trust his/her colleagues. Let your team introduce themselves.” Diversity in the broadest possible sense makes for better team. Different skills, different personalities, different interests, different methods, different backgrounds, etc. People who get things done know how to hire other people with complementary skills. Mark Suster is also pointing out that a genuinely functional team does not rely on a single person to get things done.

 

12. “Focus on large disruptive markets.” “We want the 4 M’s: management, market size, money, momentum.” “In startup world, low GM almost always equals death which is why many Internet retailers have failed or are failing (many operated at 35% gross margins). Many software companies have > 80% gross margins, which is why they are more valuable than say traditional retailers or consumer product companies. But software companies often take longer to scale top-line revenue than retailers so it takes a while to cover your nut. It’s why some journalists enthusiastically declare, ‘Company X is doing $20 million in revenue’ (when said company might be just selling somebody else’s physical product) and think that is necessarily good while in fact that might be much worse than a company doing $5 million in sales (but who might be selling software and have sales that are extremely profitable).” There are a range of things that a VC is looking for when investing in a startup. Mark Suster identifies some of these things throughout these twelve quotes: Large addressable market. Significant optionality. High gross margin. The time it takes to cover your expenses. He also points to one of my biggest pet peeves about business: journalists who are obsessed with the top line revenue of a business. Unfortunately, these journalists too often pass this obsession with top line revenue on to others.

I have easily said this thousand times: revenue does not equal profit. It is such a simple idea and it only requires grade school math to understand. I included this quote in my post on Jeff Bezos and it is appropriate to quote it again: “free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins… What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.”

 

Notes:

I recommend all of Mark Suster’s posts at Both Sides of the Table

Both Sides of the Table - What is the right burn rate?

Walker Corporate Law – Mark Suster on helping entrepreneurs succeed

Huffington Post – Mark Suster’s Eight Steps for Startup Success

Both Sides of the Table – The Very First Startup Founder you need to Invest in is You

Stanford University – Mark Suster speaks at Stanford

Techcrunch - Fail Week: Guest Mark Suster (video)

PandoDaily interview (video)

A Dozen Things I’ve Learned From Bill Ackman about Value and Activist Investing

Bill Ackman is the founder of the investment holding company Pershing Square Capital Management. This post will focus on only one aspect of Bill Ackman’s investing system: his underlying belief in value investing principles. That Bill Ackman uses value investing principles at all may be a surprise to some people, since he is most known for being an activist investor. Since activist investing is often both controversial and confrontational it generates a lot of press interest. That often leaves the value investing part of his system in the background, but that does not mean it is less important.

At the 2014 Berkshire shareholder meeting, Warren Buffett was asked about activist investing. Buffett put the activist investing style into two different buckets. He approves of activists who are “looking for permanent changes in the business for the better” but disapproves of activists “looking for a specific change in the share price of the business.” In my view, this matches closely with Buffett’s definition of investing versus speculation. If you’re an investor, you’re trying to understand the value of the asset. By contrast, a speculator is trying to guess the price of the asset by predicting the behavior of other investors. Charlie Munger, at the same 2014 Berkshire meeting, commented that there is far too much activism that is based on price and not value by saying: “It’s not good for America, what’s happening. It’s really serious.” Unfortunately, there is no bright line that separates investing from speculation.

When asked about what Buffett and Munger said at that 2014 Berkshire meeting, Bill Ackman introduced a time dimension. Bill Ackman told Bloomberg: “I 100 percent agree with them. [Seeking short-term gains without creating better businesses] is bad for markets, and it’s bad for shareholders” [Pershing Square typically holds stakes] “four, five, six years or more.” Carl Icahn, when commenting in what Buffett and Munger said, also introduced a time element: “I understand and somewhat agree with their criticisms that some activists are going for a short-term pop.” Which actions are improper short-termism and which are appropriate actions to increase shareholder value, also lacks a bright line test.

That there is no bright line does not mean that these questions can’t be sorted out in a reasonable manner by using a healthy dose of common sense. For example, Buffett’s standard on buy backs, whether advocated by an activist or initiated by company management, is as follows: “First, a company [must have] ample funds to take care of the operational and liquidity needs” and “Second, its stock [must be] selling at a material discount to the company’s intrinsic business value, conservatively calculated.”

As I promised, the focus of what follows in this blog post is on the value investing part of Bill Ackman’s investing system.

 

1. “Short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.” Value investing has three bedrock principles that are inviolate and will be identified in italics and discussed throughout this post. The first of these bedrock principles is:  Make Mr. Market your servant, not your master. Investors who follow this principle understand that if you wait patiently Mr. Market will inevitably deliver his gifts to you as his mood swings unpredictably in a bi-polar fashion from greed to fear. The trick is to buy when Mr. Market is fearful and sell when Mr. Market is greedy. If you must predict the direction of the market in the short term to win, Mr. Market is your master and not your servant. Anyone who has been reading this series of posts on my blog has seen investor after investor talk about the folly of trying to make short-term predictions about markets.

 

2. “You read [Ben Graham] and it is either an epiphany and it affects the way you live your life, or it’s of no interest to you… I found it fascinating.” I have encountered the phenomenon which Bill Ackman is referring in this quote many times in my life. Warren Buffett and Seth Klarman both say value investing is like an inoculation, either you get it right away, or you don’t. Value investors use fundamental analysis as part of the value investing system to decide whether to make a bet a about whether something will happen and don’t fool themselves that they can time when that will happen. People who are not successfully inoculated into value investing most often fail to see the difference between waiting opportunistically for something to happen and trying to predict when something will happen.  Waiting opportunistically for something to happen is not predicting.  Arguments that the unchanging assumptions that underlie value investing are predictions are a rhetorical sideshow. If you don’t understand the “patiently waiting, then opportunistically pouncing rather than predicting” element to value investing, you won’t ever understand value investing. This explains why a core attributes of successful value investing are patience and a willingness act differently than the crowd. In other words, some people internalize the importance of the idea that Mr. Market should be treated as your servant and some don’t.

 

3. “You should think more about what you’re paying versus what the business is worth. As opposed to what you’re paying versus what they’re going to earn next quarter.” “Don’t just buy a stock because you like the name of the company.  You do your own research.  You get a good understanding of the business.  You make sure it’s a business that you understand.  You make sure the price you’re paying is reasonable relative to the earnings of the company.” The second bedrock principle of value investing is: treat a share of stock as a proportional interest in a business. A share of stock is not a piece of paper to be traded based on what you think, others will think, about what others will think [repeat] about the value of a piece of paper.  To be successful at value investing, you must understand the actual businesses in which you invest. This means you must do a considerable amount of reading and research and work to understand the fundamentals of the business. If you are not willing to do that work, don’t be a value investor. Bill Ackman has said on this point: “Find a business that you understand, has a record of success, makes an attractive profit, and can grow over time.” What could be more simple?

 

4. “Our strategy is to seek to identify businesses … which trade in the public markets for which we can predict with a high degree of confidence their future cash flows – not precisely, but within a reasonable band of outcomes.” The third bedrock principle of value investing is:  Margin of safety! A margin of safety is a discount to intrinsic value which should be significant to be effective. Warren Buffett wrote to Berkshire shareholders in 1994: Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” Buying at a significant discount to intrinsic value (e.g., 25%) creates a margin of safety.  If you have a margin of safety you don’t need to precisely predict intrinsic value, which is a somewhat fuzzy concept that different people calculate in slightly different ways. This explains Bill Ackman’s use of the phrase “reasonable band of outcomes.” The important thing about intrinsic value is that you only need to be approximately right, rather than precisely wrong.

 

5. “Often, we are not capable of predicting a business’ earnings power over an extended period of time. These investments typically end up in the ‘Don’t Know’ pile.” This quotation is about what a value investor calls “circle of competence.” This aspect of value investing is handled by different value investors is different ways, so it is not a bedrock principle in my view. Sometimes the intrinsic value of a given business can’t be calculated, even by an expert. This is not a tragedy.  There are plenty of other businesses which do have an intrinsic value that can be calculated within a reasonable band of outcomes. Risk comes from not knowing what you are doing. When you don’t know what you are doing, don’t do anything related to that lack of knowledge. One key attribute value investors have is being calm as Buddha when muppets are screaming at them to do something. You don’t need to swing at every pitch. Almost all of  the time the best thing to do is nothing. Having a “too hard” pile is tremendously valuable.

“…for an individual investor you want to own at least 10 and probably 15 and as many as 20 different securities.  Many people would consider that to be a relatively highly concentrated portfolio.  In our view you want to own the best 10 or 15 businesses you can find, and if you invest in low leverage/high quality companies, that’s a comfortable degree of diversification.”  One publication notes that Bill Ackman runs a concentrated portfolio “generally owning fewer than 10 companies, with a high concentration of his portfolio invested in his top two or three picks.” Charlie Munger calls this style “focus investing,” which is very different from an investor like Joel Greenblatt who was recently quoted in the press saying that he owns 300 names. On this question of diversification, value investors can often differ, so it is not a bedrock principle. In fact, there are many ways that value investors can successfully differ as long as they follow the three bedrock principles.

 

6. “We like simple, predictable, free-cash-flow generative, resilient and sustainable businesses with strong profit-growth opportunities and/or scarcity value. The type of business Warren Buffett would say has a moat around it.” You want to buy a business that is going to exist forever, that has barriers to entry, where it’s going to be difficult for people to compete with you… You want a business where it’s hard for someone tomorrow to set up a new company to compete with you and put you out of business.”

“The best businesses are the ones where they don’t require a lot of capital to be reinvested in the company.  They generate lots of cash that you can use to pay dividends to your shareholders or you can invest in new high-return, attractive projects.” This is a clean description of the key attributes a value investor looks for in a business, and my further commentary won’t add much. The core point being made here is simple: if there is no barrier to competition, the competitors of any business will drive profit down to the opportunity cost of capital.  Bill Ackman’s goal is to discover businesses with a moat that are mispriced by the market. On this I suggest you read Michael Mauboussin on Moats, and my post on Michael Porter

 

7. “People seem to be happier buying something at 50 percent off for $50 as opposed to having it marked at $40 and there being no discount, which is sort of an interesting psychological phenomenon. But it’s real.”

“To be a successful investor you have to be able to avoid some natural human tendencies to follow the herd.  When the stock market is going down every day your natural tendency is to want to sell. When the stock market is going up every day your natural tendency is to want to buy, so in bubbles you probably should be a seller.  In busts you should probably be a buyer – you have to have that kind of discipline.  You have to have a stomach to withstand the volatility of the stock markets.” A child of ten knows that markets are not composed of perfectly informed rational agents. There are many dysfunctional heuristics which cause people to make poor decisions. If some people did not make poor decisions, being an investor who performs better than the market would not be possible. Someone else must make a mistake for an investor to outperform a market. Being an investor is fundamentally about searching for mispriced assets. No one speaks more clearly about this than Howard Marks.

 

8. “In order to be successful, you have to make sure that being rejected doesn’t bother you at all.” “Generally it makes sense to be a buyer when everyone else is selling and probably be a seller when everyone else is buying, but just human tendencies, the natural lemming-like tendency when everyone else is [doing something] you want to be doing the same thing, encourages you as an investor to make mistakes.” Being contrarian is not easy since people find comfort in being part of a herd. This feeling of comfort is no small part of why being an investor who outperforms the market is not easy. You must be comfortable with being criticized for your sometimes contrarian views and, of course, you must be right enough times about those contrarian views. If you don’t understand what Howard Marks says about mispriced assets, do yourself a favor and buy a diversified portfolio of low fee index funds/ETFs since you are not a candidate to be a successful active investor.

 

9. “The investment business is about being confident enough to know that you’re right and everyone else is wrong. Yet you have to be humble enough that you recognize when you’ve made a mistake. Earlier in my career, I think I had the confidence part pretty solid.  But the humbleness part I had to learn.’’ Knowing when to be humble and when to admit that you are wrong requires good judgment. Judgment tends to come from having bad judgment, or seeing others make bad judgments. Bill Ackman has said: “Experience is making mistakes and learning from them.” If press reports are to be believed, there are people who think that Bill Ackman is not humble. But those people don’t seem to be very humble themselves. Bill Ackman has said of Icahn: “He’s a bully who thought of me as road kill on the hedge fund highway.” Icahn countered: “I wouldn’t invest with you if you were the last man on Earth.”

 

10. “When you go through something like the financial crisis, it makes a psychological imprint on you. It becomes hard to interpret information in a way that is positive.”

“A lot of people talk about risk in the stock market as the risk of stock prices moving up and down every day.  We don’t think that’s the risk that you should be focused on.  The risk you should be focused on is if you invest in a business, what are the chances that you’re going to lose your money, that there is going to be a permanent loss.” “[The] key here is not just shooting for the fences, but avoiding losses.” People have a tendency to acquire what people in the sports world call “muscle memory” when exposed to something. Memories of things like touching a hot stove or encountering a financial crisis tend to be particularly strong. People who have decades of experience as investors have seen times when the ability to generate new cash dries up in a matter of days, and when people seem to have wealth but can’t generate any new cash.

Here’s Buffett on the value of cash: “We will always have $20 billion in cash on hand. We will never depend on the kindness of strangers. We don’t have bank lines. There could be a time when we won’t be able to depend on anyone. We have built Berkshire for too long to let that happen. We lent money to Harley-Davidson at 15% when interest rates were 0.5%. Cash or available credit is like oxygen: you don’t notice it 99.9% of the time, but when its absent, it’s the only thing you notice. We will never go to sleep at night without $20 billion in cash. Beyond that, we will look for good opportunities. We never feel a compulsion to use it, just because it is there.”

 

11. “Investing is one of the few things you can learn on your own.” “You can learn investing by reading books.” “I went to business school to learn how be a good investor. When I got to Harvard Business School and I opened the course catalog for the first time and discovered there wasn’t a class on investing. I decided I had to open my first self-study program.” It is amazing how much you can learn by reading and paying attention to what happens in your life and in the lives of others. That applies in life generally, but especially in investing. Investing involves a range of ideas that are far more easy to learn than they are to put into practice. 

If you are reasonably smart, work hard, read a lot, and can keep control of your emotions it is possible to be a self-taught investor. Many good and a few great books on investing have been written. I would rather re-read a great book that read a mediocre or lousy book for the first time. That many business schools do not teach investing (specifically value investing) is, well, bonkers. How does a CEO or CFO allocate capital without understand investing principles? The answer is too often: not very well and with poor results. Buffett has written: “The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.” That business schools are not more focused on training executives to intelligently allocate capital is unfortunate, to put it mildly.

 

12. “Buy high-quality businesses at a price that is not reflective of the intrinsic value of the business as it is, and certainly not reflective of what the intrinsic value would be if it were run better. That allows us to capture a double discount. That’s a benefit we can have over private equity. They can buy a company and run it better to extract incremental value, but they’re typically paying the highest price in a competitive auction, so they don’t get that first discount. We don’t get full control, but because we have a track record of making money for other investors, we can often exert enough control to make an impact.” “Our greatest competitive advantage, though, comes from using our stake in a company to intervene in the decision-making, strategy, management or structure of the business. We don’t like waiting for the market to be a catalyst.”  

 

As I said above, Bill Ackman differs from most value investors in that he is also an activist shareholder. Here is Ackman’s pitch:

 

“‘I call them happy deals, not hostile deals…Unsolicited, I think, is a little more gentlemanly. I think it’s also more accurate.’ And while he’s at it, he’d rather people didn’t call Pershing Square a hedge fund. He would prefer ‘investment holding company.’ “When people think hedge fund, they think highly levered, short-term trading-oriented, you know, arbitragers, where we are very different from that,’ he said. Pershing Square is ‘really much more similar to Berkshire Hathaway.’”WSJ

Is Pershing Square really similar to Berkshire? The two investors share value investing as a core activity, but not “unsolicited” activism. Warren Buffett may have early in his investing career tried to turn around some businesses, but as a whole his attempts at activism were not a rousing success. Buffett seems to have abandoned that style of investing. In a 2014 interview, Buffett said: “You might say I took an active role in Berkshire Hathaway in 1965 when I took control, but we’re not looking to change people. We may be in a situation with them where [taking an active role] might influence, but we want to join with people we like and trust. We will not come in in a contentious way – it’s just not consistent with Berkshire principle.”

Charlie Munger simply described some of the reason for this shift at Berkshire regarding active investing earlier this year: “Berkshire started with three failing companies: a textile business in New England that was totally doomed because textiles are congealed electricity and the power rates were way higher in New England than they were down in TVA country in Georgia. A totally doomed, certain-to-fail business. We had one of four department stores in Baltimore [Hochschild Kohn], absolutely certain to go broke, and of course it did in due course, and a trading stamp company [Blue Chip Stamps] absolutely certain to do nothing, which it eventually did. Out of those three failing businesses came Berkshire Hathaway. That’s the most successful failing business transaction in the history of the world. We didn’t have one failing business – we had three.”

Warren Buffett has famously said: “Turnarounds seldom turn.”  The failure of a business to ‘turn around’ is a good description of Bill Ackman’s unsuccessful JC Penney investment and Buffett’s own losses in department stores and retail. The turnaround strategy worked well for Bill Ackman in the case of companies like Canadian Pacific. What Canadian Pacific as a value investing stock did was provide potential upside plus limit downside if the turnaround failed. In short, that a business is a bargain by value investing standards creates a margin of safety, which can be a very good thing for any  investor.

 

Notes:

Bio of Bill Ackman

Charlie Rose - Interview with Bill Ackman 

Saïd Business School – Conversation with Bill Ackman

The Floating University – Bill Ackman Lecture Transcript 

Big Think – Everything You Need to Know About Finance and Investing in Under an Hour (video)

Bloomberg News – Rules for Investing like a Maverick (video)

The Floating University – The Psychology of Investing (video)

Investary Group – Icahn and Ackman (video)

 

A Dozen Things I’ve Learned From Bill Murray about Business, Money, Startups, Investing and Life in General

The challenge I gave myself with this blog post was to take quotations from Bill Murray (the actor and comedian) and apply his advice to investing.  Writing this has been like one of those cooking competition shows where you get some ingredients in a basket (for example, cotton candy, spam, kiwifruit and pimento cheese) and you must make a delicious meal with it using other ingredients that are in the pantry. I decided to throw in Charlie Munger as my other ingredient in this post, since he can make almost anything make more sense. Charlie Munger is the investing equivalent of butter in cooking since his wisdom makes almost anything taste better.

The task is actually easier than it seems. Investing is mostly about making wise decisions, and many people like Bill Murray who aren’t professional investors have learned strategies to make better decisions – especially after making some less-than-good decisions over the years.  Learning to make better decisions most often comes from having made bad decisions in the past, and actually paying attention to the reasons why they were bad decisions.

Here are the Bill Murray quotations in bold text, followed by my thoughts interweaved with the views of Charlie Munger.

1. “I try to be alert and available. I try to be available for life to happen to me.” “Eh, it’s not that attractive to have a plan.”  This advice from Bill Murray is straight-up consistent with Charlie Munger, who believes: “[Successful investing 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.”  The Murray/Munger approach is simple: Don’t try to predict the future. Be patient, alert to opportunity, and ready to act aggressively when the time is right. In looking for optionality, it is essential that the optionality be mispriced by the market. The approach followed by Bill Murray preserves optionality and enables him to take advantage of mispriced bets that don’t happen very often.

This quote from Bill Murray’s character in Ghostbusters is a great example of the right attitude in a situation with positive optionality: “If I’m wrong, nothing happens. We go to jail — peacefully, quietly. We’ll enjoy it. But if I’m right, and we CAN stop this thing… you will have saved the lives of millions of registered voters!” Small downside and big upside is the essence of optionality, which is the essence of business and investing. When you see a huge potential upside with a small downside in business or investing, you should grab the opportunity.

Nassim Taleb wrote in Antifragile: “the idea present in California, and voiced by Steve Jobs at a famous speech: “Stay hungry, stay foolish” probably meant “Be crazy but retain the rationality of choosing the upper bound when you see it…. Any trial and error can be seen as the expression of an option, so long as one is capable of identifying a favorable result and exploiting it…”

2. “I think we’re all sort of imprisoned by — or at least bound to — the choices we make…. You want to say no at the right time and you want to say ‘yes’ more sparingly.”  Most of the time in life when you are asked to do something, the best thing to do is nothing.  Saying “yes” too often can destroy positive optionality. For Bill Murray this means things like not accepting every movie offer that come along. Charlie Munger puts it this way: “When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.”

I have this friend who likes to say “when someone wants to hand you a turd, don’t feel obligated to take it.”  It’s a pretty simple idea that many people forget. The correct response when someone tries to hand you a turd is: “Hey, thanks for thinking of me, but no thanks. You can keep that turd. Have a nice day.”

3. “What do they give you to do one of these things?” And they said, ‘Oh, they give you $50,000.’ So I said, ‘Okay, well, I don’t even leave the fuckin’ driveway for that kind of money’.” Bill Murray is describing an opportunity cost analysis here. Two of the more important opportunity costs in life involve time and money. Of course, time is the most precious opportunity cost of all. Charlie Munger’s description of the same process is as follows:  “…intelligent people make decisions based on opportunity costs — in other words, it’s your alternatives that matter. That’s how we make all of our decisions.”

The funny part of the story related to Murray’s quote is that it concerned his decision to do the voice of Garfield in an animated movie. He ended up taking the part because he thought a Coen brother was involved. Murray said: I had looked at the screenplay and it said ‘Joel Cohen’ on it. And I wasn’t thinking clearly. It was spelled Cohen, not Coen.”

4. “Don’t walk out there with one hand in your pocket unless there’s something’ in there you’re going to bring out.” You gotta commit.” “Let’s just roar a little bit. Let’s see how high we can go.” When you see an opportunity to make a bet that has odds substantially in your favor, you should bet big. Otherwise, don’t bet more than is needed to stay in the game. Charlie Munger: “The chief thing I learned from poker was that when you really have an edge, you have to push hard because you don’t get edges that often.” Often that bet is about time as well as an emotional and intellectual commitment, not just money. Going “all in” can be fun as hell.

 

5. “I made a lot of mistakes and realized I had to let them go. Don’t think about your errors or failures, otherwise you’ll never do a thing.”  You will never stop making mistakes, so dwelling on mistakes does you no good. A trick to making wise decisions in life and in business is recognizing the poor decisions you and people you know have made, and understanding why they were poor decisions. Then, try to learn as much from those experiences as you can, to help you make a higher ratio of new mistakes to old mistakes.

The world does not stop being an unpredictable nest of complex adaptive systems because you are getting older and, on the margin, a bit wiser. This quote reminds me of a story about a young woman who attends a church near my home. After the sermon was over one Sunday, she lingered after the other members had shook hands with the minister on their way out. As the young woman finally shook hands with the minister, she asked, “Reverend, do you believe someone should profit from the mistakes of others?” “Certainly not,” replied the minister. “Well, in that case, could I have the $300 back that I gave you for officiating my marriage?”

 

6. “You have to hope that [good things] happen to you… That’s the only thing we really, surely have, is hope.”  Bill Murray is talking about the value of optimism. In this way Bill Murray is more like Warren Buffett than Charlie Munger, who has said:I don’t see how anybody could be more optimistic that Warren. He has this real faith in the long term. I’m not quite so enthusiastic, but he’s right that there’s a lot good that’s happening.” Being positive is, well, a positive thing. As an analogy, in terms of characters from The Hundred Acre Wood, it is far better to be a mix of Owl and Tigger, than Eeyore. As for Charlie Munger, his view is: “Is there such thing as a cheerful pessimist? That’s what I am.”

I think optimism is the better approach, but sometimes we are who we are. There’s a old joke about this idea: A family had twin boys, who had very different personalities even though they were identical twins. One boy was an eternal optimist, the other a complete pessimist.  Just to see what would happen, on the twins’ birthday their father loaded the pessimist’s room with a huge pile of toys and games. In the optimist’s room, he brought in a huge pile of horse manure. That night the father visited  the pessimist’s room and found him sitting next to his new gifts crying bitterly.  “Why are you crying?” the father asked. “Because my friends will be jealous, I’ll have to read all these instructions before I can do anything with this stuff, I’ll constantly need batteries, and my toys will eventually get broken,” answered the pessimist twin. The father then went to the optimist twin’s room and father found him happily digging deep in the pile of manure. “What are you so happy about?” the father asked. The optimist twin replied: “There’s got to be a pony in here somewhere!”

There’s a joke about this topic that goes like this: Two friends, one an optimist and the other a pessimist, could never quite agree on anything it seemed. The optimist hatched a plan to pull his friend out of his pessimistic thinking. The optimist owned a hunting dog that could walk on water. His plan was to take the pessimist and the dog out duck hunting in a boat. They got out into the middle of the lake, and the optimist brought down a duck. The dog immediately walked out across the water, retrieved the duck, and walked back to the boat. The optimist looked at the pessimistic friend and said: “What do you think about that?” The pessimist replied: “That dog can’t swim, can he?”

 

7. “When you play with great players, you play better, it just elevates your game.” Working with smart people makes you smarter, and that feeds back on itself in a recursive way. Success of all kinds feeds back on itself in a process called “cumulative advantage.” Being lucky and talented leads to exposure to other talented people, experiences and training that makes you more talented [repeat]. Of course, some people are born on third base and have convinced themselves they hit a triple.  Bill Murray is about as far from that as you get – even though he is an actor. He will, occasionally, comment on the economy. He once said: “A few decades ago we had Johnny Cash, Bob Hope and Steve Jobs. Now we have no Cash, no Hope and no Jobs. Please don’t let Kevin Bacon die.”

 

8. “The [work] I like most [is] where I connected with great people.” This quote is slightly different that the previous one, since this point is about how much you enjoy something rather than what makes you more skilled. Charlie Munger: “Even Einstein didn’t work in isolation. Any human being needs conversational colleagues.” Working with smart motivated people makes you smarter and more motivated. It is a virtuous cycle when you get it right. If you are just working to make money and are not in that process connecting with great people, it may be work, but its not really living.

 

9. “It’s hard to be anything.” Lots of aspects in life and business are simple, but not easy. It is emotions and psychology that make both investing and life hard. Charlie Munger: “If [investing] weren’t a little difficult, everybody would be rich.” If things aren’t going well, keep working. Never give up. Be relentless. That time in life when nothing is hard is when you are dead. There’s no need to rush that.

Even though life is hard, try to look on the bright side, like the Bill Murray character Spackler in the movie Caddyshack: “And I say, ‘Hey, Lama, hey, how about a little something, you know, for the effort, you know.’ And he says, ‘Oh, uh, there won’t be any money, but when you die, on your deathbed, you will receive total consciousness.’ So I got that goin’ for me, which is nice.”  

 

10. “You need all kinds of influences, including negative ones, to challenge what you believe in.” Charlie Munger expresses a similar view:  “Any year that passes in which you don’t destroy one of your best loved ideas is a wasted year.” If you are not being challenged, you are not growing. As you go through life if you are not discovering that the amount that you know you don’t know is growing even faster than what you do know, you are not paying attention.

If you don’t get excited when you are wrong about something and understand why you were wrong, that is actually a bit of a tragedy. You are very unlikely to be a good investor if that is the case. Anthony Bourdain said once, on his preconceptions of Ferran Adria’s Michelin 3-star restaurant elBulli the first time he ate there, “I like being wrong about things.” I agree with Andy Bourdain. Being wrong occasionally is the way people learn. Some people refuse to admit when they are wrong, and are terrible investors as a result.

 

11. “The gratification part is: I worked with that son of a bitch. I worked with her. If you get that thing done, you’re professional friends for life. There are people who drove me crazy, but they got the job done. And when I see that person again, I nod my head. Respect.” There’s nothing like a shared experience to bring people together. This shared experience is powerful enough that you can end up with a bond with people you never would have been friends with otherwise. When that creative process results in something valuable, it is not only gratifying but also creates a treasured bond with the people who were involved in that shared experience.

 

12. “[When I saw Ivan Reitman’s early cut of “Ghostbusters] I knew I was going to be rich and famous, and be able to wear red pants and not give a damn.” GQ’s Dan Fierman wrote about Murray in a 2010 interview: “If [Bill Murray’s] three and a half decades in the public sphere have taught us anything about the actor, it’s that he simply does not give a good goddamn.” The best thing about money is that you have the option to be independent. You have choices when you have money. Conversely, people who are poor or even rich people who have lots of debt tend to have lousy options in life. What you want to avoid are situations where you only have two choices: take it or leave it.

Charlie Munger: “Like Warren, I had a considerable passion to get rich, not because I wanted Ferraris – I wanted the independence.  Having a lot of money and toys is over rated — having a lot of great choices is highly underrated. Cash has optionality that is valuable in and of itself. The ability to be exactly who you are and make the choices you want is a very wonderful thing indeed.

 

Notes:

Bill Murray Stories

PageSix – Bill Murray drove a taxi while the cabbie played sax in the back

Splitsider – Collected Wisdom of Bill Murray

DailyBeast – The Wisdom of Bill Murray

Huffington Post – Bill Murray Life Lessons

SNL Transcript – Caddyshack

Pajiba – Bill Murray’s Best Quotes on Acting & Fame

Funtrivia – Quotes from Ghostbusters

CNBC – Bill Murray’s View on the Economy