A Dozen Things I’ve Learned from Dan Levitan About Venture Capital, Business and People

“Dan Levitan cofounded consumer-only venture firm Maveron in 1998 with friend Howard Schultz, the famed Starbucks CEO, whom he met as Starbucks’ investment banker for its 1992 IPO. Levitan was a seed and Series A investor for Maveron in e-commerce company Zulily.” “Dan currently serves on the boards of Trupanion, Pinkberry, PayNearMe, Peach, Potbelly and Earnest.”

1. “Get the team right.  Startups to me are about: people, people, people.”

“We’re looking for people first.” “We can find a great sector or business, but we’re investing so early that unless there’s this tenacious grit, determination, resourcefulness, ability to evolve, it won’t work.”

The earlier a venture capitalist invests the greater the level of uncertainty and the more the investment is about buying mispriced optionality. The future of truly disruptive startups is so uncertain that founders and team members who can quickly respond to unanticipated changes have tremendous value. The qualities Dan Levitan describes are essential in a founder and team members since the future is never predictable with certainty. The ability of the startup to adapt to an unpredictably evolving world is essential and is driven by the founders and team members.

Successful venture capitalists also know that the right team chemistry is critical. When you are working with people you know and trust, tremendous efficiencies are created. Charlie Munger refers to the approach that allows Berkshire headquarters to consist of only 25 people as a “seamless web of deserved trust.” The more you know a person, the more likely it is that a seamless web of trust environment can be created. Successful venture capitalists and founders are obsessively focused on finding great people to work with. They spend far more of their time recruiting than most people would imagine for this reason.

When I was writing my post on Maveron co-founder Howard Schultz, Dan Levitan looked at an early draft and said “you need to put the points about people right up front.” Dan emphasized that Howard Schultz is all about people and so it should not be a surprise that Dan is all about people too. Not just any people, but great people. That applies to having the right skills but also to being great people in terms of values (the Yiddish word for this would be mensch: “a person of integrity and honor”) and how the person treats other people.  The best people treat everyone with respect.  Even little things are big clues about character.

2. “We’re looking for extraordinary entrepreneurs who can create very large businesses.  After 15 years and backing almost 100 entrepreneurs, I think it’s that rare person who has a combination of attributes that gets through the challenges of a startup and is able to really create value.”

“The shortage is great entrepreneurs. There’s still too much capital chasing too few great entrepreneurs attacking big ideas.” 

“The world does not need to be a zero sum game with founders. By contrast, there are so few great entrepreneurs and great ideas it is somewhat of a zero-sum game among VCs.”

Fred Wilson wrote a rather famous blog post about factors that limit the scalability of the venture capital model and, by implication, the number of innovative startups that help create growth, productivity and jobs. Dan Levitan and many other people believe that the primary bottleneck shortage in the venture industry is a limited supply of great startup founders. What does it take to be a great founder of a business? Dan Levitan’s firm Maveron has compiled a list:

1) works ridiculously fast;

2) has superior communications skills with team, investors and partners;

3) is self-aware and can evolve;

4) balances being aware with being detail oriented;

5) all-star recruiter that prioritizes team and company building;

6) prioritizes value creation for company investors etc.;

7). can sell both product/vision and knows his/her customers inside out;

8) has category advantage from past experiences and relationships;

9) is a data driven decision maker;

10) has contagious passion and relentless perseverance.

That list is a tall order, but it does sometimes get filled. When venture capitalists see these characteristics there is nearly always a rush to be an investor in the startup.

3. “How is the CEO recruiting? If we are two years in [after seed round] and we think this is a big idea and there’s been no impact players hired, that tells you something about the space or the CEO. The best biggest companies always seem to be able to hire people they shouldn’t be able to hire.”

One characteristic on Maveron’s list of qualities they seek in a CEO is that they be an “all-star recruiter”. Great founders know how to sell and one key “tell” of sales skill is recruiting. If the founder can’t sell employees on the vision and prospects of the business they will probably have trouble selling to potential customers of the product or service. Early hires at a startup are particularly important. On the importance of hiring the right people Dan Levitan has quoted Maveron’s co-founder Howard Schultz: “If you are going to build a 100-story skyscraper, make sure the corners are perfect.”  What Howard Schultz means is that the early hires are particularly important since they set the foundation of what will become the culture of a growing business.

4. “We always talk about how you have to build a brand from the inside out, not the outside in. Brands are not wrappers. Brands are based on the values of the founders, and then they spread to the people who work for the company, and then that psychological contract is spread to the customer.”

“Get the people right and it flows to the customers.”

Even when it comes to building a brand, Dan Levitan believes that the process starts with people. What do founders value? How do the transmit those values to customers? As an example, one of the most interesting things to watch in business right now is McDonald’s current set of challenges and how it is responding with new marketing. McDonald’s does not need new marketing, it needs better food. MCD would benefit from listening to Howard Schultz who points out: “You have to stand for something important. What is your core purpose and reason for being? That should be the guardrails within which you create the enterprises meaning to your customers.” I’ve wrote about Howard Schultz’s approach to branding in this post (see #2 in particular).

5. “Early stage money is not fungible. It comes with an attitude. Makes sure that the people on your bus are the people you want on your bus.” 

“Early stage investing [in particular] is all about the people.”

At this point if you haven’t figured out that Dan Levitan believes people are more important than any other variable in just about everything you are clearly not paying attention. People, People, People. Founders must be great people. The team must be composed of great people. Brands start with great people. Venture capitalists must be great people too. What Dan Levitan is saying is that money received from an investor can come with a big extra price tag attached – choose well. I suggest calling other people who have worked with the venture capitalist who wants to invest in your startup. Doing research on people pays off.

There’s expensive money and value-added money. Knowing the difference is important. And life is lots better when you get to work with great people.

6. “I spent a lot of my thirties and forties creating mentors. As I’ve gotten older, it’s become more fun turning that around and find someone who want to be mentored.”

“One of my mentors is Bill Campbell.  He’s: ‘Product, Product, Product.’” Howard Schultz says the first person you should hire is a human resources person.”

Dan Levitan has said he has four primary mentors: 1) Howard Schultz  2) Coach Bill Campbell  3) Coach K of Duke and 4) Joel Peterson. These mentors are all different and bring different skills and attributes to the relationship.  As Dan Levitan points out, they will disagree on some points. That’s OK and in fact desirable. As you go through life you can say: “I really like how person X does Y.” You don’t need to adopt everything that X does to get this benefit. Having a number of mentors is like being at a supermarket and buying ingredients. Of course, wanting to “be like X when they are doing Y” is a lot easier said than done sometimes, but at least you know what you want. Listening to Dan talk about his mentors is infectious. For example, it was Coach Krzyzewski who taught Dan the central lesson of Maveron’s consumer-focused success: always ask “Do you love your team?”

7. “There are lots of ways to make money in venture capital, and there are even more ways to be mediocre. We believed the world didn’t need another commoditized venture capital firm. Our theory was that the operating characteristics of technology companies would be incorporated into consumer businesses in an unprecedented way.” “Technology-driven consumer-facing brands.”

“We decided to focus on consumer very narrowly and invest only in end-user consumer brands. It’s worked much better, including because we’re presented with more [of these types of startups]; we have a greater pool of companies facing similar problems, which helps our entrepreneurs; and our LPs are getting more consistent returns.”

Dan Levitan is a believer that venture capital firms will increasingly specialize as competition increases. Maveron’s decision to be “consumer only” in its approach to venture capital is “walking the talk” on that viewpoint. When you focus on something you tend to get better at it. When you get better at it, people come to you for that skill, which makes you better yet at that skill. This feedback loop is powerful and financially rewarding if you pick skills that scale well.  It is more lucrative to be a venture capitalists than to be a great maker of chicken rice in a hawker stand in Singapore, but specialization is valuable in both professions.

8. “We dabbled in enterprise and we sucked at it.  This is a humbling business. It’s really hard to be good. We asked ourselves: and every startup should ask yourself: what do you do better than others and how does that concentration work in your favor? What do you do well?”

A value investor would refer to what Dan Levitan is talking about here as implementing a “circle of competence” approach. A good example of someone implementing a circle of competence concerns Tom Watson Sr., the founder of IBM, who once said: “I’m no genius. I’m smart in spots—but I stay around those spots.” By finding what you are truly great at as an investor and focusing on those things you can create in an investing edge. Every investor has strengths and weaknesses and the sooner you recognize what yours are the faster you will travel down the road to success.

Another way of looking at circle of competence is as an opportunity cost analysis.  Charlie Munger puts it simply: “Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other.” In investing’s case you have two skills, and you are way better at one skill than another. The choice for many people is obvious enough that they chose to specialize.

9. “What we’ve learned over the years is that one of our formulas for success is a smaller fund, where one or two significant wins can really have a positive impact. The challenge for successful venture capitalists is having the discipline to stay small and keep the fundraising within the same parameters as they originally achieved success in. I think there is a lot of temptation [to go big], particularly when the press asks ‘How big is the fund?’ What’s more important is what’s in the fund.”

In investing after a certain scale is reached in terms of “assets under management” or AUM, size can work against performance. Sometimes $500 million is not much more effort to manage than $50 million. But once you reach a certain size it is impossible to put more money into a single business so you must find a new business and have the necessary time to devote to that new business. Since the number of great founders with the right business attacking huge markets is limited, this can cause the some venture capital firms to stretch too far and fund startups that will drag down returns. As was the case with Goldilocks and the Three Bears, what you are looking for is something that is “just right” in terms of fund size.

10. “There’s plenty of money out there for great consumer entrepreneurs with great consumer products attacking really big markets.”

“Grand slam home runs are what defines [success in the venture business.”

Massive wins require big markets. Fred Wilson’s post that I referred to above lays out the simple arithmetic that leads to this conclusion. The other point Dan Levitan makes is that (especially right now) money is not the input to a business that is in short supply. It is not easy to raise money for a new business, but if you have a great team of people attacking a big market with an innovative solution to a real problem raising money is not your biggest problem. For example, the bottleneck problem at Series A referred to by Josh Koppelman is not happening because venture capitalists are grading on a curve. It is happening because startups are not satisfying the metrics needed for success. Stated simply, the problem at series A is not insufficient dry powder held by venture capitalists.

11. “Some of the best ideas that we’ve invested in have made no sense to conventional sources.”

There have been a few times in the last 16 years when we’ve funded something that was a no-brainer and it worked well for us. But most of the time, it’s not a no-brainer.”

It is mathematically provable that you must be contrarian if you are going to outperform the market. Ray Dalio puts it this way: “You have to be an independent thinker because you can’t make money agreeing with the consensus view, which is already embedded in the price. Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.”

Dan Levitan and his firm have chosen to specialize and with that comes an opportunity to “think different.” Being a contrarian can be uncomfortable for some people. As Mike Maples points out: “Wildly disruptive startups will be misunderstood for a long time.” Too many people would rather fail conventionally than succeed unconventionally. Great venture capitalists are comfortable standing apart from the crowd.

12.  “We get over 1,000 inquiries a year and will make 4-6 core investments and 15-20 seed investments. If businesses are not referred to us in some way or another, it is hard for us to really focus on it.”

“If we put $100,000 into a seed round, we want to earn the right to do the A round.”

Sorting through more than 1,000 inquiries a year is not simple or easy. This process inevitably means that you must deliver a lot of “no” messages and only a few “yes” messages. By requiring a referral three objectives are achieved:

1) you get a filter operating to make decisions easier,

2) you reduce the number of pitches you need to consider, and

3) you put entrepreneurs to the test (if they can’t somehow get a referral they are not resourceful and may not have good sales skills).

The biggest fear of any venture capitalist’s at this stage are mistakes of omission. There aren’t any venture capitalists who have been in the business that have not passed on a big success. That’s a part of the process. As long as you hit your share of grand-slam tape-measure home-runs, errors of omission will be overshadowed. They know that they will not always be right and that it is magnitude of success and not frequency of success that drives financial returns in their business.

Notes:

Dan Levitan and Michael Grabham at Startup Grind: Full Episode (video)

Seattle Business Journal – Maveron’s Dan Levitan on Elephants Under the Table

King5 Seattle – Maveron’s Levitan: Seattle’s Entrepreneurs “Need More Wins” (video)

Strictly VC – Maveron’s Dan Levitan: This Time Is Not Different

A Dozen Things I’ve Learned from Morgan Housel about Investing and Life

1. “’I don’t know’ are three of the most underused words in investing.”

“What’s really interesting about finance – and I think this is true for a lot of fields whether you’re in physics, math, chemistry, history, or whatever it is – the more you learn, the you more you realize how little you know.”

There is nothing more fundamental to investing than understanding that risk comes from not knowing what you are doing.  And as Morgan Housel is saying here: the more you know, the more you know that there is even more that you do not know. If you are not getting more humble as you: 1) get older, 2) grow as a person, or 3) learn, then you are not paying attention. The best investors keep their circle of competence tightly defined and limited in scope. Skills can atrophy or become outdated. New competencies can be developed with time and effort.

What you are doing when you are investing is buying an ownership interest in an actual business. No matter how hard you may work to know everything about that business, the phenomenon effecting that business, and the markets in which it competes, there always be much that you do not know.  Even if you may chose an index-based approach to investing, you are making choices about what types and amounts of assets to buy. The very best investors have been able to develop systems that deal effectively with the fact that investing is probabilistic process. The best systems are designed to enable the investor to buy and sell assets in a way that is “net present value positive” over time after fees and expenses. Systems that do not produce net present value positive results over time after fees and expenses, are speculation and are not investing.

 

2. “There are no points awarded for difficulty.”

The best investors make frequent use of a “too hard” pile when it comes to investing.  One of the many things that investors like Morgan Housel have learned from great investors like Charlie Munger is how much investing performance can be improved by just avoiding some of the boneheaded mistakes made by other investors. For example, there is no shame in admitting that a given business can’t be valued. There are plenty of other businesses that are understandable which present investment decisions that are not very difficult.  Most of the time what an investor should do is nothing. And there is no better time to do nothing than when something is difficult.

On this point Warren Buffett likes to say “I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.” These 1-foot bar jumping opportunities with big financial payoffs don’t appear very often, but when they do, it is wise to bet big.

3. “Three of the most important variables to consider are the valuations of stocks when you buy them, the length of time you can stay invested, and the fees you pay to brokers and money managers.”

“The single most important variable for how you’ll do as an investor is how long you can stay invested. I’m always astounded when I think about compound interest and the power that it has for investing.  Time is massively powerful.”  

Each of the points made here by Morgan Housel has a major champion. On the first point, Howard Marks points out:  “It shouldn’t take you too long to figure out that success in investing is not a function of what you buy. It’s a function of what you pay.” On the second point, Charlie Munger puts it simply: “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”  On the third point there is John Bogle: “You get what you don’t pay for.”

An excerpt of a Motley Fool post called I Prefer to Keep Things Simpleby Morgan Housel helps explain compounding:

“What [too often] happens … is that the magic of compounding returns is overwhelmed by the tyranny of compounding costs. It’s a mathematical fact.

You’ve probably heard the story about the guy who invented the game of chess.

It goes like this: An inventor brought his chess board to the emperor of China, who was so impressed he offered to grant the man one wish. The inventor had a simple wish: He requested one grain of rice for the first square on the board, two grains for the second square, four for the third, eight for the fourth, and so on. Sounding like a modest proposal, the emperor agreed. But filling the chess board’s last 10 squares would have required 35 quintillion grains of rice – enough to bury the entire planet. Unamused, the emperor had the inventor beheaded.

While I doubt the story is true, its message is important to understanding the power of compound interest: When things grow exponentially, gains look tiny at first, modest in the middle, and then — very suddenly — they shoot utterly off the charts.” 

4. “[Investing] is just buying and waiting.”

It is hard for some people to understand the difference between 1) waiting and 2) predicting.  Fundamentally, the difference between waiting and predicting is the difference between focusing on what to buy by finding an asset selling at a discount to value right *now* versus trying to guess about *when* in the future the value might rise. Price is not the same thing as value. Price is what you pay for an asset and value is what you get in buying an asset. Only rarely doe price equal value. James Montier adds: “We need to stop pretending that we can divine the future, and instead concentrate on understanding the present, and preparing for the unknown.” We have lots of information about the present and exactly zero information about the future. To work hard to understand the present moment in time is not to think you can predict when something will happen in the future. You may be working from an assumption that sometime over a ten year period Mr. Market will raise price of as asset so it is equal to or greater than value. But it is a fool’s errand to try to predict precisely when it will happen. When it happens, it happens. You will “know it when you see it” if you understand value.

5. “It’s much easier to say ‘I’ll be greedy when others are fearful’ than to actually do it. But those who can truly train themselves to be skeptical of outperformance and attracted to underperformance will likely do better than most. They have an advantage.”

Buying stocks when Mr. Market is fearful is easier to say than do.  You can’t simulate investing. The best way to learn to invest is to invest. The feelings involved in investing are primal and often hard to control. For example, humans are simply not hard wired to be contrarian when others are full of fear. You can read all the books, articles and speeches about being fearless when others are fearful and yet fail to be calm when the time comes. This presents a fundamental problem in that this is the best time to be buyer of assets. The best investors are actually nostalgic for times like March of 2009 when the market was rife with fear and uncertainty. Screaming buys based on valuation like those that existed in March of 2009 may appear only two to three times in an investing lifetime.  By the time you get good at this key skill you may be too old to take advantage of the opportunity.

 

6. “The most important thing to know when you look at long term financial history is that volatility in the stock market is perfectly normal.”  

Anyone who believes in the Mr. Market metaphor understands that volatility is both inevitable and the source of an opportunity for a rational investor. Charlie Munger: “To [Ben] Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time.” It is volatility that creates the mispriced assets which present an opportunity for investors. Volatility is one type of risk. For example, if you’re retiring or have tuition bills to pay at a certain time. While volatility is one type of risk you must face, it’s not the only risk. Why do some investment managers try to equate risk with volatility rather than just considering it as one important type of risk? They want you to believe that volatility is equal to risk because volatility is a major risk for them since, if assets drop in price, investors will flee from their services. They also want you to believe that risk can be expressed a number and controlled by magic formulas with Greek letters in them you do not understand.

 

7. “Saving can be more important than investing.”

“The most powerful way to grow your money is learning to live with less, since you have complete control over it.”

It is reasonable to assume that over long periods of time the return on stocks will be about 6% more than the return on cash. You can quibble with that estimate but not too much. The idea that you can invest your way to retirement is simply not possible without savings. This is especially true since most investors chase performance and earn less that an average return of the market, especially after fees and expenses.  “Boston College’s Center for Retirement Research found that the two most important factors for creating a retirement nest egg are one’s savings rate and the age of retirement. “If people could work until they’re 70, they would have a much higher chance of having a secure retirement. Social Security is higher if you wait until age 70, and it gives your 401(k) assets a longer chance to grow, and it reduces the number of years you have to support yourself,” says Alicia Munnell, the center’s director. Less important was the rate of return earned on investments.”

8. “Most financial problems are caused by debt.” 

“Most people’s biggest expense is interest, which comes from living beyond your means, and buying things you think will impress others, which comes from insecurity. Avoid these two, and you’ll grow richer than most of your peers.”

Debt causes many problems, the worst of which is that the magic of compounding is working against you instead of for you. Leverage can also create situations where underperformance takes you completely out of the investing process.  Since “staying invested” is a key to financial success anything that takes you out of the process is a very bad thing. As Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” James Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad.  When you are leveraged you can run into volatility that impairs your ability to stay in an investment which can result in “a permanent loss of capital.”

 

9. “It can be difficult to tell the difference between luck and skill in investing.”

Investing involves both skill and luck. Sorting out how much of a given result is skill versus luck is neither easy or always possible. The very best books on this topic have been written by Michael Mauboussin, including The Success Equation. Howard Marks also has useful view on the difference between luck and skill and investing: “Success in investing has two aspects. The first is skill, which requires you to be technically proficient. Technical skills include the ability to find mispriced securities (based on capabilities in modeling, financial statement analysis, competitive strategy analysis, and valuation all while sidestepping behavioral biases) and a good framework for portfolio construction. The second aspect is the game inwhich you choose to compete. You want to find games where your skill is better than the other players. Your absolute skill is not what matters; it’s your relative skill.” Warren Buffet describes the object of the process simply: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect but that’s what it’s all about.”

10. “Investing is overwhelmingly a game of psychology.”

“Almost invariably the best investors are the people who have control over their emotions.”

Most mistakes in investing are psychological or emotional in nature. Being rational about investing is a task that has no finish line – it is a constant struggle for any human to be rational. It is harder for some people to be rational than others, but everyone is not rational at times. My post on Daniel Kahneman and James Montier examine this in greater depth. Housel elaborates: “Investing is very complicated.  It’s an interaction of psychology and math and history and politics, and it’s all just mushed together and it’s really complicated.  It’s always more complicated than we think it is.  My journey has been one towards growing gradually more humble over the years.  I would say each year that goes by, I realize that I know less and less.”

11. “Daniel Kahneman’s book Thinking Fast and Slow begins, ‘The premise of this book is that it is easier to recognize other people’s mistakes than your own.’ This should be every market commentator’s motto.”

It is an unfortunately aspect of human nature that we do not have perspective on ourselves. Humans have developed a series of heuristics that make it hard for us, especially in a modern world, to see our own mistakes. If you have an interest in exploring this topic, Daniel Kahneman explains why this is true in this excerpt from his book:

“I’m better at detecting other people’s mistakes than my own…. When you are making important decisions and you want to get it right, you should get the help of your friends. And you should get the help of a friend who doesn’t take you too seriously, since they’re not too impressed by your biases.”

Having a posse of people around you who are afraid to tell you that the emperor has no clothes is not helpful in overcoming this bias.  Morgan Housel cites Charlie Munger’s wisdom on this problem: “Only in fairy tales are emperors told they’re naked.Pavlovian association and other heuristics Morgan has written about acting together in the form of a lollapalooza make things worse.

12. “When you think you have a great idea, go out of your way to talk with someone who disagrees with it. At worst, you continue to disagree with them. More often, you’ll gain valuable perspective. Fight confirmation bias like the plague.”

“Starting with an answer and then searching for evidence to back it up.  If you start with the idea that hyperinflation is imminent, you’ll probably read lots of literature by those who share the same view. If you’re convinced an economic recovery is at hand, you’ll probably search for other bullish opinions. Neither helps you separate emotion from reality.”

“Charles Darwin regularly tried to disprove his own theories, and the scientist was especially skeptical of his ideas that seemed most compelling. The same logic should apply to investment ideas.”

I have always loved this Charlie Munger quote on confirmation bias: “Most people early achieve and later intensify a tendency to process new and disconfirming information so that any original conclusion remains intact. The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. … And of course, if you make a public disclosure of your conclusion, you’re pounding it into your own head.” The trick is to really listen to other people who you trust. Ray Dalio’s investing process is very focused on this approach. Set out immediately below are two paragraphs on Dalio’s view:

“There’s an art to this process of seeking out thoughtful disagreement. People who are successful at it realize that there is always some probability they might be wrong and that it’s worth the effort to consider what others are saying — not simply the others’ conclusions, but the reasoning behind them — to be assured that they aren’t making a mistake themselves. They approach disagreement with curiosity, not antagonism, and are what I call ‘open-minded and assertive at the same time.’ This means that they possess the ability to calmly take in what other people are thinking rather than block it out, and to clearly lay out the reasons why they haven’t reached the same conclusion. They are able to listen carefully and objectively to the reasoning behind differing opinions.

When most people hear me describe this approach, they typically say, “No problem, I’m open-minded!” But what they really mean is that they’re open to being wrong. True open-mindedness is an entirely different mind-set. It is a process of being intensely worried about being wrong and asking questions instead of defending a position. It demands that you get over your ego-driven desire to have whatever answer you happen to have in your head be right. Instead, you need to actively question all of your opinions and seek out the reasoning behind alternative points of view.” 

Both Morgan Housel and Charlie Munger cite Darwin as a model for people working hard to avoid confirmation bias. Here’s Munger: “The great example of Charles Darwin is he avoided confirmation bias.  Darwin probably changed my life because I’m a biography nut, and when I found out the way he always paid extra attention to the disconfirming evidence and all these little psychological tricks. I also found out that he wasn’t very smart by the ordinary standards of human acuity, yet there he is buried in Westminster Abbey. That’s not where I’m going, I’ll tell you.”

  

Notes: 

Morgan Housel WSJ Articles

Morgan Housel Motley Fool Articles

Morgan Housel USA today Articles

Morgan Housel on money, psychology, and investing (video)

Everyone Believes It; Most Will Be Wrong: Motley Thoughts on Investing and the Economy (buy on Amazon)

50 Years in the Making: The Great Recession and Its Aftermath (buy on Amazon)

A Dozen Things I’ve Learned from David Tepper about Investing

David Tepper is an the founder of the hedge fund Appaloosa. Bloomberg writes that Appaloosa “invests in the equity, fixed income, and hedging markets. For the fixed income investments, the firm invests in high-yield bonds, bank loans to highly-leveraged companies, sovereign debt, debt of distressed companies, and other debt securities. It employs a fundamental analysis to make its investments.” The Reformed Broker (Josh Brown) adds: “If you had put a million dollars with David Tepper when he started Appaloosa 20 years ago, it would now be worth $149 million net of fees.”

 

1. “We have this saying: The worst things get, the better they get. When things are bad, they go up.”

This is David Tepper’s version of Warren Buffett’s view that the time to be greedy is when others are fearful. The principal cause of significantly mispriced assets is when Mr. Market is fearful. If you can be brave and aggressive at such times perhaps you have one of the attributes of a successful distressed asset investor. The problem is that vastly more people think they can be brave and aggressive at times like this than actually can do so. While Warren Buffett and David Tepper view the same phenomenon (fear) as an investing opportunity, the way they capitalize on the opportunity is very different. Both Tepper and Buffett know that Mr. Market is bi-polar, but they operate in different ways (e.g., operate in different time scales, with different circles of competence; different systems; different temperaments).

Most everyone should buy a diversified portfolio of low-fee/no load indexed investments. The fact that a very small number of people like David Tepper exist does not change that fact. Some fund managers find it easier to give advice by pretending that people like David Tepper don’t exist since it makes their narrative simpler and their job easier. Academics are often hired to deliver a simple message which basically says: “It is impossible to beat the market. It can’t be done.” This approach is attractive since it means that no client must be told that they are lacking the skills or temperament to succeed as an active investor. A message delivered to a client that essentially says “it is impossible to beat the market” goes down a lot smoother than: “it is impossible for you and most everyone to beat the market.” Many clients benefit from hearing this message since otherwise they would try to beat the market and inevitably underperform. The motivation of the fund saying “you can’t beat the market, period” is arguably not improper. It benefits most all people to say this.

The reality is that investors like David Tepper do exist. But the bad news is: 1) the small number of people like him most likely won’t take you on as a limited partner and 2) you are very unlikely to be able to do what investors like David Tepper, Seth Klarman or Howard Marks can do on your own.

 

2. “Markets adapt. People adapt.”

People have a tendency to extrapolate from the present in trying to predict the future. Many pundits make their living extrapolating X or Y to the sky or to the ground depending on the most recent trend. David Tepper makes the point with an example: “In 1898, the first international urban-planning conference convened in New York. It was abandoned after three days because none of the delegates could see any solution to the growing crisis caused by urban horses and their output. In the Times of London, one reporter estimated that in 50 years, every street in London would be buried under nine feet of manure.” The nature of capitalism is that often the remedy for high prices is high prices and low prices is low prices. Incentives are created and people respond in a capitalist economy by adapting based on price signals. David Tepper likes to make bets against people who don’t believe markets will adapt. He stuffs perma-bears and perma-bulls in his game bag.

 

3. “We won’t stop if we’re down a little bit. We don’t freeze. We keep investing with a disciplined, logical approach.”

Michael Mauboussin points out: “You must recognize that even an excellent process will yield bad results some of the time. If you are going to be the in the business that David Tepper is in you need to stay focused on your process, rather than any specific short term result. If you make an investment and the odds are substantially in your favor and you generate a loss, that is OK as long as your process was sound.

A sound process exists when the process is net present value positive (i.e, genuine investing). If the process is net present value negative, that is gambling/speculation/a fool’s errand. Howard Marks points out the key elements in his process as follows: “a) have an approach b) hold it strongly c) accept that, no matter what, there will be times where your approach doesn’t work, and d) work within your own skill set and personality, not someone else’s.” David Tepper, Howard Marks, John Bogle, George Soros are not you and vice versa. Your investing approach should be consistent with who you are. Everyone is different. In addition to being disciplined and logical, David Tepper believes: “We’re pretty unemotional when we invest” which is a very good thing since most mistakes in investing are based on emotional or psychological errors.

 

4. “We invest in a lot of bonds and preferred (stock), which we can convert to equity. It not as risky as people make it out to be.”

When you make an investment in distressed debt your ownership interest can (under certain circumstances) convert into equity ownership, which gives you certain control rights that can be helpful in generating the return you desire. People who understand areas like bankruptcy and finance can do things like determine what is likely to be the “fulcrum security” which will convert into sufficient equity to exert some measure of control when the business restructures via a plan of reorganization. This sort of activity combines investing with the profession of distressed investing/bankruptcy. Distressed investing is not an activity where amateurs and people learning on-the-job experience a positive result. That David Tepper can do it does not mean that you can do it.

 

5. “This company looks cheap, that company looks cheap, but the overall economy could completely screw it up. The key is to wait. Sometimes the hardest thing to do is to do nothing.”

People have a tendency to believe there is a prize for hyperactivity. Not only is there not a prize but hyperactivity instead imposes significant penalties. Warren Buffett likes to say there are no “called strikes” in investing. For this reason, sometimes sitting on your hands can be the very best thing you can do as an investor. Patience is key. But so is aggression when the time is right, as was the case, for example, in 2009. The combination of being patient and yet sometimes aggressive seems odd for many people, but it is the right approach. When bargains do appear it is not only a rare event, but a fleeting event. If you snooze when a bargain appears, you lose. Fortune favors the person who is patient, brave, aggressive and swift to act when the time is right. Times like March of 2009 appear rarely in a lifetime for an investor.

 

6. “For better or worse we’re a herd leader. We’re at the front of the pack. We are one of the first movers. First movers are interesting; you get to the good grass first, or sometimes the lion eats you.”

To outperform the market you must be contrarian, and you must be right about that contrarian view often enough so that the financial math works. But there is big risk and uncertainty in this approach. The good news is that because most people would rather fail conventionally than succeed unconventionally assets can sometime be mispriced. Howard Marks, again, is on the mark: “Non-consensus ideas have to be lonely. By definition, non-consensus ideas that are popular, widely held or intuitively obvious are an oxymoron. Thus such ideas are uncomfortable; non-conformists don’t enjoy the warmth that comes with being at the center of the herd. Further, unconventional ideas often appear imprudent. The popular definition of “prudent” – especially in the investment world – is often twisted into ‘what everyone does.’”

 

7. “There is a time to make money and a time to not lose money.”

There is a time to reap and a time to sow. There is also a time to be defensive and not lose money. Sometimes almost all potential investments are properly put in the “too hard” pile. At times like this, the best thing you can do is preserve what you already have. Investing is a probabilistic activity. If you don’t have an investing thesis that is the output of a sound investing process which is net present value positive, then don’t invest. It’s that simple. Having a “too hard” pile is such a huge advantage in life.

 

8. “We don’t want to be bigger than we can invest.”

“The question is what size gets you – except more fees for the manager. But it doesn’t necessarily make the investor more money.”

Part of what David Tepper is saying is that he would rather be an investor than an asset gatherer. A smaller fund in which he has a greater personal stake can be a far better outcome for him than trying to make a lot of fee-based income from investing the capital of other investors. He also believes there is no optimal size for every fund. Size matters. David Tepper explains: “Say you want to buy 5 percent of a $2 billion company, and have it be meaningful. That means it’s a 1 percent position in a $10 billion fund. So if you’re an equity fund, if you keep getting bigger and get to $20 billion, that means your position is now only a half percent position. The 1 percent position doesn’t do much for the fund and so the half percent position does half as much. So there’s an aspect to the business, in equity funds especially, that gets funky on size.” The other problem that people have learned the hard way in many cases is that as you grow assets under management, it becomes harder to find opportunities. For example, Charlie Munger points out: “The future will be harder for Berkshire Hathaway – we’re so big – it limits our investment options. But, something has always turned up.”

 

9. “Replaying losses in your head is the only way you learn from your mistakes.”

As I said in my post about Keith Rabois, you can’t simulate investing. The way to learn to invest, is to actually invest real money (preferably your own money) so you have actual skin in the game. And when you invest and fail, you should be “rubbing your nose in your mistakes” as Charlie Munger suggests. When you inevitably make mistakes and get feedback, if you don’t learn from that you are not going to build up an edge versus other investors.

 

10. “Some of our best positions were ones we initially lost money on.”

An investor can be too early or too late and still win. David Tepper is not afraid to lose money if he believes he has followed a sound process and performed a sound analysis. Most people can’t put their fears aside and so they often sell at the worst possible time. This is sometimes called “performance chasing” or “the behavior gap.” A very small number of people have ice in their veins when it comes to investing. David Tepper knows fearlessness is a key part of his investing edge and that without an edge investment out-performance is unlikely. That you will have the same fearlessness as David Tepper, particularly if you will lose your home or will live in poverty as a retiree if you make a mistake, is highly unlikely. Betting fearlessly with what gamblers call ‘house money’ is far easier than making bets where one possible outcome is that you lose your house.

 

11. “After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.”

The sell-side provides services to clients for a fee. There’s an old joke that goes like this: “What’s the difference between the buy-side and the sell-side? The buy-sider curses at you and hangs up the phone. The sell-sider hangs up the phone and then curses at you.” The sell-side is selling and will tell you what you want to hear. The sell-side’s job is to directly or indirectly generate fees. Sell-siders do not have what Nassim Taleb calls “skin-in-the-game.”

Ben Carlson has described the life of a sell-sider: “When I worked on the sell-side the head of research pulled up the total number of buy and sell recommendations from every analyst during one meeting, there were only 3 sell calls — in the entire firm. He was basically begging these analysts to make a sell recommendation or two. Yet they weren’t really budging because… Relationships Matter. What I came to realize is that all of the number crunching didn’t matter nearly as much as the meetings and conference calls with company management. These relationships all carried much more weight than the financial models that the junior analysts toiled away at back at the office. The analysts didn’t seem to want to make a critical call against a company in fear of upsetting the management relationship where they got their questions answered.”

 

12. “What’s bad is good and what’s good is bad, right? You’ve got a long life. Don’t get upset by setbacks. Setbacks are another way to say opportunity.”

Opportunity comes in strange, lumpy, and often nonlinear ways. Success rarely takes the form of a steady process similar to climbing a ladder, nor does failure operate in the other direction. As I pointed out in my post on Reid Hoffman, modern careers are more like a jungle gym on a playground than a ladder. There are many examples that illustrate this point. Michael Bloomberg was fired before he started his information services business. David Tepper himself was passed over for a partnership at Goldman, which ended up making him both richer and happier with his life.

If life deals you lemons, make lemonade. Resiliency is a far greater determinant of success in life than most people imagine.

 

Notes:

The Reformed Broker – The Apotheosis of David Tepper

NY Magazine – Ready to be Rich

Pittsburgh Tribune – Investor David Tepper goes where others don’t dare

Bloomberg – How Tepper Makes 22 Billion

The Alpha Masters – Quotes from David Tepper

2007 speech at Carnegie Mellon

A Dozen Things I’ve Learned from Rich Barton About Startups, Business and Investing

Rich Barton started Expedia inside of Microsoft in the mid-90’s, then spun it out into EXPE in 1999 and was CEO until 2003.  He is a co-founder of Zillow, Glassdoor and Trover, an investor in a range of startups and a Venture Partner at Benchmark Capital. He is also on the board of directors of Netflix, Avvo, Realself and Nextdoor.
 
1. “Marketplace is an important word. It takes two sides to make a marketplace.”

User-generated content models are magic. And they are magic because the more reviews you have of hotels, for instance, the more it attracts users to the site. And the more users you have, of course, the more reviews you get. This is a very simple, elegant example of a positive feedback system. This flywheel spins faster and faster, and what happens is the competitive moat — the defense, the competitive differentiator or the moat around the castle — gets wider and deeper every day with every review that is done.”

The demand-side economies of scale (network effects) and associated supply-side economies of scale that are associated with certain systems are the magic that Rich Barton is referring to. Success with a user generated content business model feeds back on itself in a positive way to create more and more success (as in a flywheel). For example, if Side A values the platform more if there are more customers on Side B, there are positive network effects which are an attractive way for a technology company to create barriers to entry (sometimes called a “moat”). If the right marketplace-based flywheel is operating, the only real limit to success is the size of the addressable market. Marketplaces like Expedia, Zillow, and Glassdoor have multiple “sides” which interact directly through a “platform” which generates barrier to entry as more user generated content appears in the system.
 
2. “If you really do have a flywheel, it is OK to spend money to get it spinning. It is OK to do un-economic things to hand-crank stuff, so long as once it is spinning you can take your hand away.”  

Getting to critical mass with a marketplace platform is sometimes called overcoming the “chicken and egg” problem.  This problem can be described simply: How do you get one side to be interested in a platform until the other side exists, and vice versa. Part of the challenge is to get enough customers on both sides so there is critical mass.  Critical mass is tricky to obtain, particularly if the two sides need to show up simultaneously. Businesses that are slow to get to critical mass can run out of cash and momentum. How do you get one side on board? Well, one critical task is to acquire market participants in a cost effective way. What you want is low customer acquisition cost (CAC). Rich Barton is saying that investing money to get the flywheel spinning from a standing start is a natural part of the process. But the goal is to be able at some point to ramp down the spending once the positive feedback loop is operating.  One way to acquire customers in a cost effective way is with a great brand and a method of creating low-cost impressions.
 
3. “My tendency has been to focus on big vertical industry categories where there has historically been database information that’s been locked up behind walls by the industry.  I want to empower users to access that info. I like those verticals that involve real people, real decisions and real money because it is easier to monetize. It’s not a stretch to sell ads in the industry because they want to be there when people are making decisions.”

Expedia, Zillow and Glassdoor are prime examples that fit into Rich Barton’s “power to the people” thesis. Simply put, the thesis is: “If we’re doing things for regular folks that make their lives better and save them money and give them transparency, we’re on the side of the angels.”

Rich Barton tells a great story about power to the people in a Wired Magazine article: “[I wanted to give] consumers access to information and databases that they knew existed because they either saw or heard professionals over the phone clacking away on a keyboard accessing that information. I remember I wanted to jump through the phone and look at the screen myself, turn it towards me and just take control. And I knew that I would spend more time and do a better job searching than this person who was doing something on my behalf, and who really didn’t know my preferences but was just trying to approximate them.”

Rich Barton is also saying that certain vertical industries involve a lot of real money transactions and often high customer acquisition costs.  If you can create a user-generated content marketplace in a vertical market in which businesses pay significant amounts of cash for effective advertising, it is an attractive segment. Convincing people to pay for things that they have traditionally received for free is a genuinely hard problem. Startups are hard and challenging enough already that taking on addition very hard challenges that are not central to the creation of the core customer value delivered by the startup is unwise.
 
4. “What I tell people is, if it can be rated it will be rated. If it can be free it will be free, and if it can be known it will be known.”

Information that can be made digital is what economists call “a public good.” These sorts of goods are called non-rival (you having it does not mean others can’t have it) and non-excludable (you can’t prevent others from having it without paying you). Rich Barton is saying that information like this that is digital is increasingly not going to be sitting behind firewalls in a way that is not accessible by the public. The model of giving away information to create a marketplace is so strong that it is unlikely that someone won’t decide to make it free. Similarly, the power of a user-generated content business model is so powerful that everything will also be rated.
 
5. “Find me a provocative topic, and I’ll show you something you don’t have to spend a lot of marketing dollars to launch. People like to be provoked, and if you are provoking with information that is on the side of the angels, on the side of the consumer, the louder the industry reacts. And they just can’t win. It’s the greatest way to market, pick a fight with somebody who can’t win.”

What we see in the market today are businesses which are transforming controversy (e.g., Uber) or valued information (e.g., Zillow; Glassdoor) into free brand impressions, which lead to more usage which translates into more controversy or information (i.e., a positive feedback loop which can result in a moat).
 
6. “Ideas are cheap. Execution is dear.”

“Great leaders need three key attributes to successfully execute — brains, courage and heart [pointing to The Wizard of Oz as inspiration].”

Ideas are necessary but not sufficient for success with a startup. And the idea itself will inevitably evolve as time passes and the environment changes. Execution is a harder problem than generating a good idea. Finding a team to build the product, finding product market fit and scaling the business are the biggest tasks. I sat on the board of a startup once and it eventually was a very profitable category. The explanation is long, but the net result was that they always shipped late because they were always building more into the product than the market wanted, which made them late to market. The result was a 2X which is essentially a failure.
 
7. “It is much more powerful long-term to make up a new word (e.g., Expedia, Zillow, or recently Glassdoor, three words that my teams have created) than it is to use a literal word.  I also like high point scrabble letters in my brands if I can work them in. They are high point, because they are rarely used.  A letter that is rarely used is very memorable.  Z and Q are all worth 10 points in scrabble.  X is 8.  They jump off the page when you read them and they stick in your memory as interesting.”

“When you successfully make up a new word and introduce it into everyday language, you own it.  It becomes a major differentiating asset that cannot be confused with anything else or encroached upon by competitors.  At the very best, you end up defining a whole new category – Kleenex, Levis, Polaroid, Nike, eBay.  The downside to creating your own brand is that it is hard, and most of the time, very expensive and time consuming to hammer a new word into the consumer vocabulary.”

Creating a brand that is eventually a verb is an amazing accomplishment. People who make the effort to try to transform a “made up” word into a powerful brand are thinking big, which is attractive to a venture capitalist since they need tape measure home runs to make the venture capital business model work. That an entrepreneur is thinking they can turn their startup into a verb is a tell that they have the right mindset and DNA of an entrepreneur who should be seeking venture capital. But it is hard. Sometimes it is too hard. For example, Buuteeq eventually changed its name to Booking Suite.
 
8. “If you want to have a growing and vibrant organization you want to have big, new opportunities opening in front of you.”

It is much more interesting to work in an organization that is growing and vibrant.  Rich Barton was fortunate to work at Microsoft in an era when it was growing quickly and the opportunities to advance and learn were unlimited. When Microsoft was growing quickly, people’s responsibilities and opportunities were constantly growing. The environment is far from a zero sum game. During Rich Barton’s tenure at Microsoft there were many battlefield promotions. The situation is the same at Zillow and Glassdoor. This is in contrast to a business that is in decline and the employee count is shrinking. Shrinking opportunities mean employees face a less than a zero sum game which can too often create politics and a divisive culture.
 
9. “You can have a great team of people, but if they’re fishing in the wrong spot, you know, they’re fishing in a little puddle in the backyard, they’re not going to catch any fish. So, a big market, is like a proxy for (Total Addressable Market).”

“Tech startups are not capital-intensive. It takes money to build the first version of the software, but it’s very inexpensive to deliver that to millions of people. They’re high-margin businesses if you can get scale.”

“A big dream and a clear vision, and a little bit of nuttiness is required to take something from an idea stage all the way to creating something that [realizes that dream].”

“Dreams are largely self-fulfilling.” “There is almost as much blood sweat and tears in building something small as there is in building something big.”

“Look, you have an at bat, and it takes just as much energy to swing for the fences as it does to bunt.  OK.  So, why bunt?  Why bunt?  Why not swing for the fences?”

Venture capitalists are very focused on finding audacious entrepreneurs who are trying to create value in very large markets. An entrepreneur simply can’t generate the necessary financial returns at scale if the market is small. If you have a small downside (not capital intensive to try) and if it is a big pond (a massive potential upside) you have optionality. It is rare to find a capable entrepreneur with a sufficiently clear, audacious, (and slightly nutty) mission to make venture capital financing work by delivering the necessary tape measure home run. The number of entrepreneurs with these qualities is one reason why cities like Silicon Valley and Seattle are so successful.

The plan must be audacious to deliver 10X to 1,000X returns. The plan must be a little bit nutty or others (particularly large companies) will be working on something similar. He is also saying that as long as you are devoting years of your life to this effort: why not try to accomplish something truly great? And if the goal is genuinely a “mission”, that provides extra motive beyond just financial returns. If you can do great things for society and do well financially at the same time, the combination is a very powerful thing.
 
10. “It’s key to hire the best and sharpest folks in the beginning so that you can build an organizationally wise company.”

“Surround yourself with superstars. And not just the people you choose to work with.  That’s really important.  But the people you raise money from as well. Surround yourself with superstars, and everything else takes care of itself.  Whenever in my career I’ve compromised because I’ve had a short-term itch I needed to scratch – and I just had to hire somebody – it’s been a mistake. And I’ve regretted it. It’s really hard to get rid of the (poor) performers.  Surround yourself with superstars. They hire superstars.”

Being around smart people who love to get things done makes you smarter and more able to get things done. Rich Barton is making the point that the early hires are particularly important as they are the kernel around which culture, value, and best practices are built. He also believes that fixing a bad hire is way more costly and time consuming than people even imagine. People who are easily threatened hire people who are non-threatening and add less value to the business as a result. In short, bad hires can be toxic. And, of course, smart people love to hire and be around other smart people.
 
11. “Get the highest octane fuel in the tank [when choosing a venture capitalist].”

The founders of a fundable startup have lots of options to raise money. Rather than just raising money the smartest entrepreneurs select the VCs who deliver far more than just money. What the great venture capitalists realize is that they are in a service business. A venture capitalist who does not help with recruiting and other aspects of the business is underperforming. As just one example, the world is increasing driven by the power of networks and the best venture capitalists have access to the best networks.  As an example, Rich and I are big fans of “Bill [Gurley], the rare wicked smart guy who can also communicate his analyses and opinions through compelling analogies and in a ‘hat in hand’ Texan’s drawl.” Bill Gurley and his partners have forgotten more than I know about venture capital. Despite that fact, much what I know about the venture capital business is attributable to them. Benchmark is lucky to be working with Rich Barton and vice versa.
 
12. “The whole idea of building a career these days is much different from say when my dad did. My dad graduated from Duke University with an engineering degree — I don’t know what the year was, it was probably like 1956 or something —and he went to work for a large chemical company, which was like the computer company of his age. Plastics. Like in The Graduate. My dad always said: ‘What you are doing on the Internet, I was in plastics, and that was the thing.’

Anyway, he went to work for that company, and he retired from that company 34 years later. And he worked there the whole time, and that was his era’s idea of work. The company man. The gray suit, and the brief case. And the martini on Friday and the hat and whole thing.  I love and admire my dad, and I love that he was always supportive and sort of tickled by how I built my career and my views on the modern career path. From my perspective, building a career is trying something really interesting, getting some skills, putting tools into your tool kit, going to the next place and putting a few more tools in, until finally you have all of the tools that you can build your own house.”

Rich Barton is making a point here about the importance of accumulating skills in an iterative fashion, and that means in today’s world a path that is not a linear march in a single company. The metaphor of a career ladder has been replaced with a jungle gym. What is most remarkable about Rich is his success rate. Very few entrepreneurs have had so many different successes. Nick Hanauer, a Seattle entrepreneur and venture capitalist points out: “You can name people who are richer than Rich, but you can’t name very many people who have his track record. You will find very few people in this country who have as many times created something from nothing.”
 
Notes:

Geekwire – Barton on Transparency

Wired – The Man Who Escaped Microsoft and Took a Whole Company With Him

 

BizJournals – Zillow, Expedia founder Rich Barton on tech bubbles, startups, transparency

Hopper and Dropper (Barton’s blog) – Scrabble Letters and Brand Names
New York Times – The art of something from nothing

Geekwire – Barton on Startups and Competition

 

Zillow’s Rich Barton on Risk and Success

Geekwire – Closet Revolutionary Rich Barton

 

Geekwire Summit – Gurley and Barton

Geekwire Seattle Startup Week – Barton Interview

A Dozen Things Taught by Warren Buffett in his 50th Anniversary Letter that will Benefit Ordinary Investors

 
 
1. “We are limited, of course, to businesses whose economic prospects we can evaluate. And that’s a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now.”

“My experience in business helps me as an investor and that my investment experience has made me a better businessman. Each pursuit teaches lessons that are applicable to the other. And some truths can only be fully learned through experience.”

Treat an investment security as a proportional ownership of a business!  A security is not just a piece of paper. Not all businesses can be reasonably valued. That’s OK. Put them in the “too hard pile” and move on. See my #3 in my Bill Ackman post.

 
 

2. “Periodically, financial markets will become divorced from reality.”

“For those investors who plan to sell within a year or two after their purchase, I can offer no assurances, whatever the entry price. Movements of the general stock market during such abbreviated periods will likely be far more important in determining your results than the concomitant change in the intrinsic value of your Berkshire shares. As Ben Graham said many decades ago: ‘In the short-term the market is a voting machine; in the long-run it acts as a weighing machine.’ Occasionally, the voting decisions of investors – amateurs and professionals alike – border on lunacy.”

Make bi-polar Mr. Market your servant rather than your master! See my Howard Marks post or my Jason Zweig post.

 
 

3. “A business with terrific economics can be a bad investment if it is bought for too high a price. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this.”

Buy at a bargain price which provides a margin of safety! See my Seth Klarman, Bill Ackman or Howard Marks posts.

 
 

4. “As Tom Watson, Sr. of IBM said, ‘I’m no genius, but I’m smart in spots and I stay around those spots.'”

Circle of competence! Risk comes from not knowing what you are doing. See #6 in my Joel Greenblatt post.

 
 

5. “Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: ‘The fault, dear Brutus, is not in our stars, but in ourselves.'”

Most investing mistakes are psychological! Investing is simple, but not easy. Buffett has a great system, but his emotional and psychological temperament is especially suitable for investing. Like Charlie Munger, he is highly rational as human beings go. Everyone, including Buffett, makes mistakes. You can do very well in investing by just avoiding stupid mistakes. See my post on Kahneman or Michael Mauboussin.

 
 

6. “It is entirely predictable that people will occasionally panic, but not at all predictable when this will happen. Though practically all days are relatively uneventful, tomorrow is always uncertain. (I felt no special apprehension on December 6, 1941 or September 10, 2001.) And if you can’t predict what tomorrow will bring, you must be prepared for whatever it does. Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”

Buy at a bargain and wait! See my post on avoiding forecasting. See also Seth Klarman and Howard Marks posts on this point. You can determine that buying an investment *now* is a bargain that creates a margin of safety based on a valuation process, but you cannot predict *when* the price will rise.  So you wait.

 
 

7. “Gains won’t come in a smooth or uninterrupted manner; they never have.”

Investing results will always be lumpy! See #10 in my Henry Singleton post.

 
 

8.”Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”

“It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.”

Risk is not the same as volatility! See #6 in my Jason Zweig post.

 
 

9. For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky….”

Most investors should buy a diversified portfolio of low fee index funds/ETFs! See my posts on John Bogle and asset allocation.

 
 

10. “Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”

Follow the cost matters hypothesis! See #1 and #3 in my John Bogle post.

 
 

11. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.” “When bills come due, only cash is legal tender. Don’t leave home without it.”

The only unforgivable sin in business is to run out of cash! See #7 in my post on Don Valentine. The need for some cash as dry powder applies to everyone, the only question is how much cash to have on hand.

 
 

12. “We will never play financial Russian roulette with the funds you’ve entrusted to us, even if the metaphorical gun has 100 chambers and only one bullet. In our view, it is madness to risk losing what you need in pursuing what you simply desire.”

Black Swans can appear any time! People will try to get you to buy things by hiding this risk. See my post on Nassim Taleb.

A Dozen Things I’ve Learned from Don Valentine about Venture Capital and Business

“Don Valentine participated in the beginnings of two significant milestones: the birth of the silicon chip and the development of the venture capital industry. From humble beginnings, Valentine became a legendary salesman at Fairchild Semiconductor and National Semiconductor, before founding Sequoia Capital in 1972.” He “was one of the original investors in Apple Computer, Atari, LSI Logic, Cisco Systems, Oracle, and Electronic Arts.”

1. “[Venture capital] is all about figuring out which questions are the right questions to ask, and since we don’t have a clue what the right answer is, we’re very interested in the process by which the entrepreneur get to the conclusion that he offers. Our business is a business of highly intuitive decision making and that fact that it’s done in a scientific area doesn’t make it scientifically practical to make decisions that way…”

“We recognize by Socratic questioning opportunities that are better than others and why.”

“The art of storytelling is incredibly important.  Learning to tell a story is critically important because that’s how the money works. The money flows as a function of the story.”

Michael Mauboussin points out in one of his wonderful slide decks: “The best in all probabilistic fields: 1) focus on process versus outcome and 2) always try to have the odds in their favor.” If you read the many posts in this series on my blog you will see that all great investors focus on having a sound process. A great venture capitalist like Don Valentine learned early in his career the importance of having a sound investing process.

When you are in a business driven by optionality, like the venture capital business, investing a lot of resources in creating spreadsheets is a waste of time since the assumptions in it are guesses. The best way to quantify the opportunity is actually with a story. Chris Sacca puts it this way: “Good stories always beat good spreadsheets….Before drawing a single slide of your pitch deck, tell the story out loud to anyone who will listen. Again and again. Now you have your deck.”  My father’s twin brother recently passed away and at his funeral one of his sons talked about how his dad liked to tell Ah Mo: Indian Legends from the Northwest stories collected by my great grandfather. My uncle knew well that the best way to get good at telling stories is to actually tell stories. He was also a great teller of jokes.

Telling stories is like public speaking: the more you do it, the better you get.  If you must to refer to notes in telling your story, it will be vastly less effective. Speak from the heart in telling your story and you can say a tenth as much but have twice or more as much impact. Sometimes I meet an entrepreneur who reminds me of an Maya Angelou quote in I Know Why the Caged Bird Sings: “There is no greater agony than bearing an untold story inside you.”  This entrepreneur has an idea, but they can’t express it well enough to get funded and attract the necessary team. In a case like that they need a co-founder who can tell the story. Or they need to focus on learning to be a storyteller. Some may consider Dale Carnegie and Toastmasters to be corny, but they work for many people who have not yet learned to tell a story.

 

2. “I’ve always been mystified by the critically important disc drive industry, without which the PC is a useless device. You have to be brilliant in electronics, you have to be brilliant in magnetics and you have to be brilliant in mechanics to get all that memory capacity in a very little place and do it for next to nothing. That market has never been rewarded financially for its brilliance.”

The reason for this “mystery” described by Don Valentine is best explained by Charlie Munger:  “there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” At its heart, what Charlie Munger is taking about here is the importance of a moat.  If a business does not create some barrier to entry, supply will be increased by competitors to a point where profit drops to the opportunity cost of capital.

Don Valentine is pointing out that many things which require sheer brilliance to create technically produce only consumer surplus and no producer surplus (profit). The level of profit of businesses in a given part of the economy can be vastly lower than their importance to society. For example, airlines and many manufacturers generate a lot more value to society than their profitability suggests.

 

3. “We have always focused on the market — the size of the market, the dynamics of the market, the nature of the competition — because our objective always was to build big companies. If you don’t attack a big market, it’s highly unlikely you’re ever going to build a big company.”

“Great markets make great companies.” “We’re never interested in creating markets – it’s too expensive. We’re interested in exploiting markets early.” 

“I like opportunities that are addressing markets so big that even the management team can’t get in its way.” 

Do startups sometimes create new big markets? Sure, but Don Valentine is saying is it too expensive for his taste. The other point he is making is similar to a point made by Warren Buffett: “When an industry with a reputation for difficult economics meets a manager with a reputation for excellence, it is usually the industry that keeps its reputation intact.” Don Valentine is saying that even a subpar management team can win in a market that is really big that is exploited early. And, of course, a first rate management team in that same situation will do even better.

 

4. “The key to making great investments is to assume that the past is wrong, and to do something that’s not part of the past, to do something entirely differently. I asked what was the most outrageous thing you’ve ever done, knowing in my heart of hearts that I’d pick the one who’d done something most outrageous.”

“What is important is to have the ability and willingness to be different. Great companies are built with different products by different people.”

To make a dent in the universe, it will be necessary to be contrarian on something very important and be right about that contrarian view in a big way. This is true both in investing and in building a business. No one speaks more clearly on this point than Howard Marks. I’ve blogged about that here. No one has taught me more about this than Craig McCaw, who is about a different a thinker as I have ever met. Don Valentine’s partner Michael Mortiz said once: “While there is danger in the venture business in getting too far away from the crowd, it can often pay to be unconventional. Don Valentine, the founder of Sequoia Capital, told me to trust my instincts, which lets you avoid getting dragged into conventional thinking and trying to please others.”

 

5. “The trouble with the first time entrepreneur is that he doesn’t know what he doesn’t know. After a failure, he does know what he doesn’t know and can beat the hell out of people who still have to learn.”

A famous Confucius quote is: “True wisdom is knowing what you don’t know.” But the important corollary to that quote is that there are some things that you can’t know, because some future states of the world are not known.  A similarly famous Don Rumsfeld quote is: “As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.” Risk comes from not knowing what you are doing and big problems can come from not knowing what you don’t know.

I have done a few posts on the work of Zeckhauser and Taleb that you can read on this point (e.g., #1 here).

 

6. “The biggest consistent irritant were co-investors more intent on talking over management, rather than listening to them, in the board room.”

“The world of technology thrives best when individuals are left alone to be different, creative, and disobedient.”

Board members who thrive on helping others succeed are the right sort of board members to have.  Board members who love to listen to themselves talk are a disaster. They are the equivalent of the people in the gym who love to stare at themselves when they work out. You might say that there is an inverse relationship between the need of a person to take selfie’s and their suitability to be a board member.

 

7. “There are two things in business that matter, and you can learn this in two minutes- you don’t have to go to business school for two years: high gross margins and cash flow. The other financial metrics you can forget… with high gross margins you can grow the company as fast as the market will allow.”

“All companies that go out of business do so for the same reason – they run out of money.”

Cash is like oxygen or water. Without it you are dead. A lot of things will be forgiven in business, but running out of cash is not one of them. Particularly in a subscription business you can have a huge mismatch between profit and cash flow. Expense can be stacked up in month one and cash coming in only over a long time. “The only unforgivable sin in business is to run out of cash” said Harold Geneen. The markets seem flush with cash right now. But that availability of new cash can disappear in a heartbeat.

 

8. “These binders cost money. Spend it on something more useful.”

Don Valentine is a believer in cost control and sending messages by walking the talk.  Give him something like a report in an expensive binder he is going to say something like “this is not a good way to create value.” Famously frugal managers like Tom Murphy are not opposed to spending money as long as it creates value. One thing that people underestimate the importance of is the need to acquire customers in a cost effective way. Acquiring customers cheaply is such a beautiful way to make generating a profit easier. Conversely, paying too much to acquire a customer is not a solvable problem. The cost of acquiring a customer and the cost of serving a customer can be stone cold killers of a business.

 

9. “We don’t spend a lot of time wondering about where people went to school, how smart they are and all the rest of that. We’re interested in their idea about the market they’re after, the magnitude of the problem they’re solving, and what can happen if the combination of Sequoia and the individuals are correct.”

One of the most attractive things about the venture capital world is that someone without credential x or y can still become a success. That is not to say that credentials are not relevant or helpful, especially early in a person’s career, but history has shown that at least they are not required. One of the very best credentials, of course, is previously scoring a very big financial return, most importantly for the person considering your proposal.

 

10. “One of my jobs as a board member has been to counsel management to avoid distraction and to execute with constructive paranoia.”

It is easy for a startup to lose focus. There are lots of “shiny new pennies” which people like journalists like to talk about that can cause distraction. Paying attention to what is actually going on in a business and avoiding distractions is essential.  The importance of being paranoid is famously attributed to Andy Grove of Intel, who said once: “The ability to recognize that the winds have shifted and to take appropriate action before you wreck your boat in crucial to the future of an enterprise.” Don Valentine is saying that vigilance is important and that the right sort of paranoia is constructive paranoia.

My father-in-law loved to joke that “just because you are paranoid doesn’t mean they are out to get you.” Andy Grove once wrote: “Business success contains the seeds of its own destruction. The more successful you are, the more people want a chunk of your business and then another chunk and then another until there is nothing.” The bigger and more profitable you get, the bigger the X on your back serving as a target for competitors.

 

11. “Think about a company like Eastman Kodak – it was the leader in its market, and now it’s gone. How can a $100 billion company go out of business? The answer is, easily and quickly.”

When optionality driven by network effects pays off, the amount of that payoff in a digital world can be nonlinear. And when network effects disappear, the amount of loss and the speed it disappears is also nonlinear.  In other words, network effects are a double-edged sword – success can disappear just as fast as it was created. Actually, the loss of network benefits is more spectacular since it is something huge transforming into nothing.  When network effects create benefits the early success is unseen and more surprising since the phenomenon involves “emergence.” Something suddenly appearing in a way that is far greater than the sum of its parts can be surprising indeed.

 

12. “I just follow Moore’s Law and make a few guesses about its consequences.”

“The nature of silicon and software and storage go hand in hand. In the case of software, you just have to be more clever about the nature of the application. So all these things kind of tick along, feeding off each other.”

Don Valentine’s partner at Sequoia Michael Mortiz once said:  “A chimpanzee could have been a successful Silicon Valley venture capitalist in 1986.” It’s been very good to be associated with Moore’s law over the years. Underestimating Moore’s law’s power is easy to do since its impact is nonlinear. Humans are not well equipped to understand nonlinear phenomenon well since most things in life are linear.

 

Notes:

UC Berkeley Digital Assets – Interviews with Donald Valentine

Computer History Museum – Donald Valentine

 

Sequoia Profile – Founder Don Valentine

SiliconGenesis – Stanford Interview

 

GSB Stanford – What Problem Are You Solving?

GigaOm – Lessons From Silicon Valley VC Legend

 

Forbes Profile – Don Valentine, Venture Capitalist

TechCrunch – VC Titans Perkins and Valentine Articulate What Makes a Good VC

Stanford Talk (video)

 

A Dozen Things I’ve Learned From Arthur Rock about Business & Venture Capital

“Arthur Rock was one of America’s first venture capitalists. He played a key role in launching Fairchild Semiconductor, Teledyne, Intel, Apple, and many other high-tech companies. Following an early career on Wall Street in investment banking, Arthur started his first venture capital partnership with Tommy Davis. Between 1961 and 1968, Davis & Rock invested $3 million and returned $100 million to their investors.”

 

1. “What attracted me first, I got this letter from Gene Kleiner when I was in New York,  actually written by his wife, suggesting that seven of the scientists at Shockley were not happy there and could I find them a job together…”

“The problem at Fairchild Semiconductor had to do with incentives. The whole idea of giving people incentives was something foreign to most companies.” “…employees like to feel they own part of the company, no matter how little.”

Seven scientists who were very unhappy with the management style of William Shockley left Shockley Semiconductor with Bob Noyce to become the famous “traitorous eight.” The capital these scientists needed after leaving Shockley was supplied by Arthur Rock’s investment firm Hayden Stone.  Each of the eight scientists received 10 percent of the equity and Hayden Stone received 20%. The incentive created by that 10% ownership interest was important in motivating these people to create one of history’s greatest businesses (Fairchild Semiconductor).

Therese Poletti once wrote about this group: “It is estimated by some that more than 400 companies can trace their roots to those “Fairchild Eight” … the most famous being Robert Noyce and Gordon Moore, who left to co-found Intel in 1968. Other famous “Fairchildren” include Jerry Sanders, a sales star at Fairchild, who left with a group of engineers to co-found Advanced Micro Devices in 1969. ‘This was the first company to spin off engineers starting something new,’ said Moore. “By luck, we caught up with some financing and got to start our own company.” But it wasn’t easy, the group approached 35 companies with the help of a young Harvard MBA named Arthur Rock.”

Fred Wilson and Andy Rachleff, among others, have both written thoughtfully on the important topic of employee equity.

 

2. “I get my kicks out of building companies…” “[Early venture capitalists] were all company builders. And people entering the business in the late 1990’s were promoters. They’re always promoting their companies and promoting their deals.”  

“You know, a lot of people are just interested in building a company so they can make money and get out. That doesn’t interest me at all.  Usually it’s not a successful way anyway…”  

The venture capitalists I admire most like to spend their time and effort building real businesses. They almost always understand finance deeply, but for them, finance is an enabler of what they most love to do. One of the ironies of venture capital is that the best way to be financially successful is to pay less attention to finance and more attention to building a business. The right financial structure doesn’t mean anything if all it does is guarantee you a high percentage of nothing.

 

3. “We spent a lot of time with our companies... [sometimes] if you divide up the number of companies they’re invested in by the number of partners, you find that the partners haven’t got ten minutes for any one company.”

Time is the scarcest resource that any venture capitalist has to offer any business in their portfolio.  A founder or business is not going to get much time from the venture capitalist if that venture capitalist is investing in too many businesses. This is part of the reason why the venture capital business does not scale well.  You can’t automate the work that a great venture capitalist does in helping grow a business. 

 

 

4. “I was more interested in people, in figuring out whether the people are good people without knowing exactly what it is they are going to do technically.”

Many people in this series on my blog have pointed out that the success of a business is fundamentally tied to its people. The company you build is the people you hire. Arthur Rock himself is not a technologist, but he is an excellent judge of people. Finding the right people is fundamental to the success of a startup. Great people create optionality for the business since they are more able to adapt to an uncertain future.

 

5. “Good ideas and good products are a dime a dozen. Good execution and good management—in a word,  good people—are rare.” “The lesson from Intel? The necessity of having great management.”

Almost everyone has good ideas once in a while. There is a light year of difference between “I thought of that” and “I built that.”  Arthur Rock’s comment on the importance of management also reminds me of the posts I did on “Coach” Bill CampbellJim Barksdale, and Sheryl Sandberg. Strong technical skills are not enough to create a successful business, and strong management skills aren’t enough either. The rarity of “good management and good people” is another reason why venture capital does not scale well as an industry.

 

6. “I am especially interested in what kind of financial people they intend to recruit. So many entrepreneurial companies make mistakes in the accounting end of the business. Many start shipping products before confirming that the orders are good, or that the customers will take the product, or that the accounts are collectible. Such endeavors are more concerned about making a short-term sales quota than about maximizing the long-term revenue stream.”

Accounting revenue is an opinion and real cash flow is a fact. A startup focused on fake metrics will eventually pay the price. The first and second rules of finance are: pay attention to cash and pay attention to cash. When the business has found product/market fit and the task at hand is more focused on scaling the business, if the focus of the sales team is to create faux success by using misleading metrics that is potentially a huge problem. The easiest person to fool is yourself.

 

7. “I look for people who [are] honest. They have fire in their belly. They’re intellectually honest meaning that they see things as they are, not the way they want them to be and, and have priorities and know where they’re going and know how they’re going to get there.”

Confirmation bias and other dysfunctional heuristics drive people to see what they want to see. This gets in the way of the intellectual honesty Arthur Rock seeks. Psychological denial is a powerful and often dysfunctional force in the world of failure. In this interview Arthur Rock is also pointing out that he is trying to sort out whether someone “is a good person.” Whether someone is a good person is a highly underrated success indicator. Not only is it the right thing to do and the most pleasant thing to do, it is the most profitable thing to do. People who deal with each other via what Charlie Munger calls a “seamless web of deserved trust” because they are good people, get more things done quickly and efficiently.

 

8. “When they have their five-year plan and they come down to net profits, that’s okay. But then when they tell you how much your earnings per share is going to be and what the dilution is going to be and then how much, at what price earnings ratio the stock is going to sell at and then they tell you, well, you know if you invest it today you would make twenty times or a hundred times or something on your money, at that point I don’t want to talk to them anymore. Very nice to have met you. Goodbye. Good luck.”

This is such a great statement since the “tell’ Arthur Rock describes reveals so much.  First, people who think they can predict the future with sufficient accuracy to create a detailed five-year plan have a lousy understanding of how business works and have not been paying attention to life. A spreadsheet is only as good as your assumptions and when you put garbage into a spreadsheet garbage comes out. Second and even more importantly, entrepreneurs like Arthur Rock described are not sufficiently focused on solving real customer problems – a precondition for creating a valuable business.

 

9. “One thing that probably has not changed is the need to be a good listener.”

In deciding which venture capitalist to select, Chris Sacca has suggested the founder ask: “Who’s gonna listen?” Mark Suster has similarly said: 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.”

This list of people recommending listening is long. Larry King: “I remind myself every morning: Nothing I say this day will teach me anything. So if I’m going to learn, I must do it by listening.”

It is not just important that you listen to your venture capitalist or your founder – any successful business must listen to its customers, suppliers and employees. Arthur Rock also pointed out in this same interview that whether someone is a good listener is best judged over time, since in the first meeting they may be on their best behavior. 

 

10. “Fred Terman was head of the engineering school at Stanford, and he encouraged his students, especially the doctoral and postdoctoral students, to form companies and continue to teach at Stanford.”

“It is entirely possible that there would be no silicon in Silicon Valley if Fairchild Semiconductor had not been established.”

The positive feedback loop that Stanford has created is powerful.  The formula is simple: allow professors and students to be entrepreneurial and give them access to great facilities and other resources. Teach them to be empathetic, ethical and thoughtful. These professors and students will build valuable businesses and will eventually be philanthropic toward the university, which creates a source of funds that can be re-invested in students, professors and infrastructure and other resources in a way that grows over time [repeat indefinitely]. That William Shockley was born south of San Francisco area was a lucky break for the San Francisco area just as Bill Gates being born in Seattle as a lucky break for the Seattle area. If you look at which areas of the world are economically successful, you inevitably see major research universities. If the research university has archaic rules about conflicts of interest the universities suffer, and so does the surrounding area’s economic environment.

 

11. “Over the past 30 years, I estimate that I’ve looked at an average of one business plan per day, or about 300 a year, in addition to the large numbers of phone calls and business plans that simply are not appropriate. Of the 300 likely plans, I may invest in only one or two a year; and even among those carefully chosen few, I’d say that a good half fail to perform up to expectations.”

This fundamental aspect of venture capital investing – the power law distribution of financial returns – has not changed and will not change. The combination of (1) the optionality discovery process inherent in venture capital and (2) the top down constraint an economy puts on income for any given business/all business collectively, means that the power law is here to stay. To find the one unicorn that drives financial returns in the venture capital industry requires that the venture capitalist look at a lot of prospects before finding an opportunity that may be mispriced. And even after carefully examining hundreds of opportunities, half of all venture opportunities will fail outright and most of the rest will mostly be “meh” results.

 

12. “Success breeds success.”

This is a simple statement of one of the most powerful forces operating in the world today. The more technical term to describe the phenomenon is “cumulative advantage.” Columbia University’s Duncan Watts puts it this way:

The reason is that when people tend to like what other people like, differences in popularity are subject to what is called “cumulative advantage,” or the “rich get richer” effect. This means that if one object happens to be slightly more popular than another at just the right point, it will tend to become more popular still. As a result, even tiny, random fluctuations can blow up, generating potentially enormous long-run differences among even indistinguishable competitors — a phenomenon that is similar in some ways to the famous “butterfly effect” from chaos theory.”

& this way: 

“…hindsight isn’t 20/20; it’s reductive and unreliable. In a section on the Mona Lisa, for example (see excerpt), he discusses how the painting languished in relative obscurity for centuries, only becoming world famous after it was stolen from the Louvre in the early 1900s—but since the idea of its greatness owing to a fluke is so inherently unsatisfying, people ascribe post-facto “common sense” explanations. (It’s the smile! It’s the fantastical background! It’s the genius of Leonardo da Vinci!) “Common sense is the mythology—the religion—of the social world,” Watts says. “It’s the simple answer that maps directly onto our experience, the explanation we need to make things make sense. So we hear thunder and say, ‘The gods are fighting.’ That’s something we understand; people get angry and throw things. Common sense is socially adaptive. If we constantly had to grapple with the complexity of the world, we wouldn’t be able to get out of bed in the morning.”… if an answer and its opposite can seem equally obvious through the right mental gymnastics, there’s something wrong with the idea of “obviousness” in the first place. “We make this mistake so often, and it really hurts us,” Watts says. “We can’t understand the social world just by telling a bunch of cute stories. You need theories, experiments, data. It’s tricky and counterintuitive, and everything is more complicated than you think it is. Your intuition is always misleading you into thinking you understand things that you don’t.” 

Descriptions of this so-called “Matthew effect” (the rich get richer) are old enough that the source of its name is the bible. What is new is that digital systems are accelerants of the Matthew effect. The rich are getting even richer since cumulative advantage scales even better when the phenomenon is digital.  As Nassim Taleb has pointed out, more and more of the world is Extremistan. Taleb gives the example of the recording device as a contributor to Extremistan results:

“Our ability to reproduce and repeat performances allows me to listen to hours of background music of the pianist Vladimir Horowitz (now extremely dead) performing Rachmaninoff’s Preludes, instead of to the local Russian émigré musician (still living), who is now reduced to giving piano lessons to generally untalented children for close to minimum wage. Horowitz, though dead, is putting the poor man out of business. I would rather listen to Horowitz for $10.99 a CD than pay $9.99 for one by some unknown (but very talented) graduate of the Julliard School. If you ask me why I select Horowitz, I will answer that it is because of the order, rhythm or passion, when in fact there are probably a legion of people I have never heard about, and will never hear about – those who did not make it to the stage, but who might play just as well.”

 

Notes:

 

HBS – Done Deals

Computer History – Arthur Rock

 

Harvard Business Review – Strategy vs Tactics

HBS – Harvard Entrepreneurs: Arthur Rock

 

Digital Assets – Oral History

Mike Markula Interviews Arthur Rock (video)

A Dozen Things I’ve Learned from Sheryl Sandberg about Management, Careers & Business

1. “I sat down with Eric Schmidt, who had just become the CEO [of Google], and I showed him the spread sheet and I said, this job meets none of my criteria. He put his hand on my spreadsheet and he looked at me and said, ‘Don’t be an idiot.’ Excellent career advice. And then he said, ‘get on a rocket ship. When companies are growing quickly and they are having a lot of impact, careers take care of themselves.’ ”

This quote above extends on the importance of getting involved in situations that create positive optionality. For example, when companies grow there is a need to do new things – workers become managers, people who do X are trained to do Y and Z, and everyone learns new skills. There tends to be more opportunity and less politics in a growing company since it is more than a zero sum game. Companies that are shrinking tend to be the reverse.

A less than zero sum game at your place of work is problematic when it comes to your career. Startups can be particularly attractive sources of optionality. In the early days of a growing company (when there are just a few people working at the company) there was no shortage of opportunity. Startups tend to make for more battlefield promotions and people are more often allowed to learn new things and grow as employees.  

 

2. “The reason I don’t have a plan is because if I have a plan I’m limited to today’s options.”

Positive optionality is very valuable. If you are not open to opportunity as it arises, you can’t harvest optionality. My friend Craig McCaw likes to say flexibility is heaven. If he can delay a decision somehow, he will do it because he knows a better option might arise in the meantime. Sheryl Sandberg is a protégé of Larry Summers who is close to Robert Rubin. So to understand Sheryl it is useful to understand Rubin. In a New York Times article Summers describes Rubin’s approach: “Rubin ends half the meetings with – ‘So we don’t have to make a decision on this today, do we?’ Summers says. New information will evolve.”

“What so many people have a tendency to do is to lock into a scenario,” Summers says. “What Rubin will say, at times to the frustration of others, is that some questions don’t have answers – which is to say that just because a problem is terrible, we don’t have to act. It may not be the right time.” In a Fortune magazine article Carol Loomis wrote about Rubin: “Part of Rubin’s approach to decisions at the Treasury was to put them off as long as possible. Some people might call that procrastination; Rubin called it getting that one last fact or well-judged opinion, from whoever at the table might offer it, that might make a decision the right one. Geithner says the young members of the Treasury staff would on occasion rush into Rubin’s office, imploring him for a decision about something consequential. Rubin’s first question would often be,How much time do we have before we have to decide? Summers calls this Rubin’s habit of “preserving his optionality.”

 

3. “There is no straight path from your seat today to where you are going. Don’t try to draw that line.”  

Life is not linear. Opportunity usually arrives in life in strange and unexpected ways.  Opportunity also tends to arrive in a lumpy fashion. This nonlinearity and lumpiness means that it is wise to be both patient and ready to be very aggressive when opportunity presents itself. One odd thing that I like to do (there are many) is read obituaries. When you read a good obituary it often reinforces how nonlinear life can be. The line “life is one damn thing after another” is variously attributed to Edna St Vincent Millay and to Elbert Hubbard, but whoever said it was speaking to a fundamental truth. You can see the nonlinear path life takes in many obituaries.

 

4. “The traditional metaphor for careers is a ladder, but I no longer think that metaphor holds. It doesn’t make sense in a less hierarchical world. … Build your skills, not your resume. Evaluate what you can do, not the title they’re going to give you. Do real work. Take a sales quota, a line role, an ops job, don’t plan too much, and don’t expect a direct climb. If I had mapped out my career when I was sitting where you are, I would have missed my career.”

Sheryl Sandberg is saying that the traditional career path is history. And that you must sometimes move horizontally into positions where you acquire new skills to advance in life.

Reid Hoffman has a similar view: “The notion of a career has changed. Whereas we used to have a career ladder, now we have a career jungle gym. Success in a career is no longer a simple ascension on a path of steps. You need to climb sideways and sometimes down; sometimes you need to swing and jump from one set of bars to the next. And, to extend the metaphor, sometimes you need to spring from the jungle gym and establish your own turf somewhere else on the playground. And, if we really want the playground metaphor to accurately describe the modern world, neither the playground nor the jungle gym are fixed. They are constantly changing—new structures emerge, old structures are in constant change and sometimes collapse, and the playground constantly moves the structure around.”

 

5. “All of us, and especially leaders, need to speak and hear the truth. The workplace is an especially difficult place for anyone to tell the truth, because no matter how flat we want our organizations to be, all organizations have some form of hierarchy. What that means is that one person’s performance is assessed by someone else’s perception. This is not a setup for honesty.”  

Genuine listening is hard. People in senior management tend to get surrounded by people who tell them what they want to hear. In his famous speech The Psychology of Human Misjudgment Charlie Munger pointed out: Now you’ve got Persian messenger syndrome. The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should’ve seen Bill Paley in his last 20 years. [Paley was the former owner, chairman and CEO of CBS]. He didn’t hear one damn thing he didn’t want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn’t want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.”

 

6. “Leadership is about making others better as a result of your presence and making sure that impact lasts in your absence.”

Here I think Sandberg shares the view that Marissa Mayer and others have, which is that at a top level in management the job is less about making many decisions but rather making a few very important decisions – then doing what it takes to enable other people to get things done that matter. An effective leader needs to articulate a set of priorities that enables the team to make decisions in the absence of a leader, which is necessary most of the time. Effective leaders find ways to amplify their impact whether they are present or not.

 

7. “Your life’s course will not be determined by doing the things that you are certain you can do. Those are the easy things. It will be determined by whether you try the things that are hard.” 

“Ask yourself: What would I do if I weren’t afraid? And then go do it.”

This again is thinking about your life as if you were a venture capitalist. As I pointed out in my post on Chris Dixon, it is in the areas where people are not looking that you can find mispriced opportunities. The “price” you pay in a career when trying to capitalize on an opportunity is not just money, but time and energy.  If you aren’t failing sometimes you are not learning. Try not to repeat the same mistakes and instead make new mistakes. Good judgment is often acquired by a progress that often involves bad judgment.

 

8. “The most important thing I can tell you is to open yourselves to honesty. So often the truth is sacrificed to conflict avoidance. You know your closest friends’ strengths and weaknesses, and what cliff they might drive off. Ask them for honest feedback.”

No one has perspective on themselves. We all need people who can tell us when we are off course. Charlie Munger puts it this way: “This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead. And, of course, if you turn on the television, you’ll find the mothers of the most obvious criminals that man could ever diagnose, and they all think their sons are innocent. That’s simple psychological denial. The reality is too painful to bear, so you just distort it until it’s bearable. We all do that to some extent, and it’s a common psychological misjudgment that causes terrible problems.”

 

9. “Google is fundamentally about algorithms and machine learning. And that that has been very important and continues to be very important. They’re doing a great job. [At Facebook] we start from a totally different place. We start from an individual. Who are you? You know, what do you want to do? What do you want to share?….There’s one thing that I think is most important that’s to Facebook, which is that we are focused on doing one thing incredibly well. We only really want to do one thing.”  

Focus matters. For a company to be a master of one thing can be very valuable, whereas an attempt to be a jack of all trades can be problematic. One thing that is tremendously clarifying for a business is a single principle around which a company can optimize decisions (that one thing). This allows people, even in a large business, to know how to optimize daily decisions. At Google, people know that the “one thing” is selling more targeted advertising. Everything is optimized to achieve that objective.

 

10.  “No one can have it all.”

“Life and business inevitably involves tradeoffs. Family, work, personal life all potentially create conflicts. Some people have a great ability to balance things in life, but no one can have everything. Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.”

Tradeoffs are inevitable in business and in one’s personal life. There is work, personal life and family. Getting the mix right between these three things is neither simple or easy. Often the tradeoffs are caused by limitations created by laws of physics. Business must also make tradeoffs. I have always found this quote from Michael Porter to be useful: “Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different.”

 

11. “Done is better than perfect.”

The people who succeed in life are people who get things done. Not just getting anything done, but the things that matter. They don’t necessarily clear their screens or desks every day, they clear their screens or desks of the things that matter most. Here’s an example of done being better than perfect: Every weekend I write 5,000 words or so. The post aren’t perfect, but I get them done. The perfect blog post is the one that has never been written. The perfect life is the life that has never been lived. Mark Zuckerberg wrote in the letter that accompanied Facebook’s S-1 filing with the SEC:

“Hackers try to build the best services over the long term by quickly releasing and learning from smaller iterations rather than trying to get everything right all at once. To support this, we have built a testing framework that at any given time can try out thousands of versions of Facebook. We have the words “Done is better than perfect” painted on our walls to remind ourselves to always keep shipping.”

Facebook has created a system where everything they ship is an experiment that is rigorously tested and improved through nearly constant iteration. Hundreds or even thousands of experiments are conducted at a software company like Facebook every day.  Most things fail, but the experimentation process discovers improvements via what Nassim Taleb Calls via negativa.

 

12. “Work hard, stick with what you like, and don’t let go.” 

Being relentless and working hard often pays big dividends, financially and otherwise. Staying relentless in pursuit of your goals and working hard is far easier and more likely to be successful if you are doing what you like. Sheryl Sandberg’s statement is not always true, since life is often unfair, but not working hard, doing what you hate and letting go, almost certainly won’t get you anywhere. What Sheryl Sandberg is saying here is quite simple. Someone might even complain that it is too simple or even obvious. Business is often made too complex and at its core is simple. Being a great manager like Jim Barksdale or Tom Murphy requires the daily equivalent of blocking and tackling in football.  Building a business brick-by-brick is what great managers do.

 

 

Notes:

New Yorker – A Woman’s Place

HBS Speech – Sheryl Sandberg: Get On A Rocketship Whenever You Get The Chance

 

Harvard Magazine – Harvard College Class Day 2014

McKinsey Interview – Facebook’s Sandberg: No one can have it all

 

Amazon – Lean In

Harvard Commencement – Sheryl Sandberg Graduation Wisdom (video)

 

NY Times – Keeping the Boom From Busting

Fortune – Robert Rubin on the job he never wanted

A Dozen Things I’ve Learned from Keith Rabois about Venture Capital and Business

1. “The only way to learn how to invest is to invest. You can’t simulate it.”

Getting feedback is fundamental to the learning process. Reading and learning from others is great but at some point the only way to refine your skill is to actually invest real money. Many people have taken a class in which they make trades that simulate investing. Simulation is no substitute for investing, since most mistakes in investing are psychological.

Without actually testing your emotions and learning from genuine feedback you really have not put yourself in a place where you can test your ability to control your emotions. Warren Buffett said once:  “Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value.” The same thing can be said about Investing.

The way to learn about investing is to invest and to have what Nassim Taleb calls “skin in the game.” One of the most useful papers I have read about investing was written by Richard Zeckhauser, who is a professor at Harvard and a top class bridge player.  The paper is entitled “Investing in the Unknown and Unknowable”:

“the wisest investors have earned extraordinary returns by investing in the unknown and the unknowable (UU). But they have done so on a reasoned, sensible basis. This essay explains some of the central principles that such investors employ. It starts by discussing “ignorance,” a widespread situation in the real world of investing, where even the possible states of the world are not known. Traditional finance theory does not apply in UU situations … Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop … new technologies.”

Who has complementary skills? Zeckhauser writes: “Venture capitalists can secure extraordinary returns… because early stage companies need their skills and their connections. In soft, the return on these investments comes from the combination of scarce skills and wise section of companies for investment.”

In a post on Keith Rabois’s partner Vinod Khosla I described what Richard Zeckhauser calls the domain of “ignorance.”  A matrix which depicts one set of important relationships that impact venture capital, based on my interpretation of the ideas of Nassim Taleb, is as follows:

Binary outcomes, complex outcomes, probability distributions

Because success in an industry is driven by the fourth quadrant (ignorance) successful venture capitalists understand that their objective is not to predict outcomes with certainty, since that is not possible. The task of a venture capitalist is instead to discover success from within a portfolio of 30-40 bets that have optionality. In the paper, Zeckhauser presents this to make clear that risk, uncertainty, and ignorance are very different things:

Escalating Challenges to Effective Investing

Venture capitalists with complementary skills have developed them over a period of years with experience in real world investing. Simulations of bets involving risk do not enable the investor to profit in the uncertainty and ignorance domains. The best way to become a venture investor is to make venture investments. There is no substitute for real world experience.

 

2. “Early stage, almost every successful entrepreneur I know doesn’t care as much about the economic terms as much as who they are going to work with.”

“If you have the option, raise money from one lead investor who has the right skill set, background, and temperament to help you.”

Khosla Ventures believes that the quality of the advice and mentoring given is so important that they present the firm as “venture assistance” rather than venture capital. Using Professor Zeckhauser’s taxonomy, it is the complementary skill and not the money that creates the extraordinary investing result.  Founders who are paying attention have figured out that the same venture capitalists are consistently generating the grand slam home runs year after year.

An important aspect of any person’s skill set is that a lot of skill comes from early luck. People who get lucky early in life end up with more skill through a process known as “cumulative advantage.” What entrepreneurs should be taking away as a message is that money is fungible but the skill of the venture capitalists is not. This series on my blog has tried to drive home the idea that money is money (assuming deal terms are equal) but not all venture capitalists are the same. Skill should drive an entrepreneur’s choice of venture capitalist.

In addition to the importance of complementary skills, it is hard to deny that there are signaling benefits from having a top venture firm as an investor. The world is filled with uncertainty and people look for signals when making decisions. Employees and others are attracted to startups that others are attracted to, which causes cumulative advantage and the power laws that exist in venture capital. Success create more success with a power that is nonlinear. As another example of success leading to success see this HBS paper on performance persistence:

“Entrepreneurs with a track record of success are much more likely to succeed than first-time entrepreneurs and those who have previously failed. In particular, they exhibit persistence in selecting the right industry and time to start new ventures. Entrepreneurs with demonstrated market-timing skill are also more likely to outperform industry peers in their subsequent ventures. This is consistent with the view that if suppliers and customers perceive the entrepreneur to have market-timing skill, and is therefore more likely to succeed, they will be more willing to commit resources to the firm. In this way, success breeds success and strengthens performance persistence.” 

 

3.  “You are looking for outliers [as Founders].”

Optionality is everywhere if you know where to look, but the best types of positive optionality can be found in places where others are not looking. If a founder is an outlier it is much more likely that will find something that others are not looking at or can see.

In post after post in this series on my blog I have driven home the point that venture capital is an investment system driven by a very small number of tape measure home runs and that distributions of success reflect power laws. An investor will not find mispriced optionality by following the crowd. The optionality will be found in what Zeckhauser calls UU situations, where exists what he calls the ‘domain of ignorance’. This concept is from another Zeckhauser paper that you might want to read, entitled “Grappling with Ignorance.”

The critical point here is that when you are a highly skilled venture capitalist uncertainty and ignorance are your friends. This is where you find the outliers that Keith Rabois is talking about.

 

4. “The [best founders] can relay incredibly complex ideas in simple terms, can see things you don’t see, are relentlessly resourceful [and are] often contrarian.”

I have seen many great founders in the course of my career and I can say that they are all different in many ways yet also similar in some ways. This topic is worthy of a separate post. Keith Rabois has identified four important qualities of a great founder in his statement. First, successful founders almost always have the quality that Jeff Bezos said he looked for in a wife: “someone who would be resourceful enough to get him out of a Third World prison.” Second, they understand that to deliver an outsized result from their startup (financially and otherwise) they must be contrarian about something important and they must be right.  Third, they can convey their ideas in ways that are easy for people to understand. Fourth, they have a unique way of looking at problems. A significant number of hyper-creative people are somewhat dyslexic. Great founders don’t think like other people in at least one important way, and are fearless about at least one important thing. This blog series has identified a range of other attributes in addition to these four that make for a great founder, like the ability to recruit talented people and a founder’s tendency to hire others who complement their skills.

The ability to find outlier founders (especially in new categories) is an especially valuable skill for a venture capitalist. I don’t think that there is any question that the skills involved in finding the best founders are based on pattern recognition. The more founders a venture capitalist sees in action, the better their ability to “know it when they see it.”  Mike Moritz is an example of a venture capitalist who is particularly good at finding great outlier founders.

 

5. “There are fundamental differences between an angel, what I call an amateur investor and being a professional investor, a venture capitalist.”

Once a person is investing other people’s money they are no longer an angel but rather a professional investor.  Great professional seed stage investors like Chris Sacca, Mike Maples Jr. and Ron Conway should not be referred to as Angels, but rather professional seed stage investors. In addition, even though someone like Max Levchin is still investing their own money at significant scale (and so might be called an angel) if you compare what Max does to a dentist in Portland writing a $75,000 seed round check, it’s apples and oranges. The way to resolve the question is to say that someone like Max Levchin who is prolific and has company building skills that go beyond being wealthy and well-connected crosses over to the professional category. The result of this taxonomy may be that a given seed round can have both professional and angel investors. My opinion is that Max Levchin investing in a seed round is not an Angel investment, but rather an investment made by a professional.

 

6. “We want to be doing what used to be called venture capital, not growth capital.”

Venture capitalists who excel in the early stage of a business provide much more than money to the business. Growth capital for companies who have product market fit and figured out a way to scale the business mostly just need more fuel to execute on what they are already doing. Once the fundamentals of the business are put in place while funded by seeds, A, and B financing rounds, many times all the business needs to scale is more capital. Even investment bankers can provide more capital. ;-) Not only is providing venture capital less financially rewarding for people with great company building skills, the work for the venture capitalist is more boring. A late-stage financing is often more about finance than building a business.  The move of marge mutual funds and others into the growth capital business naturally pushed venture capitalists to focus on earlier rounds.

 

7.  “Many entrepreneurs are raising more money than they need and it can cause derivative consequences down the road that are not healthy.”

There are many people who have written stories about venture capitalists pushing a startup to raise too much money. Experienced venture capitalists know that they often spend time with entrepreneurs counseling them to raise less money, not more. There are many ways to solve the inevitable problems that arise early in the existence of a startup. Trying to solve those problems with too much money tends to cause dysfunction in one form or another. In other words, solving hard problems with just money does not scale.

 

8. “First principle: The team you build is the company you build.”

Keith Rabois said that he first heard this phrase from Vinod Khosla when he joined the board of Square. Some investors believe that everything in a business starts with people. No one believes that more than perhaps Starbucks’ Howard Schultz, who I’ve discussed in a previous blog post.  Bill Campbell, who I’ve also discussed, would argue perhaps that product is more important but it is clear that there are two foundational things in building a business. Other venture capitalists believe that a massive addressable market is most important. One could argue that this ranking process is a bit like asking a parent which child they like best. Most parents answer: “I like them all the same.”

 

9. “There are two categories of good people: there is ammunition and there is barrels. You can add all the ammunition you want, but if you only have five barrels in your company you can literally only do five things simultaneously. If you add one barrel you can suddenly do a sixth, if you add another you can do seven. So finding those barrels that you can shoot through is key.”

I met with one of the very top executives at Boeing once with Craig McCaw, and he said that of the tens of thousands of engineers in the company only seven of those engineers were capable of designing an entire airplane. He said he could name those seven engineers. These were the equivalent of what Keith Rabois is calling “barrels.” These barrels are the unique employees who give other employees direction and fire them toward a goal. Finding and hiring barrels is hard, and a rare event. There barrels are scarce in the real world – hiring too many barrels is not a phenomenon often encountered.

 

10. “Silicon Valley, it tends to fragment talent across too many companies, so you get a suboptimal number of successful companies.”

“Generally speaking you want to hire people that share first principles, which involve strategy, people, and culture.”

“As you get into the uncharted territory where you don’t actually have any intellectual background, you need perspectives from people that are very different from you. At that point, it’s actually quite valuable to have people that are diverse.”

There are only so many great founders with audacious ideas possessing optionality, and talented engineers, and others who can create a great business. This tends to create strong rivalries in the venture industry since the competition for the best talent is intense. Competition is always good for a system and makes it more Antifragile.

 

11.  “Matching your priorities against your time is really important.”

The scarcest resource available to any venture capitalist is their own time. The venture capital business scales poorly when the venture capitalist is actively involved in each portfolio company. A venture capitalist can only sit on so many company boards or help so many businesses with recruiting. A firm or partner can invest in so many startups before they dilute themselves and begin to underperform. Many venture capital firms learned this lesson and have pulled back to raise smaller funds and do less out-of-region investing. Of course, this matching your priorities against your time idea is also true for executives and entrepreneurs, (arguably even more so).

 

12. “Your job as an executive is to edit – not to write. Every time you do something you should think through and ask yourself: am I writing or am I editing? and you should immediately be able to tell the difference.”

What comes to mind in this quote is Eric Schmidt’s advice to Marissa Mayer, which I blogged about in a previous post. He said to her: “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.” The executive should focus on what is important. Editing should be reserved for matters that are important. More supervision is needed in certain cases as Keith Rabois points out: “There are people who just know what they don’t know and there are people who don’t. Until someone shows the propensity to distinguish between those things you can’t let them run amuck.”

 

Notes:  

First Round Review – How to hire and why transparency matters

Business Insider – Eight principles for companies in 2014

 

Vimeo – Eric Eldon interview of Keith Rabois (video)

Gigaom – Angel Investor Keith Rabois 

 

Semil Shah – Interview of Keith Rabois

WSJ – Startups spend with abandon, flush with capital

AOL – Kara Swisher interview with Keith Rabois (video)

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