A Dozen Things I’ve Learned About Negotiation

Once upon a time I wrote a book on negotiation with my friend Russell Daggatt. The book is mostly a collection of real stories about our experiences working and living abroad. I lived in Seoul for four years and for a year in Sydney. Russell lived in Tokyo.  The book was published by Harper Collins, but few years after the paperback was on the market we bought back the copyright. It is available to read for free on my web site https://25iq.com/ If you want a paper copy of The Global Negotiator, try Amazon.

1. Establish Trust

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2. Do Research about the other Negotiator

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3. Be Creative:

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4. Be Humble About Your Skill Level

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5. Some Days are better Than Others

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6. Get the Other side to Make the First Offer

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7. Build relationships. Don’t do Deals.

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8. Keep the Relationship Mutually Beneficial by Sharing value

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9. Counter Gamesmanship

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10. Focus on Interests, Not Positions

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11. Create and Claim value

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12. Know Yourself and the Other Negotiator

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A Dozen Things Warren Buffett and Charlie Munger Learned From See’s Candies

This is my 200th blog post. I thought it would be most fitting given the milestone to write about a topic related to Munger and Buffett.

One of the most important decisions in the history of Berkshire was the acquisition of See’s Candies in 1972. Buffett has called See’s Candies “the prototype of a dream business.”  Berkshire’s purchase of a boxed candy business founded by the See family in California fundamentally changed the investing world because it changed the way Buffett and Munger thought about investing. While you may never have the chance to own a business like See’s Candies, by better understanding the nature of a dream business you can more easily find a business to invest in that shares some of its positive attributes.

For anyone not familiar with the company, Bloomberg provides a helpful summary: “See’s Candies produces and retails boxed chocolates. The company was founded in 1921 and has store locations in the United States and internationally. See’s Candies operates as a subsidiary of Berkshire Hathaway.”

1. Buffett: “It’s one thing to own stock in a Coca-Cola or something, but when you’re actually in the business of making determinations about opening stores and pricing decisions, you learn from it. We have made a lot more money out of See’s than shows from the earnings of See’s, just by the fact that it’s educated me.” “If we hadn’t bought See’s, we wouldn’t have bought Coke. So thank See’s for the $12 billion. We had the luck to buy the whole business and that taught us a whole lot.” Munger: “We’ve learned that the ways you think and operate must involve time-tested values. Those lessons have made us buy more wisely elsewhere and make many decisions a lot better. So we’ve gained enormously from our relationship with See’s.”

What Buffett is saying is that the more you know about business the better investor you will be (and vice versa). The best way to learn about business is to actually run one or at least work in one. As Will Rogers once said: “Good judgment comes from experience, and a lot of that comes from bad judgment.” It is the feedback loop between success and failure and various decisions and actions that are part of operating a business that gives the business executive or investor the best education. Reading about X, Y or Z aspects of business is helpful but there is nothing quite like the education that comes from being in the driver’s seat and having personal responsibility for actual business outcomes.

2. Munger: “If we’d stayed with the classic Graham, the way Ben Graham did it, we would never have had the record we have. And that’s because Graham wasn’t trying to do what we did.” “See’s was the first high-quality business we ever bought.” “After nearly making a terrible mistake not buying See’s, we’ve made this mistake many times. We are apparently slow learners.” “If See’s had asked $100,000 more, Warren and I would have walked — that’s how dumb we were. [Munger’s friend] Ira Marshall said you guys are crazy — there are some things you should pay up for, like quality businesses and people. You are underestimating quality. We listened to the criticism and changed our mind. This is a good lesson for anyone: the ability to take criticism constructively and learn from it. If you take the indirect lessons we learned from See’s, you could say Berkshire was built on constructive criticism.” “The main contribution of [buying See’s Candies] was ignorance removal. If we weren’t good at removing ignorance, we’d be nothing today. We were pretty damn stupid when we bought See’s – just a little less stupid enough to buy it. The best things about Berkshire is that we have removed a lot of ignorance. The nice thing is we still have a lot more ignorance left. Another trick is scrambling out of your mistakes, which is enormously useful. We have a sure to fail department store. A trading stamp business sure to fold and a textile mill. Out of that comes Berkshire. Think about how we would have done if we had a better start.” “See’s Candies was acquired at a premium over book (value) and it worked. Hochschild, Kohn, the department store chain (in Baltimore), was bought at a discount from book and liquidating value. It didn’t work. Those two things together helped shift our thinking to the idea of paying higher prices for better businesses.”

What Munger is talking about above (in addition to the importance of humility) is the idea that a business with superior quality bought at the right price can still be a bargain consistent with the principles of value investing. This evolution of the value investing system to consider quality in valuing a business is arguably Munger’s greatest contribution to Berkshire. Munger knew that value investing had to evolve since the “cigar butt” types of businesses that Graham liked to buy started to disappear as years passed since the Great Depression. Munger recognized that “Grahamites … realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because of momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other. And once we’d gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Graham, we started thinking about better businesses.” For Munger, not considering the quality of the underlying business when buying an asset is far too limiting:  “The investment game always involves considering both quality and price, and the trick is to get more quality than you pay for in price. It’s just that simple.” “We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.” “If you can buy the best companies, over time the pricing takes care of itself.”

3. Buffett: “Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars. Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.”

How do Munger and Buffett assess quality? This passage from the 1992 Berkshire Chairman’s letter set out the key test: “Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.”  A recent presentation from Broyhill Asset Management points out:

“See’s sold 16 million pounds of candy in 1972. In 2007, it sold 31 million pounds.  That’s a growth rate of about 2% annually.  Yet the business created tremendous value. How? Because it generated high returns on invested capital and required little incremental investment.  Growth creates value only when a business can invest at incremental returns higher than its cost of capital. The higher return a business can earn on its capital, the more cash it can produce, the more Value is created.  Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.”

4. Munger: “There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies. At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have.” Buffett: “We bought See’s Candy in 1972, See’s Candy was then selling 16 million pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine.”

Buffett believes: “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” Buffett and Munger found an asset in the form of See’s that has retained tremendous pricing power over the years. That means See’s has a moat. It is not an unlimited moat geographically as will be discussed below, but where the moat exists it is very strong.

5. Buffett: “Buy commodities, sell brands has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891. On a smaller scale, we have enjoyed good fortune with this approach at See’s Candy since we purchased it 40 years ago.”  “When we bought See’s Candies, we didn’t know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.” “Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of chocolates by the time we get through with them on our radio ads. So that Valentine’s Day is the biggest day. Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, ‘Honey, this year I took the low bid.’ And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent.” “What we did know was that they had share of mind in California. There was something special. Every person in California has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine‘s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn‘t take any capital. And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas.

The See’s acquisition taught Munger and Buffet about the power of a brand to create a moat. Munger has pointed out:

“The informational advantage of brands is hard to beat.  And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is $.40 and the other is $.30, am I going to take something I don’t know and put it in my mouth – which is a pretty personal place, after all – for a lousy dime? So, in effect, Wrigley, simply by being so well-known, has advantages of scale – what you might call an informational advantage. Everyone is influenced by what others do and approve.  Another advantage of scale comes from psychology. The psychologists use the term ‘social proof’. We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everybody’s buying something, we think it’s better. We don’t like to be the one guy who’s out of step. Again, some of this is at a subconscious level and some of it isn’t. Sometimes, we consciously and rationally think, ‘Gee, I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?’ All told, your advantages can add up to one tough moat.”

One question relevant right now is whether the power of national brands versus local brands is decreasing due to transparency created by the Internet. In any event, over the years the power of a brand when combined with commodity inputs has created a powerful combination. “In 1972, See’s sold 16 million pounds of candy, and 35 years later, it stood at 32 million, meaning it gained just 2% a year, but it’s profit rose by 9% a year”:

 

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Source: Motley Fool Berkshire Hathaway Annual Letters.

6. Buffett: “The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.” “You cannot destroy the brand of See’s Candies. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don’t see See’s candy sponsoring the local funeral home. We are at the Thanksgiving Day Parades though.” “In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor. In fact, we believe most lovers of chocolate prefer it to candy costing two or three times as much. (In candy, as in stocks, price and value can differ; price is what you give, value is what you get.)”

If you grew up in a home that bought See’s Candies (mostly on the West Coast, especially in California) and your experiences around that candy have very favorable associations, you will pay more for a box bearing the See’s Candies brand. By contrast, someone who grew up in the east cost of the United States will not attribute as much value to that brand since they do not have those same experiences. For this reason, See’s Candies has found it hard to expand regionally and has done so very slowly. What See’s Candies sells is not just food, but rather an experience that is usually offered in the form of a gift.” A perceptive writer in an Israeli newspaper points out:

“Warren suggests getting your brand into the “gift market” because people don’t give second-class gifts. If you price your new whiskey brand at 5 percent less than the leading brand, you’ll have a hard time gaining customers. “The higher-priced one is both better known and more expensive,” reasons the customer. “Why get something inferior just to save a few dollars?” This is especially true when the product will be a gift; no one wants to be seen as second class. The new whiskey would actually market itself more successfully in Grey Goose style: as a premium brand with a matching package that helps the potential buyer overcome much of his hesitancy. “Even though I’ve never had it before, it looks elegant and costs just a bit more than the brand I was planning to buy. It makes an impressive-looking gift that my host would enjoy. I’ll give it a try,” the thinking goes.”

That See’s Candies sells boxed candy mostly bought as gifts is a fundamental way that is business differs from other businesses that sell something that people eat. Buffet points out:

“Most people do not buy boxed chocolate to consume themselves, they buy them as gifts—somebody’s birthday or more likely it is a holiday.  Valentine’s Day is the single biggest day of the year.  Christmas is the biggest season by far.  Women buy for Christmas and they plan ahead and buy over a two or three week period.   Men buy on Valentine’s Day.  They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won’t dare go home without a box of Chocolates by the time we get through with them on our radio ads.  So that Valentine’s Day is the biggest day. Can you imagine going home on Valentine’s Day—our See’s Candies is now $11 a pound thanks to my brilliance.  And let’s say there is candy available at $6 a pound.  Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candies over the years—and say, “Honey, this year I took the low bid.” And hand her a box of candy.  It just isn’t going to work.   So in a sense, there is untapped pricing power—it is not price dependent.

If you are See’s Candies, you want to do everything in the world to make sure that the experience basically of giving that gift leads to a favorable reaction.  It means what is in the box, it means the person who sells it to you, because all of our business is done when we are terribly busy. People come in during those weeks before Christmas, Valentine’s Day and there are long lines.  So at five o’clock in the afternoon some woman is selling someone the last box candy and that person has been waiting in line for maybe 20 or 30 customers.  And if the salesperson smiles at that last customer, our moat has widened and if she snarls at ‘em, our moat has narrowed. We can’t see it, but it is going on every day.  But it is the key to it. It is the total part of the product delivery.  It is having everything associated with it say, See’s Candies and something pleasant happening.   That is what business is all about.” 

7. Buffett: “The ideal business is one that takes no capital, and yet grows. And there are a few businesses like that, and we own some.” Buffett [in 2007]: “Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip).”  “We’ve tried 50 different ways to put money into See’s. If we knew a way to put additional money into See’s and produce returns a quarter of what we’re getting out of the existing business, we would do it in a second. We love it. We play around with different ideas, but we don’t know how to do it.” Munger: “By the way, we really shouldn’t complain about this because we’ve carefully selected a bunch of businesses that just drown in money every year.”

Some businesses just can’t profitably put more cash or capital to work even though their underlying business at its existing scale is sound. This is why Buffet insists that all cash is allocated by him to the highest and best use within Berkshire. This avoids what Buffett calls the “institutional imperative” about which Buffett writes:

“Rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”

8. Buffett: “After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to ‘be fruitful and multiply’ is one we take seriously at Berkshire.)” 

When a given Berkshire portfolio company (for example, See’s Candies) generates cash, that cash is rarely invested in more See’s Candies stores, manufacturing plants or acquisitions since the return on capital would be lower than other alternatives within Berkshire. Because of Berkshire’s corporate structure, Buffett is able to move that cash from See’s Candies to the greatest opportunity on a tax efficient basis (without paying the tax that would be imposed if See’s Candies paid a dividend or See’s shares were sold and the money the reinvested). Buffett elaborates: “because we still have this ability to redistribute money in a tax-efficient way within the company, we can reallocate it to where it will earn a higher return than shareholders may on their own.” Sometimes the best way to appreciate a business like see’s is to contrast it with the opposite example, as Munger does here: “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.”

9. Munger: “It takes almost no capital to open a new See’s candy store. We’re drowning in capital of our own that has almost no cost. It would be crazy to franchise stores like some capital-starved pancake house. We like owning our own stores as a matter of quality control.”

Wesley Gray and Tobias Carlisle write in their book Quantitative Value:  Finding a genuine franchise is as worthwhile as it is difficult. As the See’s Candies example demonstrates, franchises are valuable because they can pay out capital to owners without affecting their ability to grow, or they can compound the capita; of the business by reinvesting it year after year. Sustainable, high return business like See’s Candies are forgiving investments. They throw off a great deal of capital every year.” Munger believes: “There are worse situations than drowning in cash and sitting, sitting, sitting. I remember when I wasn’t awash in cash — and I don’t want to go back.”

10. Buffett: “We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.”

Charlie Munger is also not a fan of consultants. He is famous for saying: “I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: ‘What this situation really needs is more management consulting.’ Never once. I always turn to the last page. Of course Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires one.” Munger has offended just about everyone at some point so consultants are part of a large club. Having said that, cold calling Buffett or Munger in an attempt to sell them consulting services is unwise.

11. Munger: “Some great businesses have very volatile returns – for example, See’s usually loses money in two quarters of each year – and some terrible businesses can have steady results.” Buffett: ‘Our company song is: ―What a friend we have in Jesus.”

If you are willing to buy a business that has volatile profits from quarter you may find the purchase price to be a bargain since others may be frightened by what they deem as “risk.” Munger has said this is a considerable willingness to accept volatile results from quarter to quarter is a considerable advantage in investing.

12.  Munger: “We wrote a one-page deal with Chuck Huggins when we bought See’s and it’s never been touched. We have never hired a compensation consultant.” “I’d rather throw a viper down my shirt front than hire a compensation consultant.”

The most important task in capital allocation for Buffett and Munger is to take cash generated by a company like See’s Candies and deploy it to the very best opportunity at Berkshire. Buffett’s view on the importance of capital allocation easily stated:

“Charles T. Munger, Berkshire Hathaway’s vice-chairman, and I really have only two jobs… One is to attract and keep outstanding managers to run our various operations. The other is capital allocation.”

Occasionally Munger and Buffett find a person on who has such superior talent that they really don’t need much of a moat. This situation is rare, but it does happen.

“Occasionally, you’ll find a human being who’s so talented that he can do things that ordinary skilled mortals can’t. I would argue that Simon Marks – who was second generation in Marks & Spencer of England – was such a man. Patterson was such a man at National Cash Register. And Sam Walton was such a man. These people do come along – and in many cases, they’re not all that hard to identity. If they’ve got a reasonable hand – with the fanaticism and intelligence and so on that these people generally bring to the party – then management can matter much. However, averaged out, betting on the quality of a business is better than betting on the quality of management. In other words, if you have to choose one, bet on the business momentum, not the brilliance of the manager. But, very rarely, you find a manager who’s so good that you’re wise to follow him into what looks like a mediocre business.”

Sometimes you have both a moat and a great manager, and as Mae West once said: “Too much of a good thing can be wonderful.”

Finally, here is Janet Lowe quoting Munger talking about See’s in her book Damn Right (the best step-by-step account of the See’s acquisition is in Lowe’s book). She quotes Munger talking at a See’s company event as follows:

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Notes:

The Investments blog: http://theinvestmentsblog.blogspot.com/2013/06/buffett-and-munger-on-sees-candy.html?m=1

Don’t Confuse Cheap with Value: http://www.broyhillasset.com/wp-content/uploads/2016/11/2016.10-BAM-Dont-Confuse-Cheap-with-Value-Final.pdf

The Secrets of See’s Candies: http://fortune.com/2012/08/22/the-secrets-of-sees-candies/

Warren Buffett Bought This Company for $25M: http://www.fool.com/investing/general/2014/07/13/warren-buffett-bought-this-company-for-25-million.aspx 

Warren Buffett basks in sweet success of See’s Candies, Bank of America deals: http://www.bizjournals.com/sanfrancisco/blog/2015/03/warren-buffett-bank-of-america-berkshire-sees-brk.html

Here’s why Buffett and Munger love companies like See’s Candies: http://finance.yahoo.com/news/why-buffett-and-munger-berkshire-hathaway-love-companies-like-sees-candies-low-capital-145432726.html

Greg Speicher: http://gregspeicher.com/?p=82

Hurricane Capital: https://hurricanecapital.wordpress.com/2015/02/04/qa-case-study-of-sees-candies/

Buffett at the University of Florida: http://basehitinvesting.com/warren-buffett-1998-talk-at-university-of-florida/

CS Investing: http://csinvesting.org/2011/12/29/why-the-study-of-competitive-advantage-and-happy-new-year/

Tips from a Billionaire  http://www.jpost.com/Business/Commentary/Tips-from-a-billionaire-322847

Quantitative Value, Wesley R. Gray, Tobias E. Carlisle  https://www.25iqbooks.com/books/95-quantitative-value-web-site-a-practitioner-s-guide-to-automating-intelligent-investment-and-eliminating-behavioral-errors

Damn Right, Janet Lowe https://www.25iqbooks.com/books/55-damn-right-behind-the-scenes-with-berkshire-hathaway-billionaire-charlie-munger

Why Moats are Essential for Profitability (Restaurant Edition)

 

Investing is about owning a partial stake in a real business. You must understand whether the actual businesses in which you own stock earns a return on capital to be a successful investor. The more different types of businesses you understand in this way, the more skill you will acquire in understanding another new business. The point I am making explains why Warren Buffett says: “I am a better investor because I am a businessman, and a better businessman because I am an investor.”  The reason why Charlie Munger has what Buffett calls “the best 30 second mind in business” is in no small part because of the many different types of businesses he has examined as potential investments. In contrast, most people spend more time selecting a refrigerator than they do selecting a business to invest in. When you buy a stock without digging in and understanding that business deeply, the odds that you have made a mistake go up significantly. Investing is so competitive that you simply can’t afford to give way that competitive edge and succeed as an active investor.

Buffett explains why some businesses are profitable and not others:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Why do only some businesses have pricing power? Charlie Munger describes the answer succinctly: “We have to have a business with some inherent characteristics that give it a durable competitive advantage.” Buffett puts it this way: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

I’ve been thinking about what might be the best example to use to try to explain the nature of the work an investor must do to determine whether a business might have a moat protecting an attractive business. The example must be narrow since people will read only so much in a blog post. Since just about everyone reading this post has at least thought about opening a restaurant at some time in their life I have created this hypothetical scenario: Two of your friends have asked you to invest in their restaurant. How should you analyze this request? What factors might create a moat for an individual restaurant? To find the answer to this question Warren Buffett recently said that when you are thinking about buying stock in a company or making an investment you should: “assign yourself a story.” Your task in doing the research is to assemble the relevant facts, talk to experts and create a model of the microeconomics of the business. Please note that this is not a post about investing in a chain of restaurants like McDonalds to keep the discussion simple.

People can and do start with as little as a food cart and from that small beginning build a successful restaurant with hard work and some luck. This aspect of the restaurant business is both good and bad. It is good since it presents a way for people with little capital to get a financial start in life. It is unfortunately also bad since there are few barriers to entering the restaurant business, which limits profitability.

Here are some illustrative facts about competition levels in the restaurant business:

In spring 2016, there were 624,301 restaurants in the US.

Between 2006 and the industry’s peak in 2014, the number of restaurants in the U.S. grew 7.3% to more than 638,000—outpacing the population 6.9% growth rate.

“New York, New Jersey, and Connecticut — have more restaurants than anywhere else in the United States; 16.9 restaurants per 10k people.  In 2013 there were 232,611 establishments in the U.S. fast food industry.

chart-chain

 

The primary reason why restaurants fail so often and have low profitability is that there are too many of them. This is true in any business. Supply is the killer of value. Adding to that oversupply problem are people who stray out of their circle of competence, since risk comes from not knowing what you are doing. Even worse, some people are in the restaurant business for non-economic reasons and that makes the economics worse for people who desire to make an actual profit. A famous Ohio State study revealed that 26.16%  of independent restaurants failed during the first year of operation. That is consistent with other studies that show:  “Over three years, that number [of failures] rises to three in five. While a 60% failure rate may still sound high, that’s on par with the cross-industry average for new businesses, according to statistics from the Small Business Administration and the Bureau of Labor Statistics.”

What is overall demand for restaurants? This brings up the top-down constraint on revenue that is caused by disposable income limits: people have only so much money to spend.

William Wheaton, a professor at MIT has identified: “an incredible regularity in what they spend on eating out: $1,200 to $1,400 per person” on average annually.  Americans tend to visit restaurants of any type, from fast food to fine dining, about 190 times a year according to NPD’s food service division. In the past 10 years, older millennials have made 50 fewer restaurant visits per capita, according to NPD.

The other factor that can adversely impact a restaurant’s profits are alternative sources of supply (like buying groceries and eating at home).  The total number of supermarkets in the United States amounted to 37,716 in 2014. What about profit of that restaurant substitute? “Grocery is among the thinnest margins out there in retail. The average grocer probably gets a 2-3% operating margin. That’s a very slim margin, and that’s before interest and taxes.”

You will sometimes hear people say that that restaurant profits are down because food costs are up. Food costs rising are not a good thing for a restaurant. When food cost go up it does suppress overall demand due to limits on what people can spend. And customers  who see higher restaurant prices will tend to seek out alternative sources of supply like buying groceries and cooking at home. But the most fundamental problem with restaurant profitability is a lack of pricing power because there are too many restaurants.

What about the flip side, when something happens like food costs dropping? Food costs going down are only an opportunity for a restaurant if competitors don’t lower their prices. Competition tends to cause the restaurants to either cut prices or use more expensive ingredients, which takes costs higher again. Competition between restaurants will tend to cause retail prices to drop to a point where there is no long term industry profit greater than the cost of capital, despite the drop in wholesale food costs. This is not just true in the restaurant business and applies to any business.

What are the economics of a full service restaurant? Well, they typically they look like this:

   San Francisco restaurants

Cost of food – 24%

Cost of alcohol sold – 5%

Wages and salaries – 32%

Employee benefit – 7%

Restaurant occupancy costs – 10%

Other – 15%

Pretax profit – 2.5%

  U.S. restaurants

Cost of food – 27%

Cost of alcohol sold – 7%

Wages and salaries – 31%

Employee benefits – 4%

Restaurant occupancy costs – 6%

Other – 19%

Pretax profit – 6%

Does 2% or even 6% pretax profit sound like a significant moat to you?

Of course, there are many types of restaurants. A food truck is not fine dining and the actual microeconomics of each business type will vary, but here is another example of the full service category from California:

“The 220-seat restaurant serves about 1,300 to 1,400 diners a week, with an average per-person check of about $40. After adding in revenues from private parties and people who just have drinks in the bar, it had 2003 sales of $3.2 million and is on track to do $4 million this year, said Chief Executive Officer Bruce McDonald.  Foreign Cinema is cash-flow positive, but it won’t realize a genuine profit for at least five years, because it carries $2 million in debt. Its earnings before interest, depreciation and amortization were $86,000 last year. With higher sales and a tight grip on operating expenses this year, they may hit $400,000, McDonald said. “[The chefs] start out most days seeking out what’s fresh and inspirational at Monterey Market, a produce dealer blocks from their Berkeley home. They spend more than $1,000 a week there. Their food and beverage costs average about $21,000 a week, or 30 percent of their weekly revenue of $70,000. That lines up closely with other full-service restaurants, which follow a remarkably similar economic formula.  Of every dollar a full-service restaurant brings in, it spends roughly a third on food and alcohol; another third on salaries, wages and benefits; up to 10 cents on rent; and up to 20 cents on other costs such as marketing, according to studies by restaurant associations. That leaves about 4 cents of pretax profit.” As with all restaurants, alcohol is far more profitable than food. “We pay $25 for a bottle of booze and sell it for $100,” McDonald said. (Beer and wine have slightly lower markups.) “Many people who start out in the restaurant business end up owning bars or in real estate.”

Here’s the situation in New York:

As the chef David Chang howled earlier this year, “Food’s too cheap, tipping makes no sense, cooks are broke, and it’s damn near impossible to earn a living in this effed-up business.”) Second, that three dollars or so in operating income isn’t even really profits. Operating income is needed to pay back the costs to build out the restaurant. Paying those costs was supposed to take about three years in the case of our restaurant. (It never happened.) Only after that come profits. The harsh bottom line: three per cent operating income isn’t that short of the definition of success in New York City restaurants of five to ten per cent operating income, depending on whom you ask. And even that piddling percentage, achieved by few restaurants, is under assault from all sides. There are rising New York rents: if our restaurant’s rent, which was twenty thousand dollars per month for about twelve hundred square feet, had consumed only ten per cent of revenue—a restaurant’s target, per the conventional wisdom—its operating income would have tripled.

There are restaurateurs who claim they are more profitable, but restaurant people I know roll their eyes when they hear a claim of 20% profit like this:

“The key to success in the business, Mr. Bastianich says, is a basic understanding of restaurant math—and “restaurant math is easy.” Appetizers cost only a small part of what customers are charged; desserts are almost pure profit. Linen is enemy No. 1 because buying and cleaning tablecloths and napkins is expensive and customers don’t pay for it, just as they don’t foot any of the bill for bread and butter. “Übermeats” such as dry-aged steaks (“the King Lear of menu items”) and veal chops are the bane of every restaurant because the initial food cost is high. As for wine, when sold by the glass the price is usually four times the actual cost, although at Babbo, the author says, the price of a small carafe called a quartino is sometimes only double.” “For Babbo, a “nice little $2.5- or $3-million-a-year operation,” the annual net is at least a half-million dollars. Not bad for a casual Italian restaurant in Greenwich Village.”

Babbo has the Mario Batali brand, but this claim of 20% profit is not normal. It helps (and can even be essential) to own the building as I explained in my post on “wholesale transfer pricing.”

The owners of Wild Ginger started their wonderful restaurant in a rented space on Western Avenue in Seattle.  The restaurant  was a huge success.  When lease renewal time came up for Wild Ginger the landlord wanted a massive rent increase. The ability of the landlord to demand that increase is wholesale pricing power.  It was not absolute, but wholesale transfer pricing power in that case was significant. The owners of Wild Ginger had a lot of brand and other value tied up in that location. The rent increase request was so big that the Wild Ginger owners brought in  up investors and bought their new building in a new location and did the huge investment required to refurbish it.  The restaurant owners had to completely change their business model by bringing in the outside money from investors.  The owners of Wild Ginger are is now in the restaurant business and the real estate business. The whole thing was kicked off by the wholesale providing power of the original landlord.   Another restaurant moved into the old Wild Ginger space on Western Avenue and went bust, probably because the rent was too high compared to the many other restaurants in Seattle. Now that restaurant space on Western Avenue sits empty. As yet another example, Anthony Bourdain in his former TV show “No Reservations” did a profile of old school restaurants in one episode on “Lost Manhattan” and pointed out that the old school restaurants that are left own their own buildings.  They are able to stay “old school” in the restaurant business only because they are their own landlords.  If they had just been tenants, they would have been priced out of business in Manhattan long ago.

In a recent Bloomberg podcast a restaurant owner said: “the lease is everything in our business.” His approach to the wholesale transfer pricing problem by having the landlord be his partner. The restaurateur said “the golden number is rent at 8% of revenue but he said achieving that is usually impossible in a place like Manhattan. One side note is important to consider here: sometimes building owners will give a restaurant with a strong brand below market rent to entice other tenants to lease space in their building. If your competitors have this lower rent and you do not, that is a problem for your business. You are not Mario Batali.

Avoid rents by having a food truck you say? Here is an accounts of food truck economics:

“These numbers do not paint a pretty picture—nor do they support the notion that there’s a ton of savings to be passed on to the consumer because they operate out of a truck. Essentially, after you sink 50-100 grand into your truck/kitchen/home, you now work 10-plus hour days and hope to hell that you can turn 150 covers in 3 hours or less of service. You read that right—150 covers in 180 minutes, or 1.2 covers per minute every day for 250 days a year. If you’re lucky enough to average that level of business every day of the year (including those dreary days in winter), then you may just walk home with enough profit to pay yourself minimum wage. All three food-truck owners agreed that most of the successful trucks are also doing catering. Edison pointed out that some owners have evolved their businesses into brick-and-mortar spaces due to the profit constraints presented by the truck model. “There’s not a single truck from the ‘old guard’ that hasn’t expanded to brick-and-mortar. Why? If we could sit back and retire on a single truck, we’d roll with that. But it’s just not possible. It’s a pretty honest way to make a dollar—but nobody’s getting rich off a single truck.”

Here’s Anthony Bourdain talking with Thrillist about the current state of the fine-dining business:

“It’s more and more difficult to even run a fine-dining restaurant. The profit margins are not getting bigger; they will probably get smaller. That space, that part of the market, will probably continue to shrink. As it is now, most restaurant people cannot afford to eat in their own restaurants.”

This short essay on restaurant economics is intended to be illustrative of the sort of research that must be done when investing in any stock. It is only a start of the actual research that should be done in any given case. As you can probably tell, I think investing in a restaurant opened by two friends belongs in the “too hard” pile at the very least. In short, there are far more attractive opportunities. Charlie Munger says it best: “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. And that’s the way we filter out buying opportunities”

I’m going to stop writing now since this post is up to ~3,500 words and research tells me that most people have stopped reading already. What you see above in terms of research is only the beginning of the sort of work that a person should do before buying a share of a business or investing in a business. Risk comes from “not knowing what you are doing” says Buffett. Researching the business before you buy a stock lowers risk. If you don’t want to or can’t do the research on the businesses in which you buy stock you should instead buy a low cost diversified portfolio of index funds. The choice is that simple. There is no shame in saying: “researching a business bores me.” But it is a shame if people buy individual stocks anyway.

P.s., Understanding the previous discussion of the restaurant microeconomics depends on the reader understanding these points which I raised in my post on Michael Porter (his quotes are in bold and mine are in plain text as is usual):

“If there are no barriers to entry… you won’t be very profitable.” If there is no impediment to new supply of what you sell competition among suppliers will cause price to drop to a point where there is no long term industry profit greater than the cost of capital.  Michael Porter calls a company’s barriers to entry a “sustainable competitive advantage.” Warren Buffett calls it a “moat.”  The two terms are essentially identical.  The principle is so simple and yet so many people think only about customers and not competitors as well.  Yes, innovate and deliver exceptional value for customers.  No, that is not necessarily enough for sustainable profitability. “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.”  If you deliver the same product or service as your competitor you by definition don’t have a moat.  Competition will in that case be based on price and price-based competition inevitably degrades to a point where profit disappears. Porter teaches: “if customers have all the power, and if rivalry is based on price… you won’t be very profitable.”  He adds: “Produc[ing] the highest-quality products at the lowest cost or consolidate[ing] their industry [is] trying to improve on best practices. That’s not a strategy.”

The five primary factors which can help create a moat, either alone or in combination with other factors, are as follows:

  1. Supply-Side Economies of Scale and Scope;
  2. Demand-side Economies of Scale (Network Effects);
  3. Brand;
  4. Regulation; and
  5. Patents and Intellectual Property.

When might a restaurant be deemed to have moat? The test is always quantitative: does the restaurant generate a return on investment that is significantly above the opportunity cost of capital and does that last for a significant number of years? If a restaurant meets that mathematical test, it has a moat even if precisely what created the moat is not clear. The task at that point is to determine what factor or factors created the moat so they can be reinforced by the owner of the business. Sometime a bit of research will reveal clues. For example, chain restaurants can create distribution networks and systems that take advantage of supply side economies of scale. Their moat is similar to a business like Costco in that way. Other factors can create moats and sometime it is the combination of factors that produces the barrier to entry. Sometimes a famous chef’s brand acquired from television appearances can help create a moat. Sometimes a location can be helpful as can longevity (the comfort food effect) and historical significance.

P.s., This is a fun chart below explaining aspects of a how different restaurant items bring in different profits. As I said above I know people who think his view on profit levels is not realistic. “Shrinkage” is a problem for many restaurants. I find this story told by Joe Bastianich humorous: “At 11 he was washing dishes. One of his jobs was to salt the wine. ‘If I didn’t put two tablespoons of salt into every gallon of cooking wine, everyone in the kitchen would be completely s—faced.’”

babbo

Notes:

http://www.newyorker.com/business/currency/the-thrill-of-losing-money-by-investing-in-a-manhattan-restaurant

https://www.thrillist.com/entertainment/nation/anthony-bourdain-interview-appetites-cookbook

https://priceonomics.com/post/45352687467/food-truck-economics

http://archive.seattleweekly.com/home/960060-129/the-tough-economics-of-running-a

http://economics.mit.edu/files/9509

https://www.quora.com/What-are-the-economics-of-running-a-restaurant

https://priceonomics.com/the-economics-of-eating-out/

http://www.wsj.com/articles/SB10001424052702303592404577362370271166862

http://www.sfgate.com/bayarea/article/Economics-of-running-a-restaurant-Tireless-2731527.php

http://www.nytimes.com/2016/10/26/dining/restaurant-economics-new-york.html?_r=0

http://www.wsj.com/articles/grocers-feel-chill-from-millennials-1477579072

http://www.cnbc.com/id/100794988

http://cqx.sagepub.com/content/46/3/304.abstract

http://www.bloomberg.com/news/articles/2016-11-03/thanksgiving-will-be-cheaper-this-year-and-that-s-not-good?cmpid=socialflow-twitter-business&utm_content=business&utm_campaign=socialflow-organic&utm_source=twitter&utm_medium=social

A Dozen Things You can Learn from Biggie Smalls (The Notorious B.I.G.) About Business

During a recent lunch meeting with a few friends I used the phrase “mo money, mo problems.” One of my friends responded by challenging me to do a Dozen Things post on Biggie Smalls similar to the one I wrote on Rza. My response to the throw down is the blog post for this week. I have made the point repeatedly on this blog that you can learn something from just about anyone. I have written posts on Bill MurrayLouis CK and comedians generally to make this same point. The other point relevant to this post is to not take yourself too seriously. Having fun is under-rated.

1.“If y’all love the music, y’all gonna buy the music.” In my post on Jessica Livingston I quoted her as saying: “Our motto is to make something that people want. If you create something and no one uses it, you’re dead. Nothing else you do is going to matter if people don’t like your product.” Biggie is making the same point as Livingston. The importance of making products people want to buy seems obvious. Unfortunately, too often people get wrapped up in other aspects of startups and can lose track of that basic truth. A founder who is focused on making products people want to buy will succeed far more often than founders who are mostly concerned with things like getting prime speaking slots at major industry conferences or having a hip office with exposed brick walls and water views.

2.“Only make moves when your heart’s in it.” http://genius.com/The-notorious-big-skys-the-limit-lyrics    My blog post last week was about how important it is for the founder of a business to be a missionary rather than a mercenary. Biggie believed that a great business founder or performer needs heart, which includes attributes like passion, determination and grit. Missionaries are far more likely to succeed in business than mercenaries since they have the qualities it takes to overcome hard problems. People with a mission in life “passionately persevere” in the face of adversity when a mercenary would bail out to do something else.

3.“Stay far from timid … and live the phrase the sky’s the limit.” http://genius.com/The-notorious-big-skys-the-limit-lyrics   My interpretation of Biggie’s statement is that he was stressing the importance of making convex bets in life and in business. What you ideally want when making a wager are bets with a big upside and a small downside (convexity). When you find a mispriced convex bet, Biggie’s advice is to “be far from timid.” My post on Nassim Taleb discussed Biggie’s point on mispriced convex wagers more extensively.

4.“Never let them know your next move.” Biggie in this quote is making a point similar to Doug Leone: “Little companies have really two advantages: stealth and speed. The best thing for little companies do is to stay away from the cocktail circuit.” This piece of advice is a bit tricky and controversial since there is another view that it is wise to get feed back early and often. My view is that one can seek early product feedback and yet still follow Biggie’s admonition that there is no need to reveal your next move.

5.“I learn from the other people’s mistakes. I know when to say no.” Biggie’s view here is aligned with the view of Charlie Munger that the best way to learn not to do something that is the equivalent of peeing on an electric fence is to watch other people do it and learn vicariously. In short, it is wise to learn from other people’s mistakes! Like Charlie Munger, Biggie put a lot of effort into when to say “no.” Putting significant resources into a few mispriced bets is a far better approach to business and investing than saying “yes” to too many things. Be patient, but aggressive when it is time.

6.“I’m living every day like a hustle.” https://www.youtube.com/watch?v=0MF6w134W6Y  Biggie knew that there is no substitute for hard work and hustle. Other successful people invariably think the same way not matter what career they have chosen. Writers, for example. need to hustle too. Anais Nin put it this way: “Good things happen to those who hustle.” Stephen King has similarly expressed his view that: “Talent is cheaper than table salt. What separates the talented individual from the successful one is a lot of hard work.” Biggie himself once said:“I can’t never stop nobody, can’t knock nobody hustle. They feel like they can come into it dissing Big and dissing Puff and doing they little thing. If that’s what they choose to do, that’s what they choose to do. Only thing I gotta do is feed [my daughter] Tianna and take care of Ms. Wallace. That’s my only job.”

7.“Your style is played out, Like Arnold and that, what you talkin’ bout Willis.” Biggie is referring to the need for genuine 0 to 1 innovation, which I discussed in my post on Peter Thiel who believes: “Maybe we focus so much on going from 1 to n because that’s easier to do. There’s little doubt that going from 0 to 1 is qualitatively different, and almost always harder, than copying something n times.”  In other words, a person or business should avoid just repeating what others have done if they want to produce a substantial and valuable innovation. The cultural reference in the Biggie quote is to a Garry Coleman (AKA Arnold) tagline from the TV show Different Strokes that repeated itself perhaps a bit too often.

8.“Watchin’ the stash grow, clockin the cash flow.” http://genius.com/2pac-2pac-and-biggie-freestyle-at-table-lyrics  Biggie knew that the only unforgivable sin in business is to run out of cash.  Biggie once quoted the sage Rza on this point: “Cash Rules Everything Around Me.” Cash can provide its holder with significant optionality. It is likely that Biggie had similar beliefs to Warren Buffett on cash:

“Ms. Schroeder argues that to Mr. Buffett, cash is not just an asset class that is returning next to nothing. It is a call option that can be priced. When he thinks that option is cheap, relative to the ability of cash to buy assets, he is willing to put up with super-low interest rates, said Ms. Schroeder, who followed Mr. Buffett for years before she became his biographer. “He thinks of cash differently than conventional investors,” Ms. Schroeder says. “This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”

9.”That goddamn credit? Dead it.” http://genius.com/The-notorious-big-ten-crack-commandments-lyrics   Biggie, like many other great investors and business people, was not a fan of debt. Charlie Munger has a view that is similar to Biggie’s: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.”

10. “Never let no one know how much dough you hold.” https://www.youtube.com/watch?v=kyWTJWrH1aI   Biggie was pointing out that certain metrics do not need to be made publicly available if you are a private business. This is one of the advantages of not going public.

11. “Never get high on your own supply.” https://www.youtube.com/watch?v=kyWTJWrH1aI   I prefer to think of this statement as an admonition from Biggie that people should be more humble so they avoid mistakes. Of course, what this advice actually represents is Biggie warning people about the dangers of consuming the inventory of your own business.  Either way, the advice is sound.

12. “Consignment is not for freshmen.” “If you ain’t got the clientele say ‘hell no’ — ’cause they gon want they money rain, sleet, hail, snow.” http://genius.com/The-notorious-big-ten-crack-commandments-lyrics   Biggie is saying that there are dangers associated with taking on a lot of inventory risk, especially from suppliers who have not yet been paid. If a business ends up with products on a shelf that it can’t sell, the suppliers will want to be paid. Biggie knew that business is business. You must get the basics right to be successful. Managing inventory risk is a core skill in many businesses. You never want to get into a situation where someone says, “Leave the gun. Take the cannoli.” https://www.youtube.com/watch?v=yHzh0PvMWTI

 

A Half Dozen Reasons Why Venture Capitalists Prefer Missionaries to Mercenaries

 

1.Mark Cuban: “Don’t start a company unless it’s an obsession and something you love. If you have an exit strategy, it’s not an obsession.”

No one should start a business if they are not obsessively committed to the mission of that business. Genuine obsession and passion are highly valuable since making the business a success will require overcoming significant obstacles. My most interesting experience with being obsessively committed to the mission of a business started in 1994. It was the most intense five years of my professional life. The business was a global broadband non geostationary satellite system known as Teledesic. My obsession with making that startup a success consumed me. My family and health all paid a serious price for this obsession. As much as I loved that business, by 1999 I knew that it was time to move on and do other things. It wasn’t easy to cut the cord, but it was necessary. Teledesic was valued at $3 billion in its last round of funding and we raised close to $1 billion in capital. The story of Teledesic has never properly been told and perhaps it is my responsibility to do so one day.  Until I write that book, you can read the blog post I have written about my experience at Teledesic that is part of this “Dozen Things” series if you are interested.

Missionary joke #1: Two cannibals met each other on a path in the jungle one day. The first cannibal said: “I just can’t seem to prepare a tender Missionary. I’ve baked ’em, I’ve roasted ’em, I’ve stewed ’em, I’ve barbequed ’em, I’ve even tried every sort of marinade. I just cannot seem to get them tender.” The second cannibal asked, “What kind of Missionary do you use?” The first cannibal replied, “You know, the ones that hang out at that place at the bend of the river. They wear brown cloaks with a rope around their waist ” “Ah ha!” the second cannibal replied. “No wonder. Those Missionaries are friars!”

2. John Doerr:  “Mercenaries are driven by paranoia; missionaries are driven by passion. Mercenaries think opportunistically; missionaries think strategically. Mercenaries go for the sprint; missionaries go for the marathon. Mercenaries focus on their competitors and financial statements; missionaries focus on their customers and value statements. Mercenaries are bosses of wolf packs; missionaries are mentors or coaches of teams. Mercenaries worry about entitlements; missionaries are obsessed with making a contribution. Mercenaries are motivated by the lust for making money; missionaries, while recognizing the importance of money, are fundamentally driven by the desire to make meaning.”

A venture capitalist I know recalls Doerr using the “missionary versus mercenary” metaphor as early as 1998 at a Stewart Alsop Agenda conference. Doerr has repeated this idea often over the years and it has essentially become a meme in the venture capital industry.  In short, mercenaries are motivated primarily by money. Missionaries are driven by a cause. Elon Musk is a classic missionary as was Steve Jobs. My advice is: don’t start a business because you want to have it on your resume or because you think it is glamorous. And don’t do so to fill a bucket list unless you feel the obsessive passion Cuban and Doerr are talking about. Here’s the slide Doerr uses when talking about this concept:

doerr-slide

Doerr’s list is largely self explanatory. There are a couple of YouTube videos of him making his case about missionaries cited in the notes below. In one video Doerr refers people to a book by Randy Komisar entitled: “The Monk and the Riddle: The Art of Creating a Life While Making a Living” for further inspiration on this topic.

Missionary joke #2: A missionary was walking in Africa when he heard the unmistakable sound of a pride of lions behind him. He immediately started praying: “Oh Lord, please make these lions into good Christians.”  The Missionary thought his prayer was being answered when heard the lions also start to pray. But then he heard the lions say in unison: “Bless us oh Lord, for this thy food, which we are about to consume…”

3. Andy Rachleff:  “Mercenaries, whose primary goal is money, fall somewhere on the middle of the entrepreneur bell curve. They seldom have the desire to change the world that is required for a really big outcome, or the patience to see their idea through. I don’t begrudge them their early payouts. They’re just not the best entrepreneurs.”

Missionaries are far more likely to work to keep their business independent – which is more likely to produce “tape measure financial home runs.” They think bigger in terms of what the business can accomplish. Missionaries with huge ambition for their business are rarer than most people imagine. Mark Zuckerberg is a classic example of a missionary:

“At the time, Facebook was just two years old. It was a college site with roughly eight or nine million people on it. And, though it was making $30 million in revenue, it was not profitable. “And we received an acquisition offer from Yahoo for $1 billion,” Thiel said. The three-person Facebook board at the time–Zuckerberg, Thiel, and venture capitalist Jim Breyer–met on a Monday morning. “Both Breyer and myself on balance thought we probably should take the money,” recalled Thiel. “But Zuckerberg started the meeting like, ‘This is kind of a formality, just a quick board meeting, it shouldn’t take more than 10 minutes. We’re obviously not going to sell here’.” At the time, Zuckerberg was 22 years old. Thiel said he remembered saying, “We should probably talk about this. A billion dollars is a lot of money.” They hashed out the conversation. Thiel said he and Breyer pointed out: “You own 25 percent. There’s so much you could do with the money.” Thiel recalled Zuckerberg said, in a nutshell: “I don’t know what I could do with the money. I’d just start another social networking site. I kind of like the one I already have.”

Founders who “flip the business” early or even in midstream usually don’t last long enough to do this. Rachleff is pointing out that mercenaries don’t always fail, but also that success is less frequent and payoffs are smaller on a relative basis for mercenaries.

Some cities have more missionaries than others. Seattle is a great example of a city with a mostly missionary culture. People in Seattle create businesses and they grow them passionately. The best examples are Bill Gates, Jeff Bezos and Howard Schultz.  This creates lasting businesses and healthy job growth. Other cities have a mostly a mercenary culture- the founders grab any early money that becomes available and move on.

Missionary joke #3: One day the African chief’s wife gave birth to a white child and the chief was stunned. He suspected some hanky panky and went to visit a white Missionary who lived nearly. “You have been having sex with my wife,” the chief said to the Missionary. The Missionary tried to escape from the difficult situation by explaining Mendel’s laws of genetics to the angry chief. “You see that herd of sheep,” he said pointing to the chief’s herd, “Most of them are white; but you will also notice two black lambs among them.” “OK! OK!” said the chief. “You keep your mouth shut, and so will I.”

4. Jim Goetz: “I am looking for unknowns, who are passionate and mission-based.” “We try hard to make that unknown underdog comfortable in our ecosystem.”

As an example of what Goetz is talking about here, he said once about WhatsApp: “It was mission-based and very different than what everyone else was doing at the time.”  Goetz calls the WhatsApp founders “talented underdogs whose unshakeable beliefs and maverick natures epitomize the spirit of Silicon Valley.” Passion is something you can’t fake. Making a better auto insurance product is a passion for some people, but it may not be for you. What’s your passion?  Sometimes I will meet a founder who has created a startup to do X and it is clear that he or she does not particularly like X, let alone has passion for it.  When I ask why he or she started that business the story is usually that they wanted to create a startup. While that may be true in some cases it sometimes seems clear that the founder is instead overwhelmingly motivated by a desire to be wealthy. The irony is that the more you are focused on a mission rather that money the higher the odds that you will become financially successful. The other point made by Goetz above relates to how underdogs have a particularity strong form of motivation that can be very helpful in creating a successful startup. People with something to prove often have a stronger motivation to succeed.

Missionary joke #4: A man became separated from his group of explorers and found himself lost in the desert. Fortunately he eventually encountered the home of a Missionary. Tired and weak, he crawled up to the house and collapsed on the doorstep. The Missionary found him and nursed him back to health. Feeling better, the man asked the Missionary for directions to the nearest town and if he could borrow his horse. The Missionary said, “Sure but there is a special thing about this horse. You have to say ‘Thank God’ to make it go and ‘Amen’ to make it stop.” Not paying much attention, the man said, “Sure, ok.” So he mounted the horse and said, “Thank God” and the horse started walking. Then he said, “Thank God, thank God,” and the horse started trotting. Feeling really brave, the man said, “Thank God, thank God, thank God, thank God, thank God” and the horse just took off. Pretty soon the man saw that the path lead to a cliff and he started doing everything he could to make the horse stop, yelling:  “Whoa, stop, hold on!” Finally the man remembered, “Amen!” The horse stopped just four inches from the edge of the cliff. The man then leaned back in the saddle and said, “Thank God.”

5. Dan Levitan: “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.”

Levitan is pointing out a key aspect of early stage investing: it is called an early stage business because it is an early stage business. Many unknowns will be encountered along the path of any business and a team with the qualities Levitan describes is far more likely to find success than a team who is just in it for the money. People with grit determination, resourcefulness, ability to evolve don’t give up easily. Ev Williams story is a classic example of how things can evolve in very different ways and how grit is critical to success. This is from a Harvard Business School case from 2008:

“The Blogger experiences had included a major blow-up with his co-founder that had resulted in legal proceedings, a brush with near-bankruptcy, and the laying off of his entire team, Williams has become even more disillusioned with his current venture, Odeo.  Odeo, a podcasting pioneer, had debuted almost two years before and had gotten off to a very strong start, with a high-profile debut at a prominent industry conference, coverage on the front page of the New York Times’ Business section, and the raising of a large round of financing from a top-tier venture capital firm. His attempts to find an acquirer have failed, layoffs have begun, and he is now facing a meeting with an increasingly hostile board of directors. At that meeting, he is very tempted to resign so he can move on to his next project and regain the thrill of being an entrepreneur.”

Odeo would evolve to become Twitter.

“One day in September 2006, Odeo’s CEO Evan Williams wrote a letter to Odeo’s investors. In it, Williams told them that the company was going nowhere, that he felt bad about that, and that he would like to buy back their shares so they wouldn’t take a loss. In his letter to Odeo’s investors, Williams wrote this about Twitter:

By the way, Twitter, which you may have read about, is one of the pieces of value that I see in Odeo, but it’s much too early to tell what’s there. Almost two months after launch, Twitter has less than 5,000 registered users. I will continue to invest in Twitter, but it’s hard to say it justifies the venture investment Odeo certainly holds — especially since that investment was for a different market altogether.

Evan proposed buying back Odeo investors’ stock, and, eventually, the investors agreed to the buyback. So Evan bought the company — and Twitter. The amount he paid has never been reported. Multiple investors, who had combined to put $5 million into Odeo, say Evan made them whole.”

Missionary joke #5:  “A Missionary travelled to what he thought was an totally uninhabited island. He discovered that there were indeed people there, but the inhabitants of the island knew nothing of Western culture. The missionary decided that it would be in the locals best interest if he could teach them about civilization. He created small schools in huts and taught the natives how to read and write and do mathematics. Part of his teaching was to take the locals one by one around the island, and teach them the correct English words for objects that they would see. One day, the Missionary was walking around the island with one of the locals. When they walked past a tree, the Missionary pointed and said: “Tree”.  The local would repeat, “Tree”. They continued further and saw a bush. The Missionary pointed to it and said, “Bush”. The native repeated the word, “Bush”. They walked around the bush – and lying on the ground behind it, were two locals making  whoopi. The Missionary hoped that the local would not ask about it, but he did: “What is that? What are they doing?” Missionary replied, “Riding a bicycle. Those two people are riding a bicycle!” The man pulled out his poison dart gun and killed the couple. The Missionary was incredulous. Angered, he yelled: “Why did you kill those two people? I told you that they were riding a bicycle! “The local answered, “He was riding MY bicycle!”

6. Jessica Livingston:  “Resilience keeps you from being pushed backwards. Drive moves you forwards.”

Livingston is pointing to one of the qualities discussed on sectin 5 as being particularly important. Dr. Angela Duckworth defines “grit” as “perseverance and passion for long-term goals.” As an example, some people I know describe Uber’s Travis Kalanick as being off the charts on grit. Steve Jobs said once: “I’m convinced that about half of what separates the successful entrepreneurs from the non-successful ones is pure perseverance…. Unless you have a lot of passion about this, you’re not going to survive. You’re going to give it up. So you’ve got to have an idea, or a problem or a wrong that you want to right that you’re passionate about; otherwise, you’re not going to have the perseverance to stick it through.”

Missionary joke #6: A cannibal was walking through the jungle and discovered a new restaurant operated by a fellow cannibal. Feeling somewhat hungry, he sat down and looked over the menu. Broiled Missionary: $25.00 Fried Explorer: $35.00 Baked Politician: $100.00. The cannibal called the waiter over and asked: “Why such a big price difference for the politician?” The waiter replied “Have you ever tried to clean one of them?”

Notes:

John Doerr Video https://www.youtube.com/watch?v=ui8yLqCxChM

John Doerr Video https://www.youtube.com/watch?v=oSCgYT8p2NQ

John Doerr Video https://www.youtube.com/watch?v=n6iwEYmbCwk

The Monk and the Riddle https://www.25iqbooks.com/books/359-the-monk-and-the-riddle-the-art-of-creating-a-life-while-making-a-living

Dan Levitan 25IQ https://25iq.com/2015/03/22/a-dozen-things-ive-learned-from-dan-levitan-about-venture-capital-business-and-people/ 

Jim Goetz 25IQ https://25iq.com/2015/06/06/a-dozen-things-ive-learned-from-jim-goetz-about-business-startups-and-venture-capital/

Andy Rachleff 25IQ  https://25iq.com/2014/07/19/a-dozen-things-ive-learned-from-andy-rachleff/

Elon Musk 25IQ   https://25iq.com/2016/06/18/a-dozen-things-ive-learned-from-elon-musk-about-business-and-investing/

John Doerr 25IQ https://25iq.com/2014/08/24/a-dozen-things-ive-learned-from-john-doerr/ 

Fred Smith: http://www.businessinsider.com/fedex-saved-from-bankruptcy-with-blackjack-winnings-2014-7

HBR case study: https://hbr.org/product/evan-williams-from-blogger-to-odeo-a/an/809088-PDF-ENG

 

Why Investors Must Be Contrarians to Outperform The Market

  1. Bill Gurley: “Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.”

Andy Rachleff elaborates on the point made by Gurley: “What most people don’t realize is if you’re right and consensus you don’t make money.” It is a bit strange that most people don’t realize this truth and yet it is common sense: you simply can’t be part of the crowd and at the same time beat the crowd, especially after fees and costs are imposed. Nobel Laureate William Sharpe famously provided the mathematical proof in a paper entitled “The Arithmetic of Active Management.” As restated by John Bogle the conclusion is: “In many areas of the market, there will be a loser for every winner so, on average, investors will get the return of that market less fees.” Of course, the part about the investors collectively getting the return of the market is key. Being a long term investor in the progress of the economy is a very good thing. As life runs its course, some investors get more of that financial return of the market than others.

A key point in all of this is that you can decide not to try to outperform a market and instead to match it as closely as you can a very low cost. Warren Buffett describes the motivation for this approach well: “By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

  1. Jeff Bezos: “You just have to remember that contrarians are usually wrong.”

This point made by Bezos is the reason why most people follow the crowd. Michael Mauboussin explains this tendency with a simple example:

“Being a contrarian for the sake of being a contrarian is not a good idea. In other words, when the movie theater’s on fire, run out the door, right? Don’t run in the door…. Successful contrarian investing isn’t about going against the grain per se, it’s about exploiting expectations gaps. If this assertion is true, it leads to an obvious question: how do these expectations gaps arise? Or, more basically, how and why are markets inefficient?”

Mauboussin explains why some investments get mispriced so badly:

“Because if the crowd takes something to an extreme, either on the bullish side or the bearish side, that should show up in your disconnect between fundamentals and expectations. And that is what allows you to make a good investment… Again, the goal is not to be a contrarian just to be a contrarian, but rather to feel comfortable betting against the crowd when the gap between fundamentals and expectations warrants it. This independence is difficult because the widest gap often coincides with the strongest urge to be part of the group. Independence also incorporates the notion of objectivity—an ability to assess the odds without being swayed by outside factors. After all, prices not only inform investors, they also influence investors.”

This blog has repeatedly profiled great investors who have acquired skill in knowing when to be contrarian. Buffett’s famous admonition is: “be greedy when others are fearful and fearful when others are greedy.” One of the best times to invest is when uncertainty is the greatest and fear is the highest. This contrarian admonition is fully consistent with the Mr. Market metaphor. Make the market your servant and not your master. For example, Jeffrey Gundlach puts it this way: “I want fear. I want to buy things when people are afraid of it, not when they think it’s a gift being handed down to them.” There aren’t many people like Charlie Munger: “We have a history when things are really horrible of wading in when no one else will.”

Bucking the crowd’s viewpoint in practice in the real world is not easy since the investor is fighting social proof. Robert Cialdini: social proof is most powerful for those who feel unfamiliar or unsure in a specific situation and who, consequently, must look outside of themselves for evidence of how best to behave there.” I discussed social proof in a recent blog post on Cialdini’s book Influence. In many cases, following the crowd (social proof) makes sense. Sticking with the warmth of the crowd is a natural instinct for most people. Many people would rather fail conventionally than succeed unconventionally. But doing the reverse is easier said that done for most people.

  1. Andy Rachleff: “Investment can be explained with a 2×2 matrix. On one axis you can be right or wrong. And on the other axis you can be consensus or non-consensus. Now obviously if you’re wrong you don’t make money. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.”

It is the existence of a gap between expected value and market price that Mauboussin talked about above which should drive investment decision making. If you have views which reflect the consensus of the crowd you are unlikely to outperform a market since a market by definition reflects the consensus view.  Buffett puts it this way: “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” Charlie Munger is more direct and colorful is his explanation: “For a security to be mispriced, someone else must be a damn fool. It may be bad for world, but not bad for Berkshire.” Sometimes waves of social proof and other dysfunctional heuristics create a significant gap between price and value. This does not happen often in areas within a person’s circle of competence, but it does happen. For some investors, spotting a gap like this happens only once or twice a year and that is just fine with them. In those instances these investors bet big and the rest of the time they do nothing. Some people, like day traders, think they can spot gaps between expected value and market price several times a day and make a profit after fees (this is almost always a triumph of hope over experience).

andy

  1. Howard Marks:To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.”

Being genuinely contrarian means the investor is going to be uncomfortable sometimes. Some people are good at being uncomfortable, and some are not. Peter Lynch said once: “To make money, you must find something that nobody else knows, or do something that others won’t do because they have rigid mind-sets.”  Successful investing is the search for the mistakes of other people say Howard Marks that may create a mispriced asset. In other words, one person’s mistake about the value of an asset is what can create an opportunity for another investor to outperform the market. This search is best done by people who are curious and hard working. Great investors hustle, have a huge scuttlebutt network and read constantly. They are constantly trying to learn more about more and know that the more that they know, they more they will know that there is even more that they don’t know. If you are not getting more humble over time, you have a flawed system.

It is Mr. Market’s irrationality that creates the opportunity for investors. Markets are often wise, but they are not always wise. The best returns accrue to investors who are patient and yet aggressive when they are offered an attractive price for an asset. Seth Klarman says: “Successful investing is the marriage of a calculator and a contrarian streak.” The most effective way to get free of social proof when the time is right is to have done the homework in advance and stay within your circle of competence.

5. Jeff Bezos: “Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a 10% chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten. We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs.” “In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.” 

It is magnitude of success and not frequency of success that matters for an investor. Bezos is talking about convexity in investments.  All a founder or venture capitalist can lose is 100% of what they invest in a startup and yet what they can potentially gain is potentially many multiples of that investment. Nassim Taleb provides a quadrant-based model as a guide to decision making. Michael Mauboussin provides a summary of what Nassim Taleb has created:

“A two-by-two matrix, where the rows distinguish between activities that have extreme outcomes and those that have more bunched outcomes, and the columns capture simple and complex payoffs. He allows that statistical methods work in the First Quadrant (simple payoffs and bunched outcomes), the Second Quadrant (complex payoffs and bunched outcomes), and the Third Quadrant (simple payoffs and extreme outcomes). But statistical methods fail in the Fourth Quadrant (complex payoffs and extreme outcomes).”

Richard Zeckhauser explains why

“The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance.”

The nature of the venture capital business is that financial returns come from the Fourth Quadrant/the world of ignorance. It is only in this quadrant that optionality will be substantially mis-priced and the type of bargains found that make a venture capital portfolio work financially.

6. Marc Andreessen: “If something is already consensus then money will have already flooded in and the profit opportunity is gone. And so by definition in venture capital, if you are doing it right, you are continuously investing in things that are non-consensus at the time of investment.  And let me translate ‘non-consensus’: in sort of practical terms, it translates to crazy. You are investing in things that look like they are just nuts.” “The entire art of venture capital in our view is the big breakthrough for ideas. The nature of the big idea is that they are not that predictable.” “Most of the big breakthrough technologies/companies seem crazy at first: PCs, the internet, Bitcoin, Airbnb, Uber, 140 characters. It has to be a radical product. It has to be something where, when people look at it, at first they say, ‘I don’t get it, I don’t understand it. I think it’s too weird, I think it’s too unusual.’”

Andy Rachleff elaborates:Being willing to intelligently take this leap of faith is one of the main differences between the venture firms who consistently generate high returns — and everyone else. Unfortunately human nature is not comfortable taking risk; so most venture capital firms want high returns without risk, which doesn’t exist.  As a result they often sit on the sideline while other people make the big money from things that most people initially think are crazy. The vast majority of my colleagues in the venture capital business thought we were crazy at Benchmark to have backed eBay. ‘Beenie babies…really? How can that be a business?’” Marc Andreessen adds: “Breakthrough ideas look crazy, nuts. It’s hard to think this way — I see it in other people’s body language, and I can feel it in my own, where I sometimes feel like I don’t even care if it’s going to work, I can’t take more change. O.K., Google, O.K., Twitter—but Airbnb? People staying in each other’s houses without there being a lot of axe murders?” Most things that sounds crazy are crazy. It is the ability to use pattern recognition developed over time to see the businesses that have massive convexity “if something goes right” that makes for a great venture capitalist. The ideal startup business for a venture capitalist is a combination of half-crazy and great convexity (big upside and small downside).

Notes:

The Arithmetic of Active Management https://web.stanford.edu/~wfsharpe/art/active/active.htm

Mauboussin: http://wp.nbr.com/your-mind-and-your-money/making-better-investment-decisions-20100215

Mauboussin:  http://www.valuewalk.com/2015/02/michael-mauboussin-contrarian-investing-psychology-going-crowd/

Rachleff: https://blog.wealthfront.com/venture-capital-economics/

Cialdini:    https://25iq.com/2016/10/08/a-half-dozen-things-ive-learned-from-robert-cialdinis-book-influence/

A Dozen Things I’ve Learned about Multi-sided Markets (Platforms)

  1. Multi-sided markets bring together two or more interdependent groups who need each other in some way. Uber, eBay, and Airbnb are all multi-sided markets. A multi-sided market is sometimes called a “platform.” Hundreds of big and small firms fail trying to create multi-sided markets in different categories every year. Since the payoff from creating a significant multi-sided markets is so massive and the financial downside relatively small, founders and venture capital investors are willing to keep experimenting since it is magnitude of correctness and not frequency of correctness that determines financial success. Just one success in creating a multi-sided market can pay for many dozens of failed attempts. Apple, Microsoft, Google, Amazon and Facebook are all platforms. Why don’t firms create more multi-sided markets if they are so profitable? Because getting all of the elements just right at just the right time is very hard to do successfully. Creating a successful multi-sided market requires a lot of skill and luck as will be explained below. 
  1. A critical difference between single and multi-sided market is that the sides interact directly. A single-sided “market maker” buys x, puts x in inventory, and eventually sells x. As an example, a person employee who buys breakfast cereal from a grocery does not deal directly with the manufacturer of the product so that value chain represents a single-sided market. The authors of the book Platform Revolution refer to single sided markets as having a linear value chain. They describe a single-sided market as “a step-by step arrangement for creating and transferring value with producers at one end and consumers at the other.” In contrast, when a recruiter contacts a potential employee directly using the LinkedIn platform that interaction is part of a multi-sided market. Multi-sided markets look like this:

 msmarket

3. Multi-sided markets are not linear. A market that has two or more sides is vastly more financially attractive to create since it has the potential to scale and generate value in a non-linear manner. In other words, the whole of the value created by a multi-sided market can be more than the sum of the parts, if the multi-sided market is correctly structured. What can happen if the right conditions and structure is present is described well by Esko Kilpi as follows: “Network effect-based value can increase exponentially at the same time as costs grow linearly, if at all. If you follow the valuations of firms today, there is an ever-widening gap between the network-economy platforms and incumbents driven by traditional asset leverage models. Investors and markets have voted.” The nature of platforms has changed the value chain in many industries. Tom Goodwin of Havas Media famously said: “Uber owns no vehicles. Facebook creates no content. Alibaba has no inventory. And Airbnb owns no real estate.” When you do not need to own these assets less capital is required and the business scales vastly better both financially and operationally.

  1. A multi-sided market is not valuable if the sides can find each other easily. Solving a hard coordination problem is the key to sustainability for any market, including multi-sided markets. How do many firms and individuals involved in a complex division of labor successfully coordinate their actions so as to optimize the creation of value and profitability, when each possesses different and changing knowledge and expectations about a risky and uncertain future? Coordination is achieved through price discovery and a multi-sided market can provide just that for market participants if the conditions are right. For example, someone may need to find a freelance artist or software programmer and since there are so many potential suppliers with different skills and availability a platform like ProFinder or UpWork will therefore often be useful to them. But sometimes a significant coordination problem does not exist and a multi-sided market is unlikely to succeed. For example, if Boeing needs a supplier of rivets, once it finds that supplier it no longer needs a multi-sided marketplace. Airbnb and Uber are example of businesses that do solve hard coordination problems.
  1. “Demand side economies of scale” (also known as network effects) result when the value of a product or service changes in a positive way as more people use it. Network effects can be positive (for example the benefits of an increasing number of members of a social network) or negative (for example, network congestion; viruses, spam).  What a business seeks in any multi-sided market are network effects since they are increasingly the most important method that can be used by a technology business to create barriers to entry against competitors (a moat). Due to the falling costs of creating a new business, especially technology businesses, network effects are the most significant way to a company to create moat and generate a profit. The famous napkin sketch that illustrates Uber’s network effects is as follows:

uber-napkin

Having a moat is essential for any business since otherwise competitors will introduce additional supply to a point where financial returns are equal to the opportunity cost of capital. Anyone who says a moat is not needed is essentially suspending the laws of supply and demand. If a business earns a financial return that exceeds its opportunity cost of capital for a significant period of time it has a moat. The only question open at that point is what the elements are that created that moat (network effects, brand, supply side scale economies, regulation, intellectual property, etc.).

  1.  “Supply side economies of scale” exist when there are reductions in the average cost per unit associated with increasing the scale of production. Sometimes you hear people say that supply-side scale economies of scale no longer matter in an age where network effects are so powerful. This is not true since supply-side scale economies can in some cases still enhance the moat of a business that also enjoys network effect benefits. A moat can never be too strong since it is always under attack by competitors.  As an example, the leading providers of cloud infrastructure  have supply side economies of scale in building web scale services that smaller companies will not be able to match.
  1. Creating a successful multi-sided market requires that the business overcome the “chicken and egg problem.”  The problem can be stated simply: How do you get one side to be interested in a platform until that 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.
  1. The chicken and egg problem is best overcome if one side is clearly made the loss leader. Experience has shown that it does not matter which side gets the free or subsidized offering- what is important is that one or more sides be chosen as the loss leader and one or more sides as the profit pool. The subsidy side tends to: (1) have more elastic demand; (2) be an offering that is harder to get; and (3) is needed more by the other side. The profit generating side tends to be the reverse, obviously. The price of the subsidy side is often below marginal cost and in some cases less than $ zero. For Uber, the subsidy side is drivers since they are relatively scarce. In the real estate business in the United States, buyers are the subsidy side.
  1. The sides of the market should complement each other – if the sides are complements, it not only reduces the customer acquisition cost (CAC) but assembles sides that want to to enter into exchanges.  A “complement” is any product or service that increases the value of another product or service.  Multi-Sided Markets work best when the offering on one side of a market complements an offering on the other side of the market. Some complements are “demand-side complements” like cars and oil, hotdogs and mustard or chips and salsa. Some complements are supply side complements, like beef and leather. Search and advertising are complements as are social networks and advertising.
  1.  Subsidizing the side of the multi-sided market with lower marginal cost/COGS is optimal. Giving away goods that have a high marginal costs is often deadly. The objective is to have zero or very low marginal cost. As an example, it is particularly financially attractive to give away software as your incentive since it has zero marginal cost after fixed costs are recovered. Giving away subsidized hardware or storage is far less attractive, since there are always additional marginal costs no matter the scale of the business.
  1. Businesses that are slow to get to critical mass can run out of cash and momentum. This problem is hard to solve for the same reason the opportunity exists. Getting the balance right and achieving critical mass is an art and not a science. People creating multi-sided markets is relatively is rare at scale. In technology business today there are few areas that do not have existing competition. If you go too slow you may fail just as you can fail if you go too fast. And as I wrote in my recent post on Bill Gurley, you may need to deal with competitors who are not acting rationally or at least are acting extremely aggressively. You need to play the game that is on the field.
  1. Clear profit pools should exist.  Products and services at a given business cannot all be loss leaders. The adoption of a multi-sided market strategy must be considered holistically. If something is a loss leader then there must be a leader that is profitable. Providing one side of a multi-sided maker at a loss cost is a tactic intended to optimize the customer acquisition process and lifetime value for a service that is profitable overall, rather than a standalone strategy.

Notes:

Invisible Engines: How Software Platforms Drive Innovation and Transform Industries. By David S. Evans, Andrei Hagiu, Richard Schmalensee.   https://www.25iqbooks.com/books/314-invisible-engines-how-software-platforms-drive-innovation-and-transform-industries-mit-press

Platform Revolution: How Networked Markets Are Transforming the Economy–And How to Make Them Work for You.  By Sangeet Paul Choudary and Marshall W. Van Alstyne. https://www.25iqbooks.com/books/315-platform-revolution-how-networked-markets-are-transforming-the-economy-and-how-to-make-them-work-for-you

Matchmakers: The New Economics of Multi-sided Platforms Hardcover – May 24, 2016 by David S. Evans (Author), Richard Schmalensee   https://www.25iqbooks.com/books/133-matchmakers-the-new-economics-of-multisided-platforms

Sangeet Paul Choudary http://platformed.info/twitter-whatsapp-uber-airbnb-network-effects/

David Evans papers: http://www.marketplatforms.com/wp-content/uploads/Downloads/Platform-Economics-Essays-on-Multi-Sided-Businesses.pdf

Van Alstyne: http://ebusiness.mit.edu/research/papers/232_VanAlstyne_NW_as_Platform.pdf

Haigu paper: http://www.hbs.edu/faculty/Publication%20Files/15-037_cb5afe51-6150-4be9-ace2-39c6a8ace6d4.pdf

Hagui interview:  http://hbswk.hbs.edu/item/new-research-explores-multi-sided-markets

Booz: http://www.strategy-business.com/article/03301?gko=16442

Esko Kilpi:  https://workfutures.io/one-theory-to-rule-them-all-c942486e4b30#.gj4wcbxtz

Sam Ghosh: https://www.linkedin.com/pulse/understanding-multi-sided-platforms-social-networks-more-sam-ghosh

A Half Dozen More Things I’ve Learned from Bill Gurley about Investing

 

I started my friendship with Bill Gurley in the mid-1990s soon after Bill Gates forwarded me a copy of Above the Crowd. I immediately signed up to receive it (by fax!). I then found a way to for us to start talking by phone and the Internet. Gurley was a sell-side analyst living in New York at that time. We kept talking when he moved to Silicon Valley, including the time he spent at Hummer Winblad Venture Partners and then on to Benchmark Capital. As fate would have it, I was sent by Craig McCaw to spend time with Benchmark Capital not soon after Gurley arrived as a partner. It was the late 1990s, the Internet bubble was in full swing and mobile was thought to be “the next big thing” in Silicon Valley. The time I spent co-investing with Benchmark for Eagle River was as much fun as I have ever had in my career. I learned as much from the Benchmark partners during that time as I have from anyone ever. Learning from Gurley, Bruce Dunlevie, Andy Rachleff, Kevin Harvey, Bob Kagle, Steve Spurlock and David Beirne was a dream come true. Unfortunately, the Internet bubble would eventually pop and that would put everyone into firefighting mode for a few years. But I have maintained my friendship with Benchmark over the years and have continued to learn from them. For example, Gurley was the person who pushed me to start using Twitter and from that came my 25IQ blog (my effort to pass along a little of what I have learned before I am dead).

When I wrote my first blog post on Gurley for 25IQ I was limiting myself to 1,000 words per post. I am now up to as much as 4,000 words on some posts since people seem to be actually reading them. So I feel like I owe Gurley and some other people who I wrote about early in this 25IQ series an addendum. As part of my effort to make amends, set out below are a few quotes from a fantastic recent ReCode interview of Gurley by Kara Swisher and my usual commentary. In the notes that are always at the bottom of each post I have assembled a collection of other videos of Gurley, including a particularly insightful interview by Om Malik:

  1. “I think everybody, to a certain extent, has to play the game on the field. I like to use the example of Hortonworks and Cloudera. So we’re in this company HortonWorks, it’s a Hadoop company. Cloudera raises $950 million from Intel. What do you do? You could sit around and say, ‘We’re going to get to profitability,’ but you’re not going to matter. You might as well lock the door and leave the building. So you’re forced into a game of capital warfare that you may have not been ready to play. And so I don’t know that any one person is responsible. Silicon Valley and venture capital have always been cyclical. And so there’s something about human nature that causes us to be increasingly risk-seeking until someone comes along and really punishes everybody.” “I’ve got an unwritten blog post about unit economics. One of the things that Silicon Valley does when it gets risk-seeking, which it did in ’99 and now, is they invest in businesses with lower and lower gross margins. And that’s riskier. And a lot of times those involve consumer products. And then what they do is they start selling them heavily discounted. And there’s this old saying about selling dollars for 85 cents. But there’s a truism to it. You can create infinite revenue if you sell dollars for 85 cents. And if you give consumers more value than you charge them for, they will love you. And I remind entrepreneurs all the time that Webvan had the highest NPS scores of any company I’ve ever known. It wasn’t that the consumer proposition didn’t work, it was that the economics didn’t work. They weren’t charging enough for the service level.”  “When bubbles come along, almost anyone can raise money. And so it creates excessive competition, you get companies that are misbehaving.” Are there any exceptions to the rule that every business needs a moat to generate a sustainable profit?  No. However, this is a trick question since it is the existence of a return on investment that is significantly above a firm’s opportunity cost of capital over a number of years that is the test of a moat’s existence in the first place. In other words, the test of whether a moat exists is fundamentally mathematical (i.e., quantitative). But what causes a moat to exist is mostly qualitative since a nest of complex adaptive systems is involved in any business and the economy in which it operates. The successful creation of a new moat is emergent – you know it when you see it. Moats are created through the interaction of a number of phenomena that I have written about many times on 25IQ series and in my book on Charlie Munger. Because moats are emergent it seems rather obvious how they were created after the fact, but the reality is they are hard to predict before the fact (which explains why venture capital firms invest in a portfolio of businesses hoping for one to three grand slam financial home runs per fund).

In order to moderate the risks associated with this phenomenon of startups and other businesses selling dollars for 85 cents Gurley has been playing the role of an industry leader when he says things like he did above. He has been pushing against the wind to try to benefit not only his own portfolio of businesses, but the industry as a whole. People get easily confused about what Gurley is saying because they tend to be almost totally focused on valuation. Valuation is easy to understand. The general public and many mercenary entrepreneurs like to read and dream about wealth. Wealth sells. But the valuation of a business is a very different issue than the issues that can arise due to risk, uncertainty and ignorance in an industry, value chain or business. In short, there is far too much talking and writing about valuation (especially about whether some company is a unicorn) and far too little focus on the set of issues created by risk, uncertainty and ignorance. In other words, the press likes to say Gurley believes valuations are too high, when he is actually saying that risk, uncertainty and ignorance are too high. Valuation ≠ Risk. Valuation can be a source of risk, but it is not the same thing as risk.

Since Gurley is an athlete and a sports fan he uses sports analogies like “play the game on the field.” Another of these analogies is “muscle memory.” He said in the Kara Swisher’s Recode interview:

[Gurley] “People discount risk slowly. Like they forget about pain and they forget about layoffs and they forget about that this is supposed to be hard, you need to profitable. And the younger generation, they’re taught in very short time windows. So most of the entrepreneurs today weren’t around in ’99.

[Kara] So they’ve forgotten.

[Gurley]They have no muscle memory of it whatsoever.”

It is hard to exaggerate what a shock it was when the Internet bubble popped. The business environment moved from a fund raising climate where you could easily raise billions of dollars for a telecom firm or hundreds of millions for a startup in days to one where you could not raise five cents over any period. Any rational founder should have given thought about what they would do if there was no more cash coming in from investors. Prior to the end of the Internet bubble some founders did and some founder didn’t, and that was a life or death decision for their business. Some founders just got lucky since they had recently done a big financing round (what looked like skill was actually luck). People like Mitch Kapor and Josh Kopelman are in 2016 talking about a Watney rule: “We need to act we’re like Mark Watney in the Martian. We can’t assume we will get a shipment of new potatoes to save us.” The Watney Rule is intended as insurance, not as an operating plan while money is available as current costs. Fred Wilson thoughtfully argues that times when liquidity is tight can be cathartic:

“As these expansion stage companies struggle to raise capital, they are forced into a cathartic (and at times painful) process of self-reflection. What is their sales process? Is it efficient? What is their unique value proposition? Is it really unique? What kind of company are they building? Will it be large enough to justify all of this investment? And as a result, these companies are coming out of these hard raises with better businesses, better operating models (lower burn rates!!), and bigger visions to go execute against.”

  1. “When I was on Wall Street I was just devouring any book I could on investing philosophy — I think I bring a structured approach. And the way I think about it, which will sound trite, but I’m always looking for some kind of competitive advantage, like some type of unfair ability to compete in the marketplace. I don’t get drawn to the kind of enterprise deals that are just, “Who has the better sales force, knock them down,” kind of thing.” “I remember the OpenTable scenario. We’re meeting with Chuck [Templeton], and he’s in, like, three restaurants, and we’re like, “How could this ever work?” And you’re like, “Well, it can work if we tip it into a network effect and then everyone has to buy it.” And that’s what played out. It’s that kind of thing. We were betting on the existence of a network effect. And people talk about network effects all the time, but you come up with ways to try and analyze whether it’s possible or not. Will more diners lead to more restaurants, and will more restaurants lead to more diners? Are there ways to measure and study that? Or to implement the go-to-market strategy such that it exploits it as much as possible?” One particularly challenging element of a technology-based business is the moats of these businesses have network effects at their core. In a value chain dominated by network effects-based moats it is rare that a business can be fully rational about spending on customer acquisition when their competitor is spending on sales and marketing as if they have a printing press set up in a huge warehouse minting non-sequentially numbered $100 bills at zero cost. Since there is no way to predict when the spigots supplying new cash will be less available or even dry up and since network effects are so critical, a technology startup or business must, as Bill Gurley says: “play the game on the field.” The entrepreneur must trade off: (1) the risk of running out of cash against (2) the risk of not acquiring essential network effects before more free spending competitors do so. There is no scientific method for optimally making this tradeoff.  However, cash in the bank is something that can give the business a margin of safety. A famous investor once called cash “financial Valium.”

All of this is obviously impacted by the availability and cost of capital. More cash means less people are paying attention to having sound unit economics. Gurley notes: “I was fortunate enough this summer to meet Warren Buffett — Chamath [Palihapitiya] was the one that made that happen. But we only had one question each, and I said, “You know, in our industry we’re seeing that low interest rates are leading to overt competition that’s irrational.” And he says, ‘You bet it is.’ And he’s seeing it in his business as well, and I think it’s played out in natural gas and all these other pockets. Real estate in Silicon Valley, right? All these asset prices, because with interest rates so low you just have people looking for yield, so money sloshes around.” There is clearly a lot of capital looking to find higher returns and that impacts the amount of capital invested in the venture capital industry which ends up in the hands of the businesses. This is having a significant impact on behavior to say the least. As Warren Buffett wrote in his February 28, 2001 Chairman’s letter:

“Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities—that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future—will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

  1. “When I first arrived at Benchmark, it was like, ‘Nothing can go wrong.’ There was an IPO every week. And then, wham! Man, the door came down hard.”

Joe Wiesenthal asked this question on Twitter recently:  What caused the end of the Internet bubble.  Here is my answer from a previous post:

“The Internet bubble was literally insane. I’ve never been involved in anything in my life that was more surreal. Fear of missing out (FOMO) caused the bubble to reach unprecedented levels. FOMO is driven by an innate human desire to avoid regret. Daniel Kahneman has counseled financial advisors to “try to prevent people from acting out of regret.” Investors and speculators who are prone to regret are more prone to change their mind at precisely the wrong time. Primarily you want to protect them from regret, you want to protect them from the emotions associated with very big losses.They key takeaway from the Internet bubble, for me, is that when it happens is not predictable. If it is a bubble and it does bust, the day before is like any other day. One key “tell” that can give you a sense that something is up is looking around and seeing lots of companies that are unprofitable paying far too much to acquire customers. What is too much? If the customer over their lifetime is producing a return that is significantly net present value negative the business is paying too much. How much is too much? It depends. If this pattern of acquiring net present value negative customers is persistent and widespread hairs should be standing up on the back of your neck. The bigger the net present value deficit the bigger the risk. Can you predict when a bubble will end? No. “You can’t predict, but you can prepare” says Howard Marks, and I agree. And for the hundredth time: risk is not the same thing as valuation.”

The Internet bubble and its end were nonlinear.  There was no single cause of its creation or its demise. They were what Charlie Munger calls “lollapaloozas.” Michael Mauboussin describes the phenomenon: “Increasingly, professionals are forced to confront decisions related to complex systems, which are by their very nature nonlinear…Complex adaptive systems effectively obscure cause and effect.  You can’t make predictions in any but the broadest and vaguest terms. … Complexity doesn’t lend itself to tidy mathematics in the way that some traditional, linear financial models do.”

  1. “It’s called asymmetric returns. If you invest in something that doesn’t work, you lose one times your money. If you miss Google, you lose 10,000 times your money. You have to orient yourself toward — Bruce [Dunlevie] uses the phrase, ‘What could go right?” And you have to kind of think that way all the time.” “The learning is that if you have remarkably asymmetric returns, you have to ask yourself, “How high could up be?” And then that “what could go right?” Because it’s not a 50/50 thing on the judgment call. Like, if you thought it was a 20 percent chance at doing it, you should still do it, because the upside is so high.” “You have to be very fortunate to fall on what people sometimes refer to as positive black swans, these break-out plays. And I think you could spend your whole career and do extremely well and never get behind one of the ones: A Facebook, a Google, that kind of thing. And it’s almost impossible to predict ahead of time what’s going to turn into something like that.” “The moment that John Doerr and Mike Moritz closed the Google investment, which was probably all of a week and half, it was the biggest event in both those firms for over a decade. And something had happened in a week and a half. And for a lot of those companies, and I’ll include the ones we’re in, if you worked there it probably would have come out that way anyway. So the seminal event was that closing event that was very quick.”

Convexity (huge upside and small downside) and power laws drive financial returns in venture capital.  Venture capitalists must deal with systems which are, in the words of Nassim Taleb, “more like a cat than a washing machine.” Nassim Taleb provides a quadrant-based model as a guide to decision making. Michael Maubousin provides a summary of what Nassim Taleb has created:

“A two-by-two matrix, where the rows distinguish between activities that have extreme outcomes and those that have more bunched outcomes, and the columns capture simple and complex payoffs. He allows that statistical methods work in the First Quadrant (simple payoffs and bunched outcomes), the Second Quadrant (complex payoffs and bunched outcomes), and the Third Quadrant (simple payoffs and extreme outcomes). But statistical methods fail in the Fourth Quadrant (complex payoffs and extreme outcomes).”

Richard Zeckhauser explains why

“The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance.”

The nature of the venture capital business is that financial returns come from the Fourth Quadrant/the world of ignorance. Standard statistical methods do not work. If you are looking for a career that is more protected from artificial intelligence, the Fourth Quadrant is a place to be. The great venture capitalists person accept this uncertainty and ignorance by seeking to become “antifragile” rather than trying to precisely predict outcomes that are not computable. This is part of the reason why there are venture capital firms. Warren Buffett advises:

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

5. “There aren’t that many [rules]. One of the games you play in venture is to know which rules to break at the right time. And so we constantly challenge ourselves. Like, “Should we maybe be dropping this rule at this moment in time because things are changing?” “In the venture rule book there’s: “Don’t back academics who insist on being CEO.” So [when Google pitched to us] there was a number of things that said, “Don’t do it.” But two of the smartest investors ever [Sequoia and Kleiner] stepped up and did it. They also wanted a price that was seemingly ridiculous, obviously a very good investment. We failed to pursue it. It’s always important to state it that way. Because to say ‘pass’ made it sound like we had a chance. I don’t know if we had a chance. They presented to us and we failed to pursue it. And if we had, we would have had to compete with two of the best.” When venture capitalists make a decision on an investment they must think about a range of issues. One of these issues is valuation. If the investor pays too much for an investment it can become very hard to hit the targeted potential return. Another issue is the ownership level. You need to own at significant stake in a business to justify diverting the time and energy of the venture capitalist and not investing in a business that may be viewed to create a conflict.  The venture capital business is about tape measure financial home runs and those returns come from exceptions to what people thought was a rule before or things no one knew. It is worth repeating what Zeckhauser said above: there is no way that one can sensibly assign probabilities to the unknown states of the world.  So for the venture capitalist the question is always: what rule it it wise to break in the case of this investment?

6. “Venture’s really hard. And there’s a lot of luck involved. And mistakes that you make — especially missing ideas.” “Most big startup breakouts are where people aren’t paying attention. As opposed to where everybody’s got their guns lined up.” “Between the time we looked at the [Uber] seed and when we did the A, Travis had moved into the CEO position. At the beginning we were just studying him as an angel investor in the thing, and probably by the time the A came around he was the CEO. It was hard. Like I said, we had a theory that it could be like OpenTable. So you know, OpenTable was sold for like $3 billion or something. So I’d be inaccurate if I suggested we had a vision that it could one day cause people to question car ownership. I never had considered that.” The best venture capitalists are open and aware of the role that luck played in their lives and in their portfolio.When you listen to a Gurley interview he always takes time to thank the people who helped him along the way and to point out the good fortune he has experienced in his career. In a Quora AMA, Gurley gave a great answer to this question: What are the top pieces of advice you would give to your younger self?  I can’t think of a better way to end this post than Gurley’s answer:

1) Read even more than you did.
2)  Thank the people (more) that helped you along the way.
3) When Larry and Sergey ask for $110 pre-money, say “yes, we would be  very excited about that.”

Notes:

Previous 25IQ on Bill Gurley: https://25iq.com/2013/09/09/a-dozen-things-ive-learned-from-bill-gurley-about-investing-and-business/

Above the Crowd:  http://abovethecrowd.com/

ReCode: http://www.recode.net/2016/9/28/13095682/bill-gurley-benchmark-bubble-uber-recode-decode-podcast-transcript

Quora AMA: https://www.quora.com/session/Bill-Gurley/1#!n=30

McCombs Interview: http://www.today.mccombs.utexas.edu/2016/05/high-stakes

Om Malik:  https://www.youtube.com/watch?v=dBaYsK_62EY

Pando: https://www.youtube.com/watch?v=nUfkK2xcwnY

TechCrunch: https://www.youtube.com/watch?v=FTGQb32DCDE

GeekWire: https://www.youtube.com/watch?v=VVbK5LCpuWk

Gurley on Coach Campbell:  https://www.youtube.com/watch?v=Lfrbn4tH-NY

Bloomberg:  https://www.youtube.com/watch?v=PwuAYyhfuMs

WSJ: http://www.wsj.com/video/bill-gurley-weve-become-comfortable-with-high-burn-rates/1A3324C6-40BF-4B64-BAD2-D2864F891AB3.html

CNBC:  http://www.cnbc.com/2016/06/01/bill-gurleys-warning-for-start-up-investors.html

TechCrunch: https://techcrunch.com/2015/10/20/bill-gurley-surprises-with-a-positive-note-on-seed-stage-startups/

Techcrunch: https://techcrunch.com/2015/09/15/bill-gurley-on-some-high-flying-startups-and-their-economics-its-the-same-shit-as-in-99/

Fred Wilson: http://avc.com/2016/10/the-hard-raise/

A Half Dozen Things I’ve Learned from Robert Cialdini’s book “Influence”

 

Professor Robert Cialdini first published his best-selling book Influence in 1984. Charlie Munger liked the book so much he sent Cialdini a thank you note and a share of Berkshire A stock then worth $75,000. Munger said in his famous The Psychology of Human Misjudgment speech at Harvard: “Cialdini does a magnificent job and you’re all going to be given a copy of Cialdini’s book. And if you have half as much sense as I think you do, you will immediately order copies for all of your children and several of your friends. You will never make a better investment.” It should not be a surprise that Influence is in the top ten on my book discovery web site 25IQ books.

Cialdini has a new book out that is at the top of my reading list called Pre-Suasion, which I will write a post about at some point. Cialdini’s describes the subject of his new book as follows: “Pre-suasion is the practice of getting people sympathetic to your message before they experience it.”

In his book Influence Cialdini identifies six important principles often used by what he calls “compliance professionals.” Do you know any “compliance professionals” who have been in the news lately? How do they use principles like authority to try to manipulate you? Influence also discusses a range of additional biases and type of dysfunctional thinking that can cause people to make mistakes. Ironically, we often act as compliance professionals with respect to ourselves to our own detriment. Unfortunately, just being aware of these tendencies is not sufficient to keep them from adversely impacting our judgment and decisions. But a tendency is not destiny, so we can learn to be less adversely impacted by these techniques. None of us will ever be perfectly rational, but we can become incrementally better at making rational decisions.

1. “The [reciprocity] rule says that we should try to repay, in kind, what another person has provided us.” “The obligation to receive reduces our ability to choose whom we wish to be indebted to and puts that power in the hands of others.” The need for reciprocity is a powerful human emotion. Compliance professionals know how to exploit this tendency. For example, when the stock broker gives away the “free” salmon dinner he or she is expecting you to reciprocate by allowing them to manage your wealth. The salesman who wants you to buy his goods in return for the football tickets is no different in his or her motivation. One weird thing about the reciprocity tendency is that you are so influenced by this tendency that what is asked for by the compliance professional can be of far greater value that what is given to you. For example, the Hare Krishna member in the airport who gives away the flower can ask for something much more valuable and yet the people being solicited will still feel the compulsion created by reciprocity. The key defensive move against reciprocity is to not accept the gift in the first place. I would rather stab myself in the thigh with a sharp fork than accept a free weekend condominium stay offered by a time share salesperson. One technique that is useful when engaging in a negotiation is to politely refuse to accept or at least immediately reciprocate when hospitality is offered. Lavish hospitality given to the employees of a business is often intended to create obligation at a personal level, which they hope will cause the employee to offer reciprocal benefits to the generous compliance professional. One problem, however, is that some studies have shown that there is also a bias toward receiving a gift: “Although the obligation to repay constitutes the essence of the reciprocity rule, it is the obligation to receive that makes the rule so easy to exploit.” I’m not so sure about this conclusion as I have an easy time saying no to giftsCialdini points to an additional factor that compliance professionals may use to generate the behavior they desire: “A well-known principle of human behavior says that when we ask someone to do us a favor we will be more successful if we provide a reason. People simply like to have reasons for what they do.” Charlie Munger has said: “the practice of laying out various claptrap reasons is much used by commercial and cult ‘compliance practitioners’ to help them get what they don’t deserve.” The sales person may say something like: “Well yes, we are charging you a 3% sales load on this index fund, but we need to do that because our costs are high.”

The “reason” cited by the compliance professional creates a tendency by the customer accept the fee, even though it is unreasonably high. Similarly an internet scammer may claim that they need to know your social security number because it is required by a state government regulation. How can this reciprocity principle be used in a positive way? One example would be someone who wants to find a career mentor. The best way to do that is often to do favors for the person you want to be a mentor first.  Cialdini talks about an important idea he calls prework:

“People will help if they owe you for something you did in the past to advance their goals. That’s the rule of reciprocity. Get in the habit of helping people out, and—this part’s really important—don’t wave it away when people thank you. Don’t say, “Oh, no big deal.” We’re given serious persuasive power immediately after someone thanks us. So say something like “Of course; it’s what partners do for each other”—label what happened an act of partnership. With that prework done, a manager who subsequently needs support, who needs staffing, who maybe even needs a budget, will have significantly elevated the probability of success.”

Cialdini believes the exchanges can:

“increase both the social value of the giver and that person’s productivity. It wasn’t the number of favors done. It was the number of favors exchanged. If the initial giver creates a sense of reciprocity—a sense that there’s a network of partners who are not just willing but eager to help—he will get a lot in return. He can increase the likelihood of a big ROI by characterizing his assistance as a two-way partnership.”

2. “We all fool ourselves from time to time in order to keep our thoughts and beliefs consistent with what we have already done or decided.” Charlie Munger believes:

“The brain of man conserves programing spaces by being reluctant to change.” He describes the relationship between the human brain and an ideas as being like a human egg with a sperm. Once an idea gets in to the brain, other ideas are prevented from entering by a shut off valve, just like what an egg does to additional sperm once one gets in.”

Commitment and consistency are a very powerful forces that kick in with particularly strong force when people do things like making a public statement about something like a stock price or a political issue. Once that public statement is made (e.g., climate change is X), the tendency is for the person who made the statement to ignore or deny dis-confirming evidence. The best antidote to this bias is arguably an outlook often described as : “Strong opinions, weakly held.” To effectively adopt this antidote a person should do enough research so their opinions are strongly believed, but be open to new dis-confirming evidence (weakly held). As an example, when you publicly state that you believe X stock is going up you are setting in place a potential bias that may cause faulty thinking. By keeping your view on that stock weakly held you can remain open to new evidence if it appears. Value investor Guy Spier writes: “I try to avoid walking into the trap of making statements about any stocks that we currently own, since the situation might later change or I might discover that I was wrong. This is why I prefer not to discuss our current investments in public settings such as annual meetings, shareholder letters, and media interviews.” Sunk cost bias is part of this bias. Munger notes:

“Failure to handle psychological denial is a common way for people to go broke. You’ve made an enormous commitment to something. You’ve poured effort and money in. And the more you put in, the more that the whole consistency principle makes you think,” Now it has to work. If I put in just a little more, then it ’all work…. People go broke that way —because they can ’t stop, rethink, and say,” I can afford to write this one off and live to fight again. I don’t have to pursue this thing as an obsession —in a way that will break me.”

How can this principle be used in a positive way? Cialdini once used this story in an interview to make the point: 

“There was a study done on college students, as freshman, were having trouble in their first year with their study habits.  They weren’t doing very well in their classes.  And they went into a particular program that was scheduled to help their study habits.  One group of them made a commitment to study regularly and specific times, in a systematic way every night.  And they kept that commitment in their heads. Another group wrote it down and kept it private.  Another group wrote it down, and showed it to everybody else in the room.  “Here’s what I promise that I’m going to do.” The first 2 groups didn’t improve at all on their next test.  But that group that showed their public commitment to everybody else in the room, 86 percent of them got one full grade better and moved from a C to a B or a D to a C on the next exam.”

3. “First, we seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Second, quite frequently the crowd is mistaken because they are not acting on the basis of any superior information.”We will use the actions of others to decide on proper behavior for ourselves, especially when we view those others as similar to ourselves.”  Social proof is powerful and someone who knew that well was Bernie Madoff. The list of his famous victims is long. Sandy Koufax, Kevin Bacon,  Henry Kauffman, Steven Spielberg, Kyra Sedgwick, John Malkovich… The list of famous victims goes on and on. Cialdini writes: “One means we use to determine what is correct is to find out what other people think is correct. We view a behavior as more correct in a given situation to the degree that we see others performing it.” Restaurants often seat the first patrons near the front window since it is harder to get people to enter if no customers are already inside. As Ben Graham once said: “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” Munger talked about how business executives makes errors based on social proof in his famous Harvard speech on human misjudgement: “Big-shot businessmen get into these waves of social proof.  Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company?  And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn’t know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa.  I think they’re all gone now, but it was a total disaster.” In order for investors to beat the performance of an index fund they must have a view that is different than the crowd and they must be right about that different view. Cialdini points out: “Daniel Kahneman won a Nobel Prize for showing that if you’re trying to mobilize people under conditions of uncertainty, notions of loss are psychologically more powerful than notions of gain. Managers can take the wind in their faces and make it wind in their sails by speaking not just of what will be gained by moving but also of what will be lost or forgone if people fail to move. A second thing that happens when people are uncertain is that they don’t look inside themselves for answers—all they see is ambiguity and their own lack of confidence. Instead, they look outside for sources of information that can reduce their uncertainty. The first thing they look to is authority.” An example Cialdini cites is changing the action line in an infomercial from “Operators are waiting, please call now,” to “If operators are busy, please call again.” Cialidni describes why the call in rates went way up when this change was put in place: “home viewers followed their perceptions of others’ actions, even though those others were completely anonymous. After all, if the phone lines are busy, then other people like me who are also watching this infomercial are calling, too.”

Social proof, like the other tendencies discussed in this post, can be uses for good as well as bad purposes. For example, an advocate of greener practices writes:

“Cialdini, a professor at Arizona State University, conducted a study in several Phoenix hotels comparing the effects of those ubiquitous hotel-bathroom placards that ask guests to reuse towels, testing four slightly different messages. The first sign had the traditional message, asking guests to “do it for the environment.” The second asked guests to “cooperate with the hotel” and “be our partner in this cause” (12 percent less effective than the first). The third stated that the majority of guests in the hotel reused towels at least once during their stay (18 percent more effective). The last message was even more specific: it said that the majority of guests “in this room” had reused their towels. It produced a 33 percent increase in response behavior over the traditional message.”

Cialdini gives this other example from an area of the United States close to where he lives:

“We’ve done some research in the petrified forest in Arizona where I live, there’s a big sign: ‘So many people have stolen pieces of wood from the forest that it’s undermining the integrity of the forest’. That sign tripled theft! But if we said ‘If even one person steals, it undermines the integrity of the forest’, that cut theft in half compared to no sign. Well, it turns out that the managers of the park made a mistake, because only 2% of people steal. So actually they made two mistakes: First of all, they didn’t use the real Social Proof: the 98% of the people who don’t steal. Secondly, they made stealing seem like the norm when it wasn’t! So it’s all about the norm. Norm is essentially Social Proof.”

4. “People prefer to say yes to individuals they know and like.” Finding examples of dysfunction based on liking is like shooting fish in a barrel with a spear gun. For example, an actor who knows nothing about finance is put in a commercial and talks in the advertisement about how you can “make money” doing X.  People know that the person is just an actor and yet statistics show they are motivated into the reverse mortgage or buy the expensive insurance or trade commodities. The sales person who wants to close the sale may want to learn the favorite sports team or hobby of the customer for the same reason. People are also more likely comply with requests of people who are physically attractive or who have similar backgrounds and interests.” Again, the liking tendency can be used for good as well as bad purposes. For example, a study concluded: “newcomers feel motivated to come back to Alcoholics Anonymous because they felt cared for, felt similar to other alcoholics, and found hope in others’ recounted experiences with the program. Findings also argue for an extension of Cialdini’s theory by augmenting the ‘liking’ peripheral cue to include social support and similarity.” Munger says Alcoholics Anonymous uses many of the same techniques as a cult like the Moonies, but for what he believes is a positive outcome. It is interesting to note that just because someone is “family” does not mean they fall outside of the liking/hating tendency.  Munger quotes Buffett as saying: “a major difference between rich and poor people is that the rich people can spend more of their time suing their relatives.”  On a more positive note, Cialdini advise salespeople as follows:

“People don’t buy from because they like you, as much as they buy from you because they perceive that you like them.  If I know that you like me, I know you’re going to give me a good deal. You’re not going to exploit my interests.  You’re not going to take me.  If you genuinely like me, I can exhale.  I can listen to what you have to tell me with confidence. So here’s the implication.  Instead of trying to find a way to get your clients to like you, you find a way to come to like your clients, and show them that you like them. That’s your secret.”

5. “We are trained from birth to believe that obedience to proper authority is right and disobedience is wrong.” “Abraham’s willingness to plunge a dagger through the heart of his young son because God, without any explanation, ordered it. We learn in this story that the correctness of an action was not judged by such considerations as apparent senselessness, harmfulness, injustice, or usual moral standards, but by the mere command of a higher authority.” Authority is often used by “compliance professionals since it is so easy to put into play. Often all is needed is an expert, who can be just about anyone with a fancy title, particularly if they are from out of town. The good news is that if someone’s expertise is shown to be fake the spell can be broken. Charlie Munger describes the problem with authority bias: “[Researchers] don’t do this in airplanes, but they’ve done it in simulators. They have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot’s doing it, and the co-pilot is sitting there, and the pilot is the authority figure. Twenty-five percent of the time, the plane crashes. I mean this is a very powerful psychological tendency.” Cialdini explains: “Someone who is in authority has a title, ranking, or the trappings of authority. But, someone who is an authority is more persuasive because they have superior knowledge, experience or expertise in a specific area.” A crook trying to steal your Internet password may claim that they are from the security department of your network services provider, bank or credit card company. The Nigerian scammer may say they are a prince, senior government official or tribal leader for the same reason. Scammers who claim to be from the IRS are also trying to exploit authority bias. Ciadini has said in an interview:

“Authority is more important, impactful and more influential on topics of fact. If you are an expert on the matters of fact then you should emphasize your authority when you are presenting that information.” How has the Internet charged this authority principle. Cialdini points out: “Social media have allowed us to access other sources of information than in the past, but I don’t think they’ve changed our responses to influence appeals. One thing we’re seeing, though, is that people are beginning to be influenced by their peers more than by experts.”

6. “Our typical reaction to scarcity hinders our ability to think.” Scarcity is often used by salespeople and other compliance professionals to motivate buyers. Bernard Madoff when approaching new marks liked to make a big show out of telling people in public that they would not be allowed to invest in his fund. The more he told them he was not willing to manage their money, the more they wanted to do so since he created a false sense of scarcity. Palm Beach accountant Richard Rampell said of Madoff: “It was almost like you were getting let into the club of investors, and everybody wanted to be in. ‘Oh, wow! You’ve got a Madoff account.'” The phrase “limited time offer” or available for the first ten customers is all about invoking scarcity bias. A limited edition Ferrari is all about creating an image of scarcity. Cialdini points out: “The scarcity principal trades on our weakness for shortcuts.” If the Yeezy sneaker is relatively scarce, is must be valuable is the message intended by the compliance professional. If there is a line outside a store to buy the latest phone it must be scarce and therefore valuable in the thinking the vendor wants to generate. If the salesperson says you need to act now, but you are not ready to act since you have not done the due diligence, just say no. As Warren Buffett says: “Investing is a no-called-strike game. You don’t have to swing at everything–you can wait for your pitch.” Addendum: It is important to note that more than one principle may be involved and that there are many more biases, tendencies and heuristics than the six discussed in this post on Influence. They can all interact to create what Charlie Munger calls a lollapalooza. Munger:

“A [decision] frequently involves a whole lot of factors interacting … the one thing that causes the most trouble is when you combine a bunch of these together, you get this lollapalooza effect. Often results are not linear.” Munger relays this story: A guy named Zimbardo had people at Stanford divide into two pieces: one were the guards and the other were the prisoners, and they started acting out roles as people expected.  He had to stop the experiment after about five days.  He was getting into human misery and breakdown and pathological behavior.  However, Zimbardo is greatly misinterpreted.  It’s not just reciprocation tendency and role theory that caused that, it’s consistency and commitment tendency.  Each person, as he acted as a guard or a prisoner, the action itself was pounding in the idea.” Wherever you turn, this consistency and commitment tendency is affecting you.  In other words, what you think may change what you do, but perhaps even more important, what you do will change what you think.  And you can say, “Everybody knows that.”  I want to tell you I didn’t know it well enough early enough.”

Notes:

Cialdini’s book Influence: https://www.25iqbooks.com/books/8-influence-science-and-practice-5th-edition 

Munger’s The Psychology of Human Misjudgment speech:  http://www.rbcpa.com/mungerspeech_june_95.pdf

Influence at Work  http://www.influenceatwork.com/wp-content/uploads/2012/02/E_Brand_principles.pdf

Atlantic article:   http://www.theatlantic.com/magazine/archive/2009/07/greening-with-envy/307498/

HBS Interview: https://hbr.org/2013/07/the-uses-and-abuses-of-influence

NPR Interview: http://www.pbs.org/newshour/bb/psychological-trick-behind-getting-people-say-yes/

Interview: http://www.mischacoster.com/2010-10/psychology/interview-dr-robert-cialdini-on-social-media-influence-with-audio/

Interview: http://www.geniusnetwork.com/robertcialdini/Genius-Network-Robert-Cialdini-Interviewed-by-Joe-Polish.pdf

A Dozen Things You can Learn by Reading “The Success Equation” by Michael Mauboussin

Asking me to select my favorite book written by Michael Mauboussin is like asking me to pick my favorite child. I love them all the same. But if I had to choose one book it would probably be The Success Equation. There are lot of reviews of this book, all of them glowingly positive. The world doesn’t need another review of this great book so I will try to write mostly about how the ideas in the book might be applied in the real world.

Anyone who has been reading this blog should know a lot about Michael Mauboussin. He is one of the clearest business thinkers ever in my view. When he writes and speaks it is in complete thoughts to an extent that astounds me. Read his books and essays. Then read them again. He is a wonderful teacher and very generous with his ideas and time.

It is rare that a post on this blog does not have a notes section identifying further resources to read, but this one is particularly long since Mauboussin’s written work is voluminous. He is a reading and writing machine.

One of the many things I like about Mauboussin is that he thinks about thinking. That is not only valuable, but fun. I am lucky to count him as a friend. His ideas have shaped mine about as much as anyone. Let’s get started.

1. “There’s a quick and easy way to test whether an activity involves skill: ask whether you can lose on purpose. In games of skill, it’s clear that you can lose intentionally, but when playing roulette or the lottery you can’t lose on purpose.” Luck is easier to describe than skill. Luck is best thought of in terms of an activity like roulette. With roulette you know the all potential future states and the probability distribution. Because the house takes a rake in roulette, there are no professional roulette players. Very few things in life involve just luck. The probability distribution of outcomes in the real world is rarely known. Mauboussin writes that luck has three core elements: 1) it operates on an individual or an organizational basis; 2) it can be positive or negative; and 3) it is reasonable to expect that a different outcome could have occurred.

Skill is harder to define, but Mauboussin believes a dictionary definition works well. Skill is: “The ability to apply one’s knowledge readily in execution or performance.” Mauboussin writes that activities like chess rely almost wholly on a player’s skill. Mauboussin explains that each sport has a different mix of skill versus luck and if you want to understand this point better read the book! You will note that in this picture below investing finds its home closer to luck than skill (see the placement of chart icon).

 luck-sk

2. “Much of what we experience in life results from a combination of skill and luck.” The mix between skill and luck in a given business or investing activity is always different and is constantly changing. Exactly where investing falls on that continuum depends on the style of investing involved and the business environment at the time. Investing in the stock market is an interesting case to consider when thinking about the mix between luck and skill since it is hard to do better than an index and it is also hard to do worse, especially if you are diversified. Venture capital investing is a more a skill driven activity since it involves things like coaching founders and significantly more uncertainty. Starting a business also involves more skill than investing in pubic equities. When Mauboussin was writing The Success Equation we had an email conversation about the role of luck in the success of Microsoft. I recall that we did not agree completely about the mix in that case. I recall that saw less luck that Mauboussin did. But I am too close to the story perhaps to be objective. Mauboussin includes writes in the book: “When asked how much of his success he would attribute to luck, Gates allowed that it played ‘an immense role.’ In particular, Microsoft was launched at an ideal time: ‘Our timing in setting up the first software company aimed at personal computers was essential to our success,’ he noted. ‘The timing wasn’t entirely luck, but without great luck it wouldn’t have happened.’

3. “Great success combines skill with a lot of luck. You can’t get there by relying on either skill or luck alone. You need both.” Sometimes you will hear people say things like: “the harder I work, the luckier I become.” Mauboussin easily demonstrates these statements to be a non sequitur with a few well-chosen words: “there is no way to improve your luck, because anything you do to improve a result can reasonably be considered skill.” This Mauboussin turn of phrase reminds me a lot of the classic Howard Marks line: if risky investments could be counted on to deliver high returns, then they wouldn’t be risky.

4. “So here’s the distinction between activities in which luck plays a small role and activities in which luck plays a large role: when luck has little influence, a good process will always have a good outcome. When a measure of luck is involved, a good process will have a good outcome but only over time.” Mauboussin believes a wise investing process has three elements: 1) you must find something the market does not believe and you must be right about that belief; 2) you must have control over your behavioral biases; and 3) you must not have organization issues that get in the way of a sound decisions. One way to find things that are true that the market does not believe is to find areas of the market that are less well known and popular. In other words, what you want to do is find a game where the competition is weak. This is exactly what investors Warren Buffett and Howard Marks recommend. What you want to do is find a bet where the other bettors are making decisions based on things that are the equivalent of the patterns made by sheep guts at a slaughterhouse or a Keynesian Beauty Contest. Munger says: “For a security to be mispriced, someone else must be a damn fool. It may be bad for the world, but not bad for Berkshire.” Warren Buffett makes the point that the way to beat a chess master is to play them at something other than chess. Buffett adds: The important thing is to keep playing, to play against weak opponents and to play for big stakes.” If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

There is no substitute for a sound process in an activity like investing. Mauboussin writes:

“If you compete in a field where luck plays a role, you should focus more on the process of how you make decisions and rely less on the short-term outcomes. The reason is that luck breaks the direct link between skill and results—you can be skillful and have a poor outcome and unskillful and have a good outcome. Think of playing blackjack at a casino. Basic strategy says that you should stand— not ask for a hit—if you are dealt a 17. That’s the proper process, and ensures that you’ll do the best over the long haul. But if you ask for a hit and the dealer flips a 4, you’ll have won the hand despite a poor process. The point is that the outcome didn’t reveal the skill of the player, only the process did. So focus on process.”

5. “When everyone in business, sports, and investing copies the best practices of others, luck plays a greater role in how well they do.” “It’s not that investors lack skill. As investors have become more sophisticated and the dissemination of information has gotten cheaper and quicker over time, the variation in skill has narrowed, and luck has become more important.” Mauboussin calls this idea the paradox of skill. For example, as the skill levels of portfolio managers rise the greater the role of luck becomes in the outcome. The classic example of this idea that Mauboussin cites is the .400 batting average of Ted Williams. One of the many joys of this book is how easily he conveys ideas that involve statistics. Mauboussin points out: “The average of all batting averages in Major League Baseball is generally in the range of .260 to .270. In 1941, when Williams achieved his feat, the standard deviation was .032. Today it is about .028. Saying this differently, Ted Williams had an average that was 4 standard deviations away from the average, getting him to .406. If a player were to be 4 standard deviations away from average in 2011, he would have hit .380. Awesome, but nowhere near .400.” Charlie Munger once said, “If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest. You’re giving a huge advantage to everybody else.”

ted-w

As investors increasingly move toward buying index funds, unskilled investors are removed from the game which makes the task of a manager trying to earn alpha harder. In their book The Incredible Shrinking Alpha, Larry Swedroe and Andrew Berkin argue that active managers are increasingly competing for a shrinking pool of alpha. So as investment skill levels rise, luck gets more important.

6. “If you take concrete steps toward attempting to measure [the contributions of skill and luck to any success or failure], you will make better decisions than people who think improperly about those issues or who don’t think about them at all. That will give you an enormous advantage over them.” The more data you have on your processes and outcomes the more you will be able to improve those processes and outcomes. What data is valuable?  I would rather have data and not need it, than need it and not have it. This quote makes me think of a quality that Mauboussin and I share. We both want to know why something is true. It is not enough to know that x is true. Why is X true? One way to know more about why something is true is to measure it. Of course people tend to ignore or hide data they do not like, which reminds me of an old joke told by Kieran Healy:

A soldier is captured during a long-running war and thrown into the most stereotypical prison cell imaginable. Inside the cell is another solider. He has an enormous, disgusting-smelling beard and has clearly been there a long time. The young solider immediately sets about trying to escape. He is resourceful and possessed of great willpower. He bribes a guard with his emergency supply of cash. The guard gets him into a supply truck and he makes it to the prison garage, but is found during a routine vehicle search while exiting the compound. He is returned to his cell. His mangy companion says nothing about his departure or return. Undeterred, the young soldier works on the bars of the cell for weeks, filing them down with a shim made from a toothbrush. The whole time the old soldier looks on, silently. The young soldier finally breaks the bars, slips out the window and makes it to the outer wall, where he is spotted and recaptured. He is thrown back in the cell. He glowers at his grizzled companion, who still remains silent. Calming himself and mastering his despair, he tries yet again, this time digging a tunnel with the narrow end of a broken plastic coffee spoon. After about two years of work he succeeds in escaping under the wall and making it to the nearest town, only to be captured again at the train station. He is delivered, once again, back to his cell and its taciturn occupant. At the end of his wits, the young soldier finally confronts the old soldier, shouting, “Couldn’t you at least offer to help me with this?! I mean, I’ve come up with all these great plans—you could have joined me in executing them! What’s wrong with you?” The old soldier looks at him and says, “Oh I tried all these methods years ago—bribery, the bars, a tunnel, and a few others besides—none of them work.” The young soldier looks at him, incredulous, and screams “Well if you knew they didn’t work, WHY THE FUCK DIDN’T YOU TELL ME BEFORE I TRIED THEM, YOU BASTARD?!” The old soldier scratches his filthy beard and says, “Hey, who publishes negative results?”

7.“Not everything that matters can be measured, and not everything that can be measured matters.” People want to be able to predict the future. To satisfy that desire, humans have a tendency to grab what data can be measured and assume that what can’t be measured does not exist or does not matter. People who are mathematically gifted are particularly prone to this tendency. For example, if you just assume that the human world works like the world of physics you can use this assumption make beautiful mathematical formulas. But there may or may not be any tie of that mathematics to reality, which can create a host of major problems. As an example, one of my biggest problems with a lot of economic discussions today related to the fact that it is very hard to measure consumer surplus. Just ignoring consumer surplus because you can’t measure it well is a bad idea that can lead to unhelpful policy conclusions. Just as unhelpful are people who say that it can be accurately measured, based on a bunch of assumptions that are essentially guesses. Sometimes we need to accept that we do not or cannot fully know something. The policy choices must deal with that uncertainty.

8. “Even if we acknowledge ahead of time that an event will combine skill and luck in some measure, once we know how things turned out, we have a tendency to forget about luck.” Survivor bias is a huge problem in human cognition. The tendency is for people to conclude: what I achieve is skill and what I fail at is luck. Too often recollections of events we see in life is best categorized as fiction. People love to tell stories, particularly about their successes. Sometimes we get lucky and sometimes we are skillful. Usually the result is some mix of both. Charlie Munger has said on this topic: “Well, some of our success we predicted and some of it was fortuitous. Like most human beings, we took a bow.” What is particularly bothersome to me is when people ascribe luck to themselves in a way that they bestow themselves some moral measure superiority. As Warren Buffett points out, he won the ovarian lottery: “I was born in the United States. I had all kinds of luck.”

9. “One of the main reasons we are poor at untangling skill and luck is that we have a natural tendency to assume that success and failure are caused by skill on the one hand and a lack of skill on the other. But in activities where luck plays a role, such thinking is deeply misguided and leads to faulty conclusions.” One of the aspects of life that bothers me the most is when I encounter someone who attributes all their success to skill, and as a result of that they assign a higher moral standing to themselves than people who have been less successful. Mauboussin illustrates this point with a story:

“For almost two centuries, Spain has hosted an enormously popular Christmas lottery. Based on payout, it is the biggest lottery in the world and nearly all Spaniards play. In the mid-1970s, a man sought a ticket with the last two digits ending in 48. He found a ticket, bought it, and then won the lottery. When asked why he was so intent on finding that number, he replied “I dreamed of the number seven for seven straight nights. And 7 times 7 is 48.”

10. “The trouble is that the performance of a company always depends on both skill and luck, which means that a given strategy will succeed only part of the time. So attributing success to any strategy may be wrong simply because you’re sampling only the winners. The more important question is: How many of the companies that tried that strategy actually succeeded?” Once up a time long ago I read a book called In Search of Excellence. The authors analyzed leading companies are sorted out the secrets of success in a way that suggested that it was a replicable formula. The best companies do X, Y and Z was the claim. What was missing of course were all the companies that did X, Y and Z and failed. Mauboussin writes:

“There are numerous books that purport to guide management toward success. Most of the research in these books follows a common method: find successful businesses, identify the common practices of those businesses, and recommend that the manager imitate them. Perhaps the best known book of this genre is Good to Great by Jim Collins. He analyzed thousands of companies and selected 11 that experienced an improvement from good to great results. He then identified the common attributes that he believed caused those companies to improve and recommended that other companies embrace those attributes. Among the traits were leadership, people, focus, and discipline. While Collins certainly has good intentions, the trouble is that causality is not clear in these examples. Because performance always depends on both skill and luck, a given strategy will succeed only part of the time.

Jerker Denrell, a professor of behavioral science, discusses two crucial ideas for anyone who is serious about assessing strategy. The first is the undersampling of failure. By sampling only past winners, studies of business success fail to answer a critical question: How many of the companies that adopted a particular strategy actually succeeded?”

As an example, I knew someone once who though that since X successful founder yelled at people that he must yell at people to succeed. People do things like see fictional accounts of Facebook in a movie and think that all they need to do is replicate that formula. Hoodies or black turtlenecks are not highly correlated with startup success. If enough people wear hoodies sure one of them will succeed to, but there is no causation involved. Free Kind bars and colorful plastic slides between floors of an office do not cause startups to succeed financially.

process

11. “The process of social influence and cumulative advantage frequently generates a distribution that is best described by a power law. … One of the key features of distributions that follow a power law is that there are very few large values and lots of small values. As a result, the idea of an “average” has no meaning.” I call this the paradox of luck as a riff on Mauboussin’s “paradox of skill.” My thesis is that the luckier you get, the more skill you can get if the conditions are right. This happens because of what is known as “cumulative advantage.” As an example, the more financial success someone like a venture capitalist gets, the more skilled people they get to work with since they are attracted to that success, which makes the venture capitalist more skilled, which makes them more financially successful [repeat]. My thesis is: financial success caused by luck begets not only greater financial success, but greater skill. A good example on this point is a statement made by Michael Moritz years ago.  He said: I know there are millions of people around the world have worked as hard and diligently as I have and weirdly enough, like [former US President] Jimmy Carter said years and years ago, ‘life’s unfair’. I just happen to have been very fortunate.” “A chimpanzee could have been a successful Silicon Valley venture capitalist in 1986.” The key point about what Moritz describes is that luck did not just make him richer, it made him more skilled since he was exposed to opportunities and teachers that he would not otherwise have encountered. Being lucky made him more skilled and that process fed back on itself. Luck and skill are different but one can lead to the other in a way that create a virtuous circle.

12. “Knowing what you can know and knowing what you can’t know are both essential ingredients of deciding well.” The best investors are certain of just about nothing and spend a lot of time trying to learn more about what they do not know and cannot know. Mauboussin is chairman of the board of trustees of the Santa Fe Institute, a leading center for multi-disciplinary research in complex systems theory. Perhaps the greatest things I have learned about complex adaptive systems is to more aware of what I do not know.

There is a difference between knowing what you do not know and not knowing very the basics necessary to do a job. As an example, I’m of the view that a US President should know what Aleppo is or be able to name a few foreign leaders. And you want you investment managers to understand things like, well, compound interest and capital gains. Call me a stickler on this point if you want. A positive example would be an investor who candidly says, “I don’t understand biotech investments.”

If you ever attend a meeting at Sante Fe Institute meeting you will see famous investors in the audience who are hungry for information on what they do not know or can’t know. Great investors are humble but yet aggressive when they see a significant opportunity within their circle of competence. Munger is a good person to give the closing statement:

“Even bright people are going to have limited, really valuable insights in a very competitive world when they’re fighting against other very bright, hardworking people. And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times.”

Notes:

The Success Equation (the book): https://www.25iqbooks.com/books/3-the-success-equation-untangling-skill-and-luck-in-business-sports-and-investing

My previous post on Mauboussin on 25IQ: https://25iq.com/2013/07/11/a-dozen-things-ive-learned-from-michael-mauboussin-about-investing/

My list of Mauboussin Essays: https://25iq.com/2013/02/17/mauboussin/

More than You Know:  https://www.25iqbooks.com/books/5-more-more-than-you-know-finding-financial-wisdom-in-unconventional-places-updated-and-expanded-columbia-business-school-publishing

Think Twice: https://www.25iqbooks.com/books/4-think-twice-harnessing-the-power-of-counterintuition

Expectations Investing: https://www.25iqbooks.com/books/24-expectations-investing-reading-stock-prices-for-better-returns

Mauboussin’s bio/CV:  http://www.santafe.edu/about/people/profile/Michael%20Mauboussin

Mauboussin’s Web site http://www.michaelmauboussin.com/

Fast Company Interview: https://www.fastcompany.com/3002729/facts-luck

CNBC post: http://www.cnbc.com/id/49791755

Strategy-Business: http://www.strategy-business.com/article/13202a?gko=50b64

Bloomberg: https://www.bloomberg.com/view/articles/2016-08-16/michael-mauboussin-on-skill-and-luck

Talk at Google: https://www.youtube.com/watch?v=1JLfqBsX5Lc

Ritholtz MIB Podcast:  https://www.bloomberg.com/view/articles/2016-08-16/michael-mauboussin-on-skill-and-luck

Economist: http://www.economist.com/blogs/buttonwood/2012/12/investing

Wharton: http://knowledge.wharton.upenn.edu/article/michael-mauboussin-on-the-success-equation/

Wealth of Common Sense:  http://awealthofcommonsense.com/2013/07/do-you-feel-lucky/

Essay on Measuring the Moat: http://csinvesting.org/wp-content/uploads/2013/07/Measuring_the_Moat_July2013.pdf

Essay on the Skill Paradox:  http://changethis.com/manifesto/100.03.SuccessEquation/pdf/100.03.SuccessEquation.pdf

Essay: https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&source_id=csplusresearchcp&document_id=1051045621&serialid=CFuLyFE%2BEXHlo12BGWMqq8fSzI8Xcj0miB1nOa39p9U%3D

Wired Interview: https://www.wired.com/2012/11/luck-and-skill-untangled-qa-with-michael-mauboussin/

Forbes interview:  http://www.forbes.com/sites/investor/2013/11/05/the-role-of-luck-and-skill-in-investing/#7368a94e3e4c

Slide Deck http://www.sloansportsconference.com/wp-content/uploads/2013/Slides/EOS/Why%20You%20Don’t%20Understand%20Luck.pdf

Prisoner Joke: http://crookedtimber.org/2011/04/23/i-predict-the-gifted-will-foresee-the-punchline/