Book Review - The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, by William Thorndike, Jr.

William Thorndike Jr.'s The Outsiders considers eight Hall of Fame CEOs (and, in some cases, the small teams that they worked closely with), the only executives that passed his twin tests: outperforming companies in their peer group, and besting the performance of General Electric's Jack Welch, widely considered one of the finest managers in business history.  Thorndike found that unlike the jet-set, media-savvy, wheeling-and-dealing, larger-than-life Welch, the truly elite eight were modest, private, and humble.  Their most notable qualities, however, were cerebral.  As Bill Stiritz of Ralston Purina put it: "Leadership is analysis" (145).  And all of the featured executives had the independence of mind to turn analysis into action.

Warren Buffett has noted that most CEOs, however exemplary their abilities in areas such as marketing, production or administration, tend to be poor capital allocators.  They're executors, not investors.  However, decisions about what to do with a spare dollar are just as important to the long-term performance of a business as the day-to-day operations.  In terms of specific policies, most of the featured CEOs repurchased shares, but none paid a significant dividend; all focused on one version or another of cash flows, rather than emphasizing earnings; and none provided earnings guidance to analysts - in short, they behaved like investors, rather than operators.  They didn't out-manage Welch; they bested him in the area of capital allocation.

Perhaps Thorndike's greatest achievement in the book is to resurrect the largely forgotten story of Henry Singleton, who Warren Buffett regards as among the greatest capital allocators in the history of business.  No business major, Singleton earned a PhD in electrical engineering, was awarded the Putnam Medal as the best math student in America, and played chess at an almost-grandmaster level.  In 1960, he and a partner founded a small firm, Teledyne, a conglomerate that swallowed a mind-boggling 130 companies in its first decade of existence, using his own firm's high-priced stock as the currency.  While the sheer scale of his shopping spree might suggest an indiscriminate approach to acquisitions, Singleton was in fact a bargain-hunter: he never paid more than 12x earnings.  

Singleton understood that using Teledyne's stock to fund acquisitions made sense only if that stock was fully (or over) priced, and by 1971 he had grown the share count by about 14x.  However, when the conglomerate form fell out of favor on Wall Street, Teledyne's stock swooned, and he correctly reversed course.  Not only did he never again issue a single share of additional stock, he spent the next decade-plus retiring an unheard of 90% of Teledyne's shares.  In part by issuing stock at an average P/E of 25, and buying it at an average of 8, Singleton managed to grow EPS by a world-beating 27% per year for 33 years.

Just as he had earlier retreated by repurchasing shares that had been previously issued, Singleton eventually decided to dismantle the conglomerate that he'd spent his life building.  He spun out several of Teledyne's largest operating companies, and sold what remained to another firm, but only at a full price.  What was it all for?  A 20.4% stock return over nearly three decades, or an 180-to-1 increase. 

John Malone, who has made his eye-popping fortune in the cable and media industries, allocates capital, and leaves operations to a trusted number two, as well as local managers.  For many years as he built his empire, Malone was the only significant cable company CEO to strive for cash flow growth, rather than increases in EPS.  In fact, the now widely used acronym EBITDA was coined by Malone.  (Admittedly, this is not a wholly desirable accomplishment).  Recognizing that scale is a powerful competitive advantage for cable operators, Malone bought smaller competitors at a heated pace, but managed to do so on attractive economic terms.  Not only did size lead to lower costs - and higher cash flows - per subscriber, Malone used it to strike unique deals in which he acquired stakes in up-and-comers such as BET and Discovery in return for access to his imposing subscriber base.  Thorndike argues convincingly that Malone used joint ventures more often and more effectively than any other CEO ever has, perhaps adding a sixth category to the Big Five types of capital allocation.  The scorecard: 30.3% per year from 1973 to 1998, over 900-to-1.

Inevitably, a book about capital-allocating CEOs will include a chapter on Warren Buffett and Charlie Munger.  While the chapter itself covers no new ground, it's an able summary of the twin Oracles of Omaha, and offers a nearly up-to-date performance record: 20.9% over 45 years, or a 6,265-to-1 return.  But Buffett and Munger cannot be bound and contained in a single chapter.  In fact, the book reads a little like an experimental, post-modern literary work, in which the mischievous author (Buffett) writes a book wherein its main character (Thorndike) writes a book about the author (Buffett).  After all, Thorndike, like most investors, almost certainly first heard of Tom Murphy and Dan Burke of Capital Cities and Henry Singleton from Buffett; Kay Graham would not have fared nearly as well as she did without the active, ongoing counsel of Buffett, long the Washington Post's largest shareholder; Buffett invested in General Dynamics well before it became a must-read case study; and most of the books Thorndike cites are about, or have been recommended by, Buffett and Munger. 

Though Buffett, Munger and Singleton are three of the finest, most original minds in the history of business and investing, better capital allocation is possible for most CEOs, regardless of their ability to play chess blindfolded or perform complex calculations in their head.  In fact, the book left this reader frustrated: a few of the case studies offer formulas that are so simple they border on boring.  How difficult can it be, after all, to close or sell poor businesses?  To be sure, not all businesses can be above average, but shareholders as a whole would be meaningfully richer even if CEOs were better at just one simple task: discriminating between paying a dividend and repurchasing cheap shares.  For even a moderately disciplined chief executive, buybacks are a far more attractive option over the long-term, since most stocks are undervalued in the market from time to time.  Thorndike is more optimistic than this reader about the potential uses of leverage: even the uber-talented John Malone nearly succumbed to bankruptcy - largely because of debt that he inherited, but not entirely - and few CEOs will be mistaken for Malone.  

Rather than merely reassembling and reinterpreting publically available material, Thorndike conducted nearly 100 interviews, talks that included many of the (surviving) subjects themselves, as well as people who worked directly with them, adding freshness to the book.  In addition to the stories noted above, he offers analysis of the Dick Smith at General Cinema, and Bill Stiritz at Ralston Purina, case studies unknown even in many business schools.  And for active investors, Thorndike addresses a few potential investments, including Transdigm, Sara Lee, Exxon Mobil and the collection of companies controlled by John Malone.  This fine book ought to be read by most investors; but it's an emphatic must read for all CEOs.

Source: Thorndike, Jr., William.  The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. Boston: Harvard Business Review Press, 2012.

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Book Review - Steve Jobs, by Walter Isaacson

Mere mortals dream of changing the world; Steve Jobs, however, hoped to "make a dent in the universe."  Partly because of an ambition that knew no earthly bounds, Jobs became one of the towering giants of the twentieth century and beyond - the focus of business case studies, tech newsletters, industry forums, and innumerable other venues.  It's telling that Walter Isaacson, the author of well-regarded biographies of Albert Einstein and Benjamin Franklin, considered Jobs a worthwhile subject.

By borrowing - or stealing - the concept of the graphical user interface from Xerox, then greatly improving on it, Jobs helped bring useful and intuitive computers to the masses.  Later the iPod changed how music is stored and consumed.  Apple sold an astounding 90 million iPhones - also known as "the Jesus phone" - over the first three and a half years of existence, collecting about half of all the profits for the global mobile phone industry.  The company later sold a mind-boggling 15 million iPads in the nine months after its release, among the most successful product launches in history.  Thanks to all these interwoven successes, Apple has recently become the most valuable company by market capitalization in history, and has had a social and cultural influence to match its financial glory.  

Not only did he play a central role in revolutionizing the computer industry, Jobs also upended a range of other businesses.  After he took command of Pixar, then fast approaching bankruptcy, it quickly became the gold standard in animation, creating hit after amazing hit, both critically and commercially.  Pixar was so spectacularly successful that even the vaunted Disney, long the standard bearer in animated movies, could no longer match the upstart studio, and bought it for the princely sum of $7.4 billion.  Moreover, Isaacson notes, the transaction had the feel of a reverse takeover, with the creative team at Pixar taking control of Disney's legendary animation studio.

More recently, he helped bring change to several sectors of the publishing industry.  The sheer reach of the iPhone and iPad together made the "app" business model viable.  Somewhat walled off from the worldwide web, applications have changed many business models in an online world, allowing magazine publishers, for example, to charge money for an exclusive readerly experience, and giving book publishers a further outlet for their literary wares.  In addition, Jobs  entered the old and difficult retail industry and achieved wild success.  By employing his famous eye for detail - only stone from a specific quarry near Florence, Italy is good enough for Apple stores, Jobs decreed - he created Apple stores, which broke a record for fastest march to $1 billion in sales, including Manhattan’s Fifth Avenue store, which grosses more than any other location in the world.

The Apple co-founder's unparalleled accomplishments came despite his many glaring defects.  Jobs, nearly everyone agrees, was petty, needlessly cruel, unreasonable, disloyal, unpredictable, and often flat-out weird.  Indeed, he often cried, and for long stretches of time, rarely bathed.  Name a character flaw, and Jobs probably suffered from it - and the people around him suffered because of it.  Yet even in the course of a foreshortened life, he achieved just what he set out to do.

How was he able to do it?  This riddle is of interest not only to entrepreneurs, business and civic leaders, but to investors, too.  Some of his success, as always, had to do with luck.  For example, it’s not an accident that many tech firms were founded in Silicon Valley in the postwar decades, and Isaacson does an able job evoking the milieu in which Jobs came of age.  And he had enviable personal qualities to go along with the less desirable ones, including charm, a dramatic showman's streak that helped with the public aspect of his job, and a "reality distortion field" that helped him realize the seemingly impossible, even as it led to many mistakes and miscalculations.  However, as Isaacson illustrates in generous detail, the answer lies largely in that Jobs embraced the same kind of multi-disciplinary mode of thinking that super investor Charlie Munger advocates.  

Much of Jobs' success derived from his natural curiosity and wide-ranging self-education.  Indeed, when he grew tired of a standard, "by-the-book" degree at Reed College, he dropped out, but remained on campus and audited classes that interested him.  These included calligraphy, which he later credited for the "multiple typefaces" and "proportionally spaced fonts" featured on the Mac.  The "Less is More" Bauhaus movement informed the design of Apple products Isaacson and a number of Jobs' friends believe that Jobs became the embodiment of the convergence of hippie counter-culture and high technology.  His many other influences included a lifelong interest in Eastern spirituality, including Zen Buddhism and meditation; organic gardening; listening to, studying and playing music; reading literature and contemplating and writing poetry.

Isaacson argues convincingly that Jobs was a "magician genius," whose world-changing flashes of insight came more from intuition than from a rational mode of thinking.  As a young man, Jobs embarked on a pilgrimage to India, where he learned to value intuition as much as abstract and rational thought.  Unlike most analytical executives, Jobs paid no attention to market research, preferring instead to intuit what customers want, often even before they knew they wanted it. 

Thanks to his broad influences, Jobs was able to wear many hats at Apple.  He knew enough about engineering and electronics to understand the hardware, and had a sufficient grasp of programming to stay abreast of the software.  Jobs had a rare and special talent for marketing and branding.  Indeed, he personally oversaw all significant aspects of Apple's marketing efforts, getting involved in the nuts-and-bolts of billboards, magazine spreads, televisions commercials, and all other communications, almost unheard of for a CEO.  And he was particularly good at aesthetics and design, devoting much of his time and energy to ensuring a beautiful and elegant physical structure for all of Apple's products.  

It's possible that Jobs reached too liberally for ideas.  He went on strange diets, and insisted, all olfactory evidence to the contrary, that eating only fruits and vegetables meant it wasn't necessary to wear deodorant or bathe.  He christened one version of Apple computers the "Lisa," after his daughter.  And it’s debatable whether the use of recreational drugs and Freudian analysis are helpful in business or otherwise.  Perhaps fatally, when he was diagnosed with cancer, Jobs embraced a variety of unorthodox ideas, including unproven remedies found on the internet and consulting a psychic, and refused to undergo standard treatments for nine long months.  However, his famed "reality distortion field" bears much responsibility, too.  And, in fairness, it's impossible to be sure that a more orthodox medical approach would have vanquished his cancer.

Still, the magic he made came at the intersection of technology and the liberal arts.  If Apple and Pixar stay true to this ethos, they may well endure for many years to come.  When it was time for Pixar to move into a new building, Jobs designed it personally, ensuring that the central atrium would encourage inter-disciplinary collaboration from members of different departments.  He died before he was able to implement it, but Jobs spent many hours in the last years of his life attempting to do the same for Apple future headquarters.  He once explained the Xerox episode by proudly quoting Picasso: "Good artists copy, great artists steal" (98).  By applying a range of ideas from different disciplines, whether borrowed, copied or stolen, Jobs did more than create a masterpiece, he made a dent in the universe.

Source: Isaacson, Walter.  Steve Jobs.  New York: Simon & Schuster, 2011.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Book Review - Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger, edited by Peter Kaufman

The printing press, the steam engine, the telephone, the automobile, the radio - everyone agrees that these were not ordinary inventions, but giant steps forward for mankind.  Charlie Munger is virtually alone in including the cash register in the same elevated category.  Munger offers these words to sum up the life's work of the leading purveyor of the modern cash register: "So great was the contribution of Patterson's cash register to civilization, and so effectively did he improve the cash register and spread its use, that in the end, he probably deserved the epitaph chosen for the Roman poet Horace: 'I did not completely die'" (453).

Why does Munger offer such overflowing praise for such a commonplace item?  The answer lies in the principles of psychology.  Many people will steal if it's easy to do, and if there's little chance of being caught.  Once they start, though, a number of psychological traits will kick in and make it nearly impossible to stop: operant conditioning (people will repeat what's worked in the past), incentive-caused bias (people often genuinely believe that what's best for them is also what's best for others) and social proof (people tend to ape what other people are doing) will combine in a "lollapalooza effect" and thievery will spiral out of control.  The cash register nips much of this in the bud, to society's great advantage. 

This is just one of the many original, profound and tantalizing observations that can be found in Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger, in Peter Kaufman's expanded third edition.  Munger is Berkshire Hathaway's long-serving Vice Chairman, and has been Warren Buffett's friend and business partner for many decades.  The book’s familiar-sounding title alludes to Poor Richard's Almanack, Ben Franklin’s famous autobiography.  Munger not only reveres Franklin, but has actively sought to emulate him.  Most would blush at the thought of modeling their lives on one of the great figures of the Enlightenment, but Munger's biography bears striking resemblances to Franklin’s. 

Munger, not just another brick in the wall, is a self-taught polymath, and can speak with authority on a staggering range of topics, just as Franklin did.  Both men became wildly rich through business in the first half of their lives, but devoted the latter half to philanthropy and other social and political causes.  And Munger is enough of a Renaissance man that he designed, built and paid for a large catamaran, just for fun, and he runs Good Samaritan Hospital in Los Angeles out of a sense of civil service.

Munger's most important contribution as a thinker is his multidisciplinary "latticework" of mental models that he uses to solve all kinds of complex problems.  He argues that this is a way of avoiding "man with a hammer syndrome," an allusion to the proverb, "To a man with a hammer, every problem looks like a nail."  He estimates that there are about one hundred powerful ideas, mostly drawn from 100-level university courses, that people should learn.  These ideas include ecosystems and synthesis from biology, backups and redundancy from engineering, probability and compound interest from mathematics, tipping points from physics and chemistry, tradeoffs and opportunity costs from economics, biases and heuristics from psychology, and so on.

Once a person's gained an understanding of the models, it becomes easy to draw parallels and analogies between them.  To cite a few of Munger’s favorite examples: interpreting an economy as a biological ecosystem, where occupying a specialized niche can offer great advantages; how the concept of "social proof" from psychology, the tendency to “ape” other people, can enhance economies of scale in business; economics borrowing from biology the "Tragedy of the commons" concept, which is a malevolent "invisible foot" to Adam Smith's benevolent "invisible hand"; and law schools applying game theory from economics to understand how competition works.  If economists made more efforts to synthesize a range of ideas, Munger contends, they wouldn't be so stumped about Japan's prolonged period of economic stagnation.  For his part, he believes that cultural characteristics and social psychology offer part of the explanation.

Munger is well aware, however, that it's possible to take even a great idea too far, and warns against borrowing indiscriminately, which has led to literature departments importing bad ideas from Freud, and business schools adopting a rigid adherence to "efficient market" hypothesis.  Devoted believers in efficient market theory arrived at a false conclusion by wanting to make economics more robust, like math or physics, than it actually is.  Markets are mostly efficient, most of the time, but the difference between mostly efficient and always efficient is vast.

Munger supplements the "Big Ideas" with a few critical rules.  For example, he often quotes Jacobi, the Prussian Mathematician, who insisted, "Invert, always invert."  In other words, some problems are best - or only - solved backwards, and some of his wisest advice is what not to do.  Accordingly, Munger once delivered a commencement speech that offered advice on what to do to achieve a miserable life, including being resentful of others, being unreliable, and refusing to learn from other people's mistakes.  Munger argues that Charles Darwin, one of the most important thinkers of all time, was merely above average in intelligence, but by avoiding bad habits and destructive behaviors, was able to make an enduring contribution to humanity.

Using a few of the powerful concepts from his multi-disciplinary approach, Munger offers a thought experiment in his fourth talk that essentially reverse-engineers Coca-Cola's astounding long-term success, explaining it using ideas such as Pavlovian conditioning and association, the biological facts of human nature resulting from evolution, using mathematical inversion to identify what not to do and avoid pitfalls.  These (and other) ideas underpin and complement more familiar concepts such as Coke's powerful brand and far-reaching distribution system.  The talk is difficult and bound to be misunderstood by many, but well worth reading anyway.

Munger can apply a striking array of ideas and concepts, but he is particularly insightful in the field of psychology.  Behavioral economics and neuroeconomics are deservedly flourishing fields, but Munger was using - and preaching about - the very same ideas long before almost anybody else was.  Munger argues that the psychological quirks are so important that wise people should write them out so they work through them checklist-style to solve difficult problems.  Pay particular note, Munger urges, to cases where several different psychological forces are working in the same direction. 

For Munger, mastering the theories that underpin psychology was no idle pursuit: he did it to "acquire capital and independence faster and better assist everything I loved" (444).  In the book's astonishing eleventh talk, Munger lists and explains 25 psychological tendencies that are generally useful, but often have unwanted side-effects that distort decision-making.  Munger goes beyond just citing psychology's best ideas; he also breaks new ground.  For example, he has long warned of what he calls "incentive-caused bias," which some belated economists are now dubbing "self-serving bias."  Munger had them beat by decades. 

On top of the psychological ideas that are all his own, Munger offers novel perspectives on others; he insists that anecdotally obvious forces such as envy and jealousy be included in the canon of psychological ideas; and he puts much greater emphasis on some of the widely-known ones than most people do, such as the overwhelming power of denial.  Munger's conclusions are deeply insightful, in part because they are often rooted in biology, a field that all of the social sciences have much to gain from.

Munger is refreshingly difficult to predict or pin down.  He proudly identifies himself as a Republican, and shares with his GOP party-mates a deep skepticism of Democrats; he has distaste for "pot-smoking journalism students"; and he's distinctly unsympathetic towards the less fortunate.  On the other hand, Munger is a staunch advocate for a woman's right to choose, having provided legal, monetary and diplomatic support to the cause; he believes that his taxes are too low; and he regards a "Drill, baby, drill" approach to oil and gas development as folly, not from a fear of global warming, but due to the value, scarcity and lack of close substitutes for those hydrocarbons.

Munger and his ideas are not to everyone's taste.  People who know him report that he is judgmental, self-righteous and arrogant.  Indeed, in one speech, he laments that a recurring problem he's faced because of his unusually high intelligence is the risk of offending bosses and experts who know less than he does about their own area of specialization.  Moreover, he has a staunch Aristocratic mindset, viewing the most eminent members of society - an exulted group that he certainly includes himself in - as superior and deserving of outsized wealth and influence, though not without duties. 

But being a snob can be a helpful trait in an investor, and it comes as no great surprise that Munger's major effect on Buffett was to move him away from investing in mediocre businesses selling at a cheap price, toward excellent businesses, even if they're selling at only a decent price.  And it was partly Munger's hard-to-please mentality that led him to prophesize disaster years before the crash of 2008-09: "I'd be amazed if we don't have some kind of significant [derivatives-related] blowup in the next five to ten years" (127).  He was among only a handful of major figures to say so, but few investors and fewer policy-makers listened, sadly.

Given Munger's dazzling intelligence and rich body of experience, it's easy to overlook Peter Kaufman's superb accomplishment as an editor.  Simply collecting Munger's thoughts, speeches, writings and other output would've been well worth the effort.  But this beautiful, coffee table-sized book has everything: a biography of Munger; a rich trove of photos and illustrations, as well as articles by and about him; brief commentaries from Munger's children, friends, colleagues, and fellow investors, including Buffett, Whitney Tilson and Bill Gross; and an array of book recommendations from Munger's long life as a devoted reader.  Kaufman also offers insightful commentary, and articulates Munger's musings in a comprehensible way.  Anybody searching for wisdom has much to gain from reading and rereading this book; but for investors this very fine work is an absolute must.

Here is a multi-disciplnary reading of Steve Jobs' life and work.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Book Review - Warren Buffett and the Art of Stock Arbitrage, by Mary Buffett and David Clark

Warren Buffett is widely known for investing in high-quality businesses with a sustainable competitive advantage, a high return on capital, run by able and honest managers, and selling at a bargain price.  When he's able to find such gems, he likes to hold them long-term, ideally "forever."  His success in arbitrage and special situations investments, however, is not widely understood.  In fact, these investments are in some ways the very opposite of his usual focus, as they offer only a one-time, short-term opportunity.  A study of Buffett's investments from 1980 to 2003 found that the average investment returned 39% per year, but the average arbitrage deal returned an incredible 81%.  Without such investments, his overall performance would have fallen significantly, from 39% to 27%.  In Warren Buffett and the Art of Stock Arbitrage, Mary Buffett and David Clark set out Buffett's criteria for making such investments.

Buffett has focused on three forms of arbitrage - friendly mergers, hostile takeovers, and corporations making tender offers for their own shares - and four kinds of special situations - spinoffs, liquidations, stubs and reorganizations.  Arbitrage is a broad term that refers to an opportunity to capture a spread between two prices, such as gold selling at a higher price in one market than another, even when accounting for currency differences.  But Buffett pursues stock arbitrage, where the price being offered for a security is higher than the price currently prevailing in the market.  If Company A, for example, offers to buy Company B for $100 per share, B's stock may settle around $95.  The $5 spread, which exists because there is always some uncertainty - financing, regulatory, legal etc. - about whether the deal will successfully close, offers arbitrageurs the chance to profit.

Buffett considers arbitrage deals once they've officially been announced, and acts only if he feels there's a high probability that the transaction will be completed.  His analysis boils down to a few variables.  On the upside, he calculates the likelihood the deal will be completed, the percentage return, and the approximate amount of time to completion.  On the downside, having already estimated the likelihood that the deal goes through as planned, the major factor left to figure out is how far the stock will fall if the deal fails.

Returning to the above example, the upside for arbitrageurs in Company B is 5.3% (5/95).  Assuming the deal is certain to close in six months, the annualized (non-compounding) return would be 10.6%.  Since most other investments are quoted in annual returns - on bonds, in the stock market etc. - this return could be compared to other potential investment opportunities, as well as alternative arbitrage deals.  (The calculation becomes somewhat more complex when adjusting for the probability of the deal closing as planned, as set out in the book's fifth chapter).  The basic concept holds for stock-for-stock deals, cash offers, and hybrids.

The math's laughably easy, but estimating the probability that a deal will close can be tricky.  Any deal faces several possible hurdles: legal impediments could nix a proposal, financing could fall through, shareholders could reject the deal, and so on.  Friendly mergers are most likely to close, since shareholders tend to vote in favor of proposals that are endorsed by management and the board.  Of those, Buffett prefers self-financing, strategic buyers that are pursuing a company to complement their existing business - think Procter and Gamble's purchase of Gillette - rather than hedge funds or LBO firms that rely heavily on financing which might dry up unexpectedly in tough markets.  Buffett is wary of deals that might attract serious scrutiny from regulators or anti-trust commissions: not only do prolonged investigations erode the time value of money, they occasionally scuttle a deal altogether.  While not all stars must be perfectly aligned - Buffett has even played hostile takeovers in the past, though rarely - these are the basic parameters that he looks for.

Buffett has also found opportunity in companies changing form, usually from corporations to royalty trusts or master limited partnerships (MLP).  Surprisingly, the market often doesn't immediately recognize the shift with an increased stock price until after the change has been made, even though the transformations are usually almost certain to be implemented.  The authors helpfully offer an example of Buffett's investment in each situation - Tenneco, a natural gas producer, which converted to a trust, and Service Master, a collection of different businesses that became an MLP - and his approximate return.

Additionally, Buffett has invested in spin-offs, where a company that owns multiple businesses breaks into two or more stand-alone firms that figure to be worth more separate than together.  Buffett's interest in spin-offs lies in the chance to acquire excellent businesses that have previously been unavailable to invest in directly.  Buffett takes his position in the parent company before the spin-off occurs, then sells the parent and holds the new stand-alone firm.  This is just what he did, for example, when Dun & Bradstreet spun off Moody's in the late 1990s.  This chapter is thin on analysis, and leaves important questions unanswered: for example, why doesn't Buffett wait until after the spin-off has concluded to purchase the preferred company, as Joel Greenblatt has done with great success? 

Given that Buffett is the greatest investor in history, any serious book about his methods is worthwhile.  However, nagging questions sometimes remain about just how accurate Buffett commentators are.  For example, on the all-important matter of how he values a business (not a concern in this particular book, granted) Buffett and Clark offer one explanation (found in Buffettology), Robert Hagstrom another (basically a standard discounted cash flow model) and Alice Schroeder still another (according to her, he requires a 15% return, and makes a "yes-or-no" decision accordingly).  All are leading authors on Buffett, yet offer differing accounts on a basic and important aspect of his approach, leaving students of investing puzzled. 

Despite the authors' past work on Buffett and their personal ties to him - Mary Buffett was married to Buffett's younger son, David Clark has been a long-time Berkshire Hathaway shareholder and student of Buffett, and they refer to him in the book familiarly as "Warren" - this book prompts a few similar doubts in places.  There's little sign that Buffett participated in this book's creation, made factual corrections or personally endorsed it.  There are other clues that the authors reach conclusions based on deduction, rather than first-hand conversations with Buffett.  For example, when discussing his 1998 investment in a liquidating REIT, they state, "Warren would have had five thoughts..." (104). There’s ample reason to suspect that their after-the-fact re-creations are largely right, but Buffett's thinking may have been different from what the authors imagine.  It would have been helpful if they'd been more forthcoming about the evidence they used to arrive at their conclusions, ideally in the form of footnotes.  Though there are no obvious errors, parts of the book seem slightly vague.

Still, Mary Buffett and David Clark have written yet another first-rate book on Buffett, and have illuminated one of the few remaining areas of Buffett's career that hasn't been widely studied.  In just over 140 short pages, they cover a range of non-standard investments that Buffett has made, while offering enough detail for investors to begin pursuing similar opportunities.  Though picky readers may have some small doubts about Buffett's precise methods, the authors discuss each topic clearly and knowledgably.  Besides, Clark runs a partnership that pursues special situation investments, so he brings insight of his own to any areas where Buffett's approach may not be entirely clear.  To complement the theory that fills most of the book's pages, they offer practical advice about how to search for ideas, what relevant filings to study, and how events such as tender offers play out in reality.  Overall, Arbitrage lives up to the high standards that Buffett and Clark have set for themselves in their past work.

Source:

Buffett, Mary and Clark, David. Warren Buffett and the Art of Stock Arbitrage: Proven Strategies for Arbitrage and Other Special Investment Situations.  New York: Scribner, 2010.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Book Review - A Short History of Financial Euphoria, by John Kenneth Galbraith

In the 1993 revised edition of A Short History of Financial Euphoria, John Kenneth Galbraith, one of the twentieth century's leading economists, concedes, "Recurrent speculative insanity and the associated financial deprivation and larger devastation are, I am persuaded, inherent in the system" (viii).  Fresh in his memory are Michael Milken, the "speculative orgy" (ix) in real estate in the 1980s accompanied by the S & L crisis, and the Salomon Brothers disaster.

These were only the most recent examples in an age-old pattern that has involved not just real estate, banks and junk bonds, but securities of all kinds, bank notes, art, tulip bulbs, joint-stock companies, and so on.  However similar to past instances - including the "Tulipomania" in the 1630s, the South Sea bubble in the 18th century, and the "roaring" 1920s - these episodes "always evoke surprise, wonder and enthusiasm anew" (11).

Galbraith doesn't just offer a laundry list of manic episodes, but identifies the characteristics they all have in common.  Though he knows that few will heed his warnings, Galbraith hopes to spare at least some people from the devastating consequences of financial manias and the ensuing crash, which in the past has taken the form of disgrace, impoverishment, exile, suicide, and imprisonment.

Psychology

Psychology is a powerful element of speculative manias.  People benefiting from an inflating bubble chafe at any criticism.  Partly this is financial, but people also prefer to believe that they are getting rich due to their own superior talent or intelligence.  Others will reinforce such views in a capitalist economy, where wealth is often considered synonymous with brains and ability, not a result of dumb luck.  Money plus ego is a powerful combination.  Lucky naysayers will be merely ignored or dismissed; unlucky ones will be attacked, accused of envy, stupidity, or worse.

Novelty

People often believe that there is "something new in the world" (18), some exception to the usual rules that will allow prices to continue rising quickly indefinitely.  The tulip bulb mania in the 1630s was particularly bewildering, since it was nothing but a flower that had long been grown in the Mediterranean.  However, they were new to Europe in the early 1600s, and people were more attracted to the blooms the rarer and stranger they were. 

Leverage

Very often leverage is a cause and aggravating factor in a mania.  In the South Sea Bubble, for example, the company of the same name incurred large leverage owed by the British government in exchange for a monopoly on trade in certain areas.  In the years preceding the Great Depression, investors were able to borrow at a 10-to-1 ratio on margin, though only at a very high interest rate.  Debt played a large part in corporate takeovers and leveraged buyouts in the 1980s.

Innovation

Frequently, financial "innovation" contributes to bubble, often involving "the creation of debt secured in greater or lesser adequacy by real assets" (19).  The joint-stock company had in fact been around for centuries by the time the South Sea company was formed, but memories are short and fuzzy in the financial industry, and investors believed that a creative new instrument would lead them to enormous wealth.  The "discovery" of junk bonds, high risk bonds accompanied by a high-yield, led to a bubble in that area the 1980s.

Government as Backstop

The state often ends up as the "recourse of last resort" (34) in the aftermath of mania turned to panic.  Insuring deposits, limiting bank leverage, creating regulatory regimes, enacting Keynesian economic stimulus, placing curbs on the use of margin, bailing out failed businesses - most or all of these forms of government intervention were in response to financial manias.

It's striking and heartbreaking how right Galbraith was, not only in his analysis, but in his knowledge that few will heed his warning, and certainly not enough to preempt future bubbles.  The ink was hardly dry in his book before the Dot Com bubble of the late-1990s began to inflate, because the revolutionary arrival of the internet made standard economic rules look old and analog (novelty); derivatives worth hundreds of trillions of dollars, more than all the assets in the world, built up before the 2008 crash (leverage); collecting and repackaging mortgages and selling them as securities relieved banks of the pesky burden of assessing borrowers (innovation).  The peculiar psychology that always helps to cause and reinforce bubble was present in these recent cases, just as it was in innumerable past instances.  Governments and central banks, as ever, were forced to avert worldwide disaster by massive intervention of all kinds.

Galbraith’s target audience is the odd stray investor, banker, or real estate developer that may be ambivalent in the face of a developing mania; he’s too realistic to believe that one book alone can wrestle with such powerful forces all working in the same direction.  By reading this short, useful book, you, dear reader, may yet avoid the next bubble and its inevitable aftermath.

Source: Galbraith, John Kenneth. A Short History of Financial Euphoria. New York: Viking Penguin, 1993.

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Book Review - The Dhandho Investor, by Mohnish Pabrai

"What does "dhandho" mean?"  That's likely the first question book browsers ask when their eye catches the spine of Mohnish Pabrai's The Dhandho Investor.  The ethnic group that the word belongs to defines it as a low risk, high return investment, which contradicts the conventional wisdom that outsized returns can only be had at the cost of high risk. As Pabrai likes to say, "Heads, I win; tails I don't lose much."

Many investors have helped affirm Pabrai's motto: the Patels, a people from India that account for just 1 in 500 Americans, but own half of all US motels; Richard Branson, who started serving an ignored niche in the airline industry, while risking little capital by leasing an unused plane; Lakshmi Mittal, who restored dying steel mills to profitability, but paid very little for them; or Warren Buffett, who amassed jaw-dropping returns, while taking on very little risk.  The "high-risk-high-reward" concept has been proven wrong. 

Pabrai is heavily influenced by Buffett and Charlie Munger.  As they do, he encourages investors to buy simple, predictable businesses.  Moreover, worthwhile businesses have a competitive advantage and resulting high returns on capital.  These gems, however, must be bought on the cheap.  Strangely enough, temporary market inefficiencies will give patient investors opportunities to buy gold for the price of brass.  But golden opportunities are rare enough that when they do arise, investors must bet heavily. 

Though Pabrai doesn't break much new ground in this book, he puts more emphasis on certain points than many other investors do.  For example, he broadens the term "arbitrage" from a narrow fixation on price differences, and uses it as a metaphor for investing in general.  What's a competitive advantage, after all, if not a form of arbitrage?  If one company is able to offer lower costs than competitors, it will draw in more customers; over time, though, high-cost producers will perish, and remaining ones will become leaner, narrowing the gap between the market leader and the also-rans.  Fortunately for investors, though, many "moats" last for decades.  Pabrai analyzes GEICO, owned by Buffett's Berkshire Hathaway, which has enjoyed a low-cost "arbitrage" spread for decades, and is likely to do so for decades to come.

One of the high points of the book is Pabrai's discussion of the difference between risk and uncertainty, a crucial distinction that many investors fail to make.  Risk is the potential for capital loss, while uncertainty is a wide range of possible outcomes.  Confusing uncertainty for risk frequently leads to underpriced securities - investors wise to the difference stand to make a lot of money. 

Along with case studies of Level 3 and Frontline, he candidly discusses his investment in Stewart Enterprises, a company that "rolled up" hundreds of locally-owned, mom-and-pop funeral homes, but amassed too much debt in the process.  Worried about the potential of default, the market pummeled the stock.  Pabrai wasn't fazed.  He calmly assessed the company's major alternatives: reselling some locations to their original owners, refinancing, or restructuring via bankruptcy were the most likely options.  Then he assigned a probability to each, and estimated the share price that would result from each option.  He decided that the bankruptcy would leave enough of the business intact to break even, and the other two options would give him a large profit.  Uncertainty was high, but the risk of loss was low.

Pabrai doesn't just vaguely advise investors to bet heavily when the odds are in their favor, he points them specifically to the Kelly Formula as a guideline for how much to wager given certain odds.  Much of the value of the Kelly Formula is that it encourages investors to consider a range of possible outcomes and attach probabilities.  It carries risks, though: it suggests precision, where only approximations can be made, and it suffers from the same "Garbage-in-garbage-out" weakness that many formulas do.  Pabrai recognizes the drawbacks to the Kelly Formula, and he devotes 10% of assets to each investment. (The book was published in 2007.  Pabrai got walloped in the Great Recession, as nearly all investors did, and now runs a somewhat more diversified portfolio).

Most investors agree that selling is an imprecise art.  With the help of the epic poem the Mahabharata, Pabrai offers some wise advice.  First, allow at least two to three years for the story to play out, unless it has become undeniably clear that the investment was a mistake.  Stocks often decline after investors buy them, even when the business is succeeding.  Jittery investors frequently panic and sell, only to watch the stock appreciate later.  In more serious cases, the business itself may stumble.  But all businesses face challenges, and investors must be patient and wait for improvement.  Pabrai did just that with USAP, a specialty steel maker: his investment fell by nearly two-thirds before roaring back and doubling from his initial purchase price.

Many investors offer a recipe for success that's long on theory, but scant on practical advice for finding undervalued stocks.  Pabrai, however, offers helpful suggestions about how to hunt for value: scan Value Line for battered stocks, consult www.portfolioreports.com and www.gurufocus.com for the holdings of prominent value investors, visit Joel Greenblatt's www.valueinvestors.com, www.magicformulainvesting.com and read his book The Little Book that Beats the Market.  Don't be afraid to clone or copycat, Pabrai urges.

Pabrai is an excellent investor.  From 1999 to 2007, he returned 28% a year, though that number has fallen since the Great Recession.  The Dhandho Investor is a success.  He wisely sticks closely to Buffett and Munger, but has the judgment to borrow from others, too.  His book, however, isn't just an collection of other people's ideas, despite his cheerful admission to copying others.  He cites several examples that don't typically make it into case studies, but also draws on more familiar ones.  He reinterprets basic ideas and gives them much more explanatory power.  Short, clear, fun and wise - this book is a must read for any serious investor.

Sources:

(1) Pabrai, Mohnish. The Dhandho Investor. Hoboken: John Wiley and Sons, 2007.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.