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This was a fantastic book that I read in one sitting. Seessel is a fund manager who does frequent appearances in the media, yet I had never heard of him until a friend asked me yesterday if I had read his book. Seessel tells us of his pilgrimage from hard core value investor (disciple of Graham & Dodd, Buffett & Munger), to a state of enlightenment and harmony in a world where only high-multiple, durable growth stocks make any sense for the long term. To me its clear that Seessel still struggles with valuation, or he wouldn’t bother with writing this book, nor the mental accounting contortions he describes in Part II, my least favorite part of the book.  I agree with Bill Ackman, who commented that this was one of the best investment books he has read in a while, but the reason I liked it so much is that Seessel does a fine job of pitching three of our favorite holdings: Alphabet, Intuit, and Heico.

Here is a 4 minute interview on CNBC where Adam Seessel is introduced as “the founder of Gravity Capital Management, advisers on roughly $8 billion.” I was unable to pull up Gravity Capital’s portfolio on the Bloomberg, which suggests they aren’t really that big by SEC standards.  I searched through SEC.gov and saw that in fact, they filed as an “exempt reporting advisor” in March 2022, with regulatory assets of $25-100m – but its common in this business for people to count assets that the SEC doesn’t, so nothing against Seessel.  With a quick Google search, I discovered that “Gravity Capital Management manages money in both a partnership and a separate-account format.  It has a long-term record of beating the market after fees, with special focus on capital preservation. In 2008, for example, the Gravity Long-Biased Fund lost only 5.5% of capital and returned 27% in 2009.” (link).  I also learned that Seessel and his wife, an artist, live in Manhattan, and that they have a grown son who is a software engineer. Adam graduated summa cum laude from Dartmouth College in 1985, with a BA in Religion.  Google also revealed that he runs Clear Mind at Work Program for the Kadampa Meditation Center of New York (link), which is a charitable entity with ties to the International Kadampa Buddhist Union – a global religious movement founded by Kelsang Gyatso in England in 1991 (Wikipedia). He mentions meditation once in his book (next to parenting), but doesn’t elaborate.

I loved the book and would recommend it as a top 10 on investing, but that doesn’t mean I wasn’t disappointed by a detail or two. Seessel never even mentions Phil Fisher, for example, yet he devotes a lot of attention to Ben Graham. Buffett even gives Fisher credit for helping him see the light on growth, but Seessel doesn’t acknowledge it.  But then, as if trying to win sympathy with the “value” school, Seessel goes and throws Jesse Livermore, the boy plunger, under the bus. “In 1940, rather than face another personal financial crisis, Livermore took a Colt pistol and shot himself in the head,” he reminds us before he utters: “Don’t be this guy.” I didn’t like that line. Jesse Livermore was a genius who was said to suffer from clinical depression, so the fact that he shot himself at 63 doesn’t mean he was a bad investor with the wrong ideas. In fact, he was known to put much weight on the quality of the people and the durability of the narratives that he invested in.  While he was famous for his trading, he recognized, like Seessel, that the big money was not made by trading, but by sitting.  Edwin Lefevre told Livermore’s story in Reminiscences of a Stock Operator (1923), and Livermore published his own book, How to Trade in Stocks (1940), seventeen years later. It remains to be seen is Seessel’s book will age as well as those two classics.

Adam Seessel and I have some friends in common so I need to take my jabs carefully.  But it would be impossible for me to read a book like his without finding some flaws.  When describing Intuit, for instance, Seessel portrays Turbotax as being “largely mature” – which is a dated view, in my opinion.  After Intuit acquired Credit Karma in Dec 2020, which Seessel doesn’t mention, they pivoted the Consumer Group (which houses TurboTax), towards a much larger total addressable market (TAM) than just tax filers. Seessell also fails to mention the acquisition of MailChimp in 2021, which significantly expanded Quickbooks’ growth opportunities. While about a third of QBO subscribers are global, international subscribers account for less than 10% of QBO revenues.  Seessel doesn’t mention this, probably because he wanted to keep it simple.  But then he suggests that Intuit overstates their TAM, which I don’t agree with.  Seessel also claims in Chapter 9 that Intuit “invented and brought to market TurboTax,” which I know isn’t true.  Turbotax was developed by Michael Chipman, founder of Chipsoft, not by Intuit.  Intuit agreed to acquire Chipsoft in September 1993, the same year it had come public. As the 1993 press release announcing the deal explained (link), Chipsoft shareholders ended up holding 39% of the merged company. I also believed TurboTax was “largely mature” when we started buying Intuit in our accounts in Q2-2017, but today we disagree with that view.  The opportunity to go up-market is enormous, and indeed, management expects half of the Consumer Group growth will come from upselling their premium offerings, including TurboTax Live and TurboTax Full Service (link).

Below I share some of my highlights from the book, but only up to Chapter 4, which is as much as the publisher allowed me to export from the Kindle. That Adam Seessel and I don’t agree on everything, is what makes a market.  I do think, though, that his book is a masterpiece.  And hats off to Professor Chris Begg of Columbia Business School, for giving Seessel the idea of framing the evolution of value investing as a series of software releases. That’s an interesting way to think about it, but beware the Value 3.0 release, since in the era of cloud computing, such launches can become obsolete quickly.

Best,
Adriano

HIGHLIGHTED EXCERPTS

Introduction: So Big, So Fast

Apple’s wonderful ascent, however, obscures the fact that four times over the last fifteen years, Apple’s stock lost 30% of its market value. Once every three to four years, Alex saw his life savings decline by almost a third. As anyone who has ever invested in the stock market can tell you, that does not feel good. But Alex didn’t lose his head, or his lunch, or his conviction in the logic for owning Apple, and he has become wealthy simply by identifying a single, superior business and sticking with it. A $10,000 investment in Apple when the iPhone came out is today worth nearly $500,000, about fifteen times what he would have made if he’d invested in the S&P 500 index.

Contrary to what many people believe, the market is neither a hall of mirrors nor the Emerald City, where the Wizard of Oz hides behind the curtain pulling the strings. The stock market is nothing more than a collection of American companies whose profits grow over time. As their profits grow, so does their market value. If you believe that the United States will continue to grow and prosper, you should own a piece of that action.

Because 5% annual appreciation is decent, putting $10,000 to work in the American real estate market over fifty years will net you slightly more than $100,000. But investing that same amount at the average stock market return will generate more than $700,000.

Even if you’re, say, forty years old, I believe you shouldn’t have much at all in bonds, which barely pay more than a three-year CD. Some so-called 2045 target date funds have as much as 15% bond exposure in them, which is 15% too much for me. With more than twenty years ahead of you to smooth out returns, you should be letting the growth of American business work for you.

Like Alex with his Apple, I want to find businesses that are going to do better than the market’s average of roughly 9% annual growth. In this book, I am going to suggest that you do the same, and I’m going to give you techniques to do so.

The magic of compounding will see to that: $10,000 invested at the market average of 9% will give you more than $700,000 after fifty years, but that same amount invested at a 12% rate will give you almost $3 million.

Lynch’s words remain as true as ever, but the problem is that over the last generation technological change has altered the economy so much that the nature and character of what constitutes a superior business has also dramatically changed. The internet, the cell phone, and social media didn’t exist when Lynch wrote. Many of the everyday examples that he used to illustrate superior businesses—Toys “R” Us, Subaru, and Hanes, the maker of L’eggs pantyhose—are now laughably out of date. That’s no knock on Peter Lynch—the world changes—but we must acknowledge that the same common sense that led him to those stocks now tells us to go nowhere near them. The internal-combustion automobile today faces threats from both driverless and electric cars; most women stopped wearing pantyhose a long time ago; and as for Toys “R” Us, squeezed between the giant pincers of Walmart and e-commerce, it filed for bankruptcy protection in 2017.

Tech dominates our daily lives so thoroughly that it’s natural to think the digital revolution is largely complete, but that’s not true. In many ways, it’s just beginning. Even after a generation of growth, Amazon’s annual retail sales volume only now matches Walmart’s. Cloud computing, which today accounts for roughly 10% to 15% of all spending on information technology, will one day likely account for more than two-thirds. Intuit, the world’s leading provider of small-business accounting software, reaches only 1% to 2% of its ultimate addressable market. The list goes on, and as computing power compounds, the list gets longer every year.

Tech’s dramatic rise has been accompanied by an astonishing fall in the old economy’s market value. Over the last decade, the fossil fuel sector has shrunk from 13% of the U.S. stock market’s value to less than 3%. During the same period, the financial services industry has shrunk from 15% of the market to 10%. As recently as 2015, Exxon Mobil and Wells Fargo, two reliable blue-chip investments for generations, were each two to three times more valuable than Amazon. Today, as the chart below shows, Amazon is four times more valuable than Exxon Mobil and Wells Fargo combined.

Big tech gets most of the headlines, but hundreds of smaller, lesser-known tech companies have also continued to appreciate. Adobe in document productivity and digital marketing; Ansys in design-simulation software; and Autodesk in digital construction tools are only a few examples, and I’ve not yet exhausted the list of companies beginning with the letter A. Most people know Adobe because of its PDF functionality; fewer know that in 2020 Adobe earned roughly $3.5 billion, about the same as Kraft Heinz, whose brands like Oscar Mayer hot dogs and Philadelphia cream cheese have been around since the 1800s.

Pessimists are wrong, however, to suggest that we’re in for another bust. Today’s tech companies have put down powerful and profitable roots in ways that the first wave of dot-com companies never did. Two decades ago, businesses such as Pets.com IPO’d at multi-hundred-million-dollar valuations on the dubious proposition that they were somehow valuable because they attracted lots of “eyeballs.” At its peak, however, Pets.com never turned a profit and never generated more than $50 million a year in sales despite spending more than twice that in marketing. Today’s online companies don’t look anything like Pets.com. Adobe’s annual revenues are nearly $16 billion, from which it makes $5 billion in profit. Facebook has 3.5 billion users, and its annual earnings approach $40 billion, which is roughly four times what Disney makes.

Some also believe that, given all the concern over big tech’s sudden influence over our lives, government intervention will soon check tech’s power and, with it, its ability to generate wealth for shareholders. Governments may well move to curb the influence of the digital giants. They may even succeed in breaking them up altogether—but it’s impossible for regulation or legislation to undo a generation of daily, habit-forming usage of the world’s largest tech applications. How is any government going to regulate away the fact that, every day, people around the world search on Google 5.5 billion times? Are politicians going to outlaw Facebook from serving its billions of regular monthly users? These companies’ applications are woven into the fabric of daily life around the world, and every year the weave gets tighter and stronger. As such, companies like Google and Facebook can rightly be regarded as the Coca-Cola and the General Motors of our generation.

When technologists introduced the field-effect transistor, a basic semiconductor that’s become the most manufactured artifact in human history, it could hold only a single chip and it cost more than $1. Today, each field-effect transistor contains millions of chips and costs $0.000000001, or one billionth of a dollar. This price/performance explosion became known as Moore’s law, and it’s been in force now for more than sixty years. Engineers have been predicting the death of Moore’s law for at least a decade, but so far it hasn’t happened.

At the turn of the millennium, only 1% of the world’s population had a broadband internet connection, as the venture capitalist Marc Andreessen pointed out in a seminal essay a decade ago. Cell phones were so expensive then that only 15% of the world’s population owned one. Such facts help explain why the dot-com boom busted: the technological backbone wasn’t strong enough yet to support it.I

Today, more than half the world’s population has both broadband access and a powerful smartphone. As a result, much of the world searches, shops, chats, banks, and performs many other everyday activities online.

Before Google Search, you had to go to the library or invest in a set of encyclopedias, which were bulky, went quickly out of date, and were hardly interactive. Before digital maps, you needed paper maps, which often ripped, never folded properly, and didn’t give you alternate routes or reports on traffic accidents along the way.

A recent MIT study led by Erik Brynjolfsson quantified how much consumers value their everyday tech applications. He and his team asked consumers how much money it would take to get them to forsake their accounts at Facebook, Google, and others. On average, the study found, it would take $550 in annual payments to make a Facebook user quit Facebook. The number was much higher, nearly ten times so, for WhatsApp. Almost unbelievably, the study found that to go without Google, the average user would require a $17,500 annual payment. That’s almost one-third the average American citizen’s income.

Intuit, the small-business software provider, has profit margins twice that of Campbell’s, the soup maker, even though Intuit spends roughly four times as much in marketing, sales, and research and development. How can that be? Campbell’s raw materials are tomatoes and chicken and noodles, which cost a lot; Intuit’s raw materials are nonphysical and therefore cost almost nothing. Moreover, software-based enterprises like Intuit have no major capital or manufacturing needs. When Campbell’s wants to make more soup, it must build a new production line or a new plant. Even Coca-Cola, which sells sugar water, must have its subsidiaries build a bottling plant and invest in trucks and vending machines to expand. Software companies don’t require factories or production lines; they require laptops manned by intelligent engineers. When a software company wants to enter a new geographic market, its engineers write new code, hit “deploy,” and their software is available around the globe, instantaneously and with almost no incremental costs. Even a software company’s major capital requirement, giant servers that process and store data, can now be rented rather than bought. That’s the essence of cloud computing. Higher profitability + lower asset intensity = the highest return on capital businesses ever seen. When Ford wants to grow its business, it must invest $10 in assets to generate $1 in profit. Coke requires roughly $6. Facebook, only $2.

Stock market speculators have always been with us, but they now can place their bets wherever they have cell reception. Recently, they banded together on social media and used new trading platforms to cripple professional short sellers. Given such turbulence and confusion, an inexperienced investor might reasonably ask: Why should we invest in the stock market at all? The answer is not complicated. We invest our money because, while it would be nice to spend all of it today, we know that we’ll require some down the road. We will need money to put our kids through college, to help our parents get long-term care, and to make sure we ourselves can live comfortably during retirement. We forgo the pleasure of spending $1 in the present to transform that $1 into $5 and then $10 to use at some time in the future. And as I laid out earlier, for the last one hundred years the U.S. stock market has been the best place to do that.

Peter Lynch told us to “invest in what you know,” and this is generally good advice. Like hunters, investors do best when they understand the terrain. Many older investors, however, today find themselves in an unfamiliar landscape. What do companies with nonsensical names such as Chegg, Splunk, and Pinduoduo do, anyway?

Younger and less experienced investors have the opposite problem. They grew up in the digital ecosystem, and they know the territory in that intuitive, born-with-it way that positions them to hunt and track today’s investment opportunities. On the other hand, many younger investors mistrust the markets and “the system” in general. They have legitimate reasons. Young investors have already endured three major market meltdowns—the dot-com bust in 2000–2001, the financial crisis in 2008–2009, and the coronavirus pandemic in 2020—and they have entered adulthood with lower incomes and more debt than their parents. No wonder that, rather than turning to reliable investments to build wealth as their elders did, the younger generation has turned to newer, more experimental asset classes like cryptocurrency, socially responsible stocks, and speculations promoted on Reddit message boards. Don’t get me wrong: I dislike crypto as an investment not because it’s young and I’m not. I dislike cryptocurrency for the same reason I dislike gold. Neither crypto nor gold are living, dynamic businesses that can expand over time. Bitcoin may be a new storehouse of value, but in the end it’s just a currency. It has no customers, no revenues, and no profits to grow.

We must remind ourselves that the stock market is nothing more than a collection of businesses and that investing in them has historically been the best way to build wealth. We should acknowledge that the world’s economy is increasingly digital, so we must learn how digital companies create wealth. We should invest in the best such companies, then let compounding do its job.

No subset of investors has had a harder time adapting to the changes brought on by the Digital Age than value investors, an investment discipline of which I’m proud to be part. Although the term is often used, “value investing” is rather hard to define. Just as there are many sects of Christianity, so are there many branches of value investing.

Value investing does, however, revolve around a few central principles. Chief among these is an insistence upon discipline, rigor, and study. Value investors approach the stock market not as a betting parlor or a bodega where we can buy a lottery ticket but as a place where we can systematically attempt to build wealth. We are not traders or speculators. We are bookish and analytical, and we love metrics, yardsticks, and ratios—anything that can help us make sense of the public markets. Above all, we seek to codify our approach to investing through a set of rules. We use a framework that we impose on the stock market so that when we beat it, it’s not a matter of luck, but rather of a system. Value investors are also notorious cheapskates who hate to pay a high price for an investment. That’s why we’re called “value” investors and that’s why we look down on other methods that give price less weight in the decision-making process. We disdain so-called growth investors, who are interested mainly in companies with steep sales and earnings trajectories. We are even more disgusted by momentum investors, who do in fact treat the market like a casino, seeking to ride their luck by following short-term trends. Because of value investing’s disciplined approach, study after academic study has shown that a value-based discipline has led to long-term, market-beating results.II Faced with technology’s radically new and alien business models, however, value investing’s frameworks have begun to break down. Reliable value-based metrics like price to book value, which measures how expensive a company is relative to its assets, and price to current earnings, which measures expensiveness in relation to how much profit a company is generating, have failed to capture tech’s enormous value creation. As a result, these same academic studies are now beginning to show that value investing hasn’t been working the way that it once did. Even Warren Buffett, the high priest of value investing and widely considered the most successful investor of all time, has struggled to navigate the new economic landscape. While Buffett’s long-term returns remain awesome in the original sense of the word, they have been diminishing. As the following chart shows, his market-beating performance peaked in the 1980s, lessened in the 1990s, and since 2017 has turned into underperformance.

As a Wall Street investment analyst since 1995, I’ve watched as tech stocks have grown from gawky adolescents into some of the most powerful economic specimens the world has ever seen. For the last several years, I’ve been wrestling with these issues as both a full-time money manager and as a contributor to Barron’s and Fortune. In this book, I do my best to resolve them.

Honestly, I’d rather not have had to investigate “tech” at all. Only a half dozen years ago, I was a stodgy value investor who was comfortable with the old orthodoxies. I’d have been happy to spend the next twenty-five years of my investing career in the same way I’d spent the first twenty-five. I have no innate interest in technology, I dislike gadgets, and I barely understand how electricity works. If it weren’t so financially dangerous to do so, I’d stay set in my ways—but old industries are dying and new ones are being born at a rate not seen in more than a century. To continue as I had would have been to ignore economic reality and to consign myself and my clients to a future of dismal performance. I arrived at this conclusion only after several years of struggle, research, and contemplation. I came to it unwillingly, with the same reluctance that a true believer gives up his faith. But as a student of business, and as someone devoted to what might be grandiosely called Truth, I had to admit that something important had happened. So I recalibrated my instruments and focused my attention on the digital economy. I did this not because tech is sexy, or interesting, or beneficial to society. I did it for the same reason Willie Sutton robbed banks: it’s where the money is.

Anyone interested in this subject would enjoy reading Andreessen’s “Why Software Is Eating the World,” first published in the Wall Street Journal in 2011. Likewise, you should read Gordon Moore’s less elegantly titled “Cramming More Components onto Integrated Circuits,” a 1965 essay that laid out the price/performance dynamics of computing power. The former is five pages long and the latter is four pages. Why are all the most important papers so short?

See for example Eugene F. Fama and Kenneth R. French, “Value Versus Growth: The International Evidence,” Journal of Finance 53, no. 6 (1998): 1975–99, http://www.jstor.org/stable/117458. “Long term” here means a decade or more.

See for example Baruch Lev and Anup Srivastava, “Explaining the Recent Failure of Value Investing,” New York University, Stern School of Business, October 2019, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3442539.

Part I: Preparing to Invest

My first job was at Sanford C. Bernstein, a firm known for the thoroughness of its investment research, and its halls were as quiet as a monastery’s.

Good investors do not live by testosterone or adrenaline; they ignore them. Peter Lynch said that his most valuable course in college had nothing to do with finance—it was a course on logic. To relax, Warren Buffett reads the philosopher Bertrand Russell and plays bridge.

This slow, incremental approach especially characterizes long-term investors, who don’t see the stock exchange as a gambling hall in which we “play the market.” Instead, we see it as a place where, over time, value is found out.

As Peter Lynch has said, superior businesses win in the stock market over time. Inferior ones either languish or die.

All value investors do their research. All value investors are disciplined about the price they pay. Above all, all value investors scorn randomness; instead, like Graham, we impose a framework onto the markets. We invest using a set of rules that we rarely alter, trusting that our discipline will help us outperform the market averages over time.

The reversion to the mean framework measures stocks as Buffett does, comparing a business’s current quoted price to its profits, and the essence of the discipline can be summed up by value investor Sir John Templeton’s dictum, “The four most dangerous words in the English language are ‘this time it’s different.’” At Bernstein, this phrase was our Apostle’s Creed. Don’t try to predict wholesale change, we were taught, because it’s not going to happen. Simply buy the companies that are historically cheap and sell the ones that are historically expensive. Eventually, life will return to normal.

I was the junior oil and gas analyst apprenticed to the senior one, and it was our job, along with all the other analysts, to feed data about the companies we covered into what we called “the black box.” This wasn’t a box at all, but rather a sophisticated computer model Bernstein used to determine statistical cheapness using mean reversion calculations. In would go data on projected sales, estimated earnings, debt ratios, and so forth, and out would come the stocks and the sectors that the black box deemed expensive and the ones it deemed cheap.

Because in the late twentieth century everything did eventually return to normal, the black box generated large gains for the firm and its clients. At its peak, Bernstein managed $800 billion, making us one of the largest money management firms in the world.

The man who presided over the black box when I was there was Lew Sanders, Bernstein’s chief investment officer. Lew was slim and quiet, and he moved through Bernstein’s corridors with the quiet grace of an abbot in his priory. Lew embodied the kind of cerebral, tide-mapping investor I wanted to be.

When I felt my apprenticeship at Bernstein was done, I left to become a more senior analyst at first one and then another firm, Baron Capital and Davis Selected Advisors. In 2000, I began co-managing a mutual fund for Davis, and by 2003 I felt experienced enough as a value investor to start my own firm.

Then, in the middle of the last decade, my system rather suddenly stopped working.

Sitting at my desk that dark December evening, however, I had the uncomfortable feeling that the market had finished weighing my stocks and found them wanting.

What if the businesses I owned were not cheap because they were on sale—what if they were cheap because their futures were bleak?

Software companies have few tangible assets and cannot therefore be valued using Graham’s original asset-based analysis.

When tech stocks collapsed in the dot-com bust, it confirmed to value investors that the four most dangerous words in the English language were indeed “this time it’s different.” If there was any reversion to the mean in the tech sector, it was to the mean of chaos, and no serious value investor was interested in that. Fifteen years later, however, something unusual happened. In 2016, Buffett, the guiding light of value investors and the keeper of the flame passed down to him by Ben Graham, bought $7 billion worth of shares in Apple. To say that this move mystified the investment community is like saying Catholics would be confused by a pope who opened the priesthood to women. Apple was a hardware technology company so historically brutalized by competition that in the late 1990s it was ninety days away from declaring bankruptcy. What, the value investing community asked itself, was the Oracle of Omaha doing? Fortunately, I had a plane ticket to hear Buffett explain himself. Every spring, 40,000 of value investing’s faithful gather in Omaha, Buffett’s hometown, to hear him and Charlie Munger expound on the state of their holding company, Berkshire Hathaway, and the world at large. Anyone interested in investing should make the pilgrimage to Omaha at least once: Buffett and Munger sit on a dais in a basketball arena and answer a full day of questions, laying out what they invested in over the past year and why. Even though Buffett is ninety-one years old and Munger’s well past that, they remain committed to transmitting the lineage of value investing the old-fashioned way: orally and in person.

By the time I went to Omaha, I’d sold Avon, Tribune, and the other stocks whose best days were behind them. I’d concluded that these companies were, in Wall Street parlance, value traps: cheap, but not valuable. My largest position was now Alphabet, my performance had improved, and my conversion to a new way of looking at the world was deepening. But it was still new, and I wanted to hear from Buffett why he’d bought Apple. Misery loves company, but so does conviction, especially when it’s recently discovered.

“I didn’t go into Apple because it was a tech stock in the least,” he would later say. “I went into Apple because I came to certain conclusions about the value of its ecosystem, and how permanent that ecosystem could be.”

Munger, who is almost always more direct than Buffett, chided both himself and his partner for not buying Alphabet, the parent company of Google. “If you ask me in retrospect what was our worst mistake in the tech field, I think we were smart enough to figure out Google,” Munger told the crowd. “So I would say we failed you there. We were smart enough to do it and didn’t do it.” Buffett agreed, recalling how Google had first appeared on his radar screen a decade earlier when GEICO, Berkshire’s auto insurance subsidiary, began to buy Google Search ads on a per-click basis. “We were paying them $10 or $11 a click or something like that,” Buffett said. “Any time you’re paying $10 or $11 every time someone just punches a little thing where you’ve got no incremental cost at all, that’s a good business.”

Aha, I thought. Buffett and I are on to the same idea, and the word is getting out. As the meeting ended, I found myself looking forward to talking about it with my peers at the dinners and cocktail parties that followed the gathering. At these events, however, I found that nobody wanted to talk about Apple. Nobody, in fact, wanted to talk about tech in general or the new world that Buffett had just described. Instead, everyone continued to chatter away about the same old old-economy businesses they’d been chattering away about for years. They talked about Buffett’s recent airline investments, even though these investments represented a smaller dollar commitment than the one he’d made to Apple. People also spent lots of time unpacking tiny, incremental changes Buffett had made to Berkshire’s various insurance subsidiaries. This struck me as insane. Both airline and insurance companies were the very kind of mature, capital-intensive businesses that Buffett had just said were fading away. Had nobody heard our guru telling us it was time to look forward rather than back?

By late 2009, the market had recovered from the crisis and the S&P was on its way to its best year in decades; Bernstein’s flagship fund, however, remained down more than 50%. On another dark day in late December, Lew Sanders left his office at Bernstein for the last time. I lost track of Lew after that, but he resurfaced for me as I began to wrestle with the ascent of the Digital Age. He had started his own firm, Sanders Capital, and I was shocked when I read that his top holdings included several tech companies, including Alphabet and Microsoft. Neither of these stocks was even close to attractive when viewed through traditional value lenses. This made me very curious indeed. What had made the archbishop of reversion to the mean renounce it? “Lew,” I began, “over the last few years I’ve come to suspect that many of our old investing methods no longer work. Businesses like Alibaba, Facebook, and dozens of other, smaller companies are prospering. None look attractive when you look at them using conventional metrics—but maybe the conventional metrics are wrong. Maybe ‘this time it’s different’ aren’t the most dangerous words in the English language anymore; maybe it’s ‘life is going back to normal.’” Lew was silent, and his ice-blue eyes were downcast. So I continued. “I’ve begun to invest in such businesses,” I said, “and I notice you’re doing the same.” Still nothing. “So, Lew, I have to ask you,” I finally said. “What the hell is going on?” Lew smiled, raised his glacial eyes to mine, and uttered four words that will remain with me for some time. “The world,” he said, “has changed.”

Chapter 2: Value 1.0: Ben Graham and the Age of Asset Values

Although Graham became known as the father of modern security analysis, he was at heart an intellectual. He knew seven languages and routinely quoted Corneille in French, Kafka in German, and Homer in ancient Greek. Graham is likely the only financial analyst in history who, during a poor stretch of investment performance during the Great Depression, composed a poem about it. (“Where shall he sleep whose soul knows no rest,” the poem concludes. “Poor hunted stag in wild woods of care?”) Like many thinkers, Graham was known in equal measure for his brilliance and his absentmindedness. He invented a new version of the slide rule, but he would also often show up at work wearing two different-colored shoes.

In 1923, Graham quit Newburger, Henderson & Loeb to start his own investment operation. He was only twenty-nine but he had an edge, and he knew it.

“To old Wall Street hands it seemed silly to pore over dry statistics when the determiners of price change were thought to be an entirely different set of factors—all of them very human,” Graham later wrote in his memoirs. But “[a]s a newcomer—uninfluenced by the distorting traditions of the old regime—I could respond readily to the new forces that were beginning to enter the financial scene. I learned to distinguish between what was important and unimportant, dependable and undependable, even what was honest and dishonest, with a clearer eye and better judgment than many of my seniors, whose intelligence had been corrupted by their experience” (emphasis added).

Graham’s reputation, his bank account, and his self-confidence all grew. His asset-based approach was working well—so well that he used the securities he owned as collateral to borrow money and buy even more stocks with it. He leveraged up, as we say on Wall Street, or “went on margin,” and he did this right into the Crash of 1929. All stocks sank, and Graham’s borrowings amplified his losses. By 1932, his investment partnership was down 70% from its peak. It would not be until five years after the crash that Graham’s fund recovered to pre-1929 levels.

Graham moved his family to a smaller apartment, and his wife found work as a dance instructor. He abandoned the car and chauffeur he’d kept for his mother, but he did not abandon his investment discipline. While other investors despaired, Graham continued to invest using his asset-based system.

While Graham’s full performance records do not survive, it appears that by using this system he outperformed the larger market by a comfortable margin from the 1930s until he retired in 1956. Graham estimated his returns to be 20% per year, roughly double the market averages over that period.

There are deeper problems with Graham’s system, however. Value 1.0 is largely a short-term strategy, one that requires a constant portfolio recycling as inexpensive stocks appreciate to fair value. Graham’s approach came to be known as “cigar butt investing,” because the stocks in a Graham portfolio are like cheap stogies picked up off the sidewalk. Good for only one or two puffs, they must be quickly discarded, then new ones found. It’s time-intensive to find such stocks, track them, and decide on entry and exit points for each one. Because the recycling is rapid, gains in cigar butt investing are also often taxed at ordinary-income rates, which are higher than long-term capital gains rates. In the upper tax brackets, a 20% short-term investment gain becomes a 10% gain after paying 50% taxes on it. Finally, and most importantly, Value 1.0 is rigid, rote, and monomaniacal in its focus on asset prices. As a result, the biggest fish routinely slip through its net. Value 1.0 was well-suited to its times; its strict adherence to numerical formulas kept investors away from speculating. It’s a simple system with easy, binary answers: either a stock meets Graham’s liquidation criteria, or it does not. Finding a company you can invest in with a margin of safety, Graham wrote in The Intelligent Investor, “rests upon simple and definite arithmetical reasoning from statistical data.”

Obsessed with formulas, Graham ignored any sort of qualitative analysis; one of his assistants recalled that he would get bored and look out the window if anyone started talking about what a company actually did.

Walter Schloss, who worked for Graham and later became a legendary value investor in his own right, once pitched Graham on a company that wasn’t selling for a fire sale price but owned a promising new technology: Haloid, which would later commercialize the Xerox machine. “Walter, I’m not interested,” Graham told Schloss. “It’s not cheap enough.”

Graham retired early for a portfolio manager, at sixty-two. A wealthy man, he could afford to return to his earlier, more intellectual interests. He translated a novel from Spanish, published a volume of poetry, and began to split his time among the United States, Portugal, and Aix-en-Provence. Shortly before he died, however, Graham made a bizarre, indirect confession about the limitations of the discipline he had created. The confession came in a two-page postscript from the final edition of The Intelligent Investor, published in 1973. Graham apparently felt so sheepish about the matter that he wrote of himself in the third person. He describes what transpired as if it had happened to someone else, whereas in fact it happened to him and his longtime business partner, Jerome Newman. “We know very well two partners who spent a good part of their lives handling their own and other people’s funds in Wall Street,” Graham begins in the postscript. “Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world…. In this way they did quite well through many years of ups and downs in the general market…” Graham goes on to say that in 1948 he put 20% of his partnership’s assets into a single stock. The stock was cheap relative to both assets and earnings, and, Graham writes, he and his partner were “impressed by the company’s possibilities.” Almost soon after Graham bought it, the stock took off and continued to appreciate—so much so that over time, it made Graham and his partners two hundred times their initial investment. This appreciation quickly made it look expensive on Graham’s asset-based metrics, but he decided to keep it because, as he says in his memoirs, he regarded the company as “sort of a family business.” “Ironically enough,” Graham concludes in The Intelligent Investor, “the aggregate of profits accruing from this single investment decision far exceed the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions” (emphasis added). In other words, a single investment in one great business made Graham more money than a generation’s worth of cigar butts combined. The company was GEICO, the automobile insurer. Yet in Graham’s memoirs, he mentions GEICO only twice, once in relation to an insurance claim he filed with them. Northern Pipe Line, on the other hand, receives a whole chapter. “Are there morals to this story of value to the intelligent investor?” Graham asks in the conclusion to his postscript. “An obvious one is that there are several different ways to make and keep money on Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision—can we tell them apart?—may count for more than a lifetime of journeyman efforts.” Here, Graham was dissembling. By the time he wrote this postscript, he knew that identifying great businesses like GEICO did not involve a lucky break. He knew that the identification of great businesses could be systemized, just as he had systematized asset-based investing. One of his former Columbia students—his star pupil, in fact, the only one he ever awarded an A+—was proving it through his own investment track record.

End of Chapter Footnote:  I am indebted to my friend and colleague Chris Begg, cofounder and chief investment officer of East Coast Asset Management, who gave me the terms Value 1.0, Value 2.0, and Value 3.0, which I use throughout the book.

Chapter 3: Value 2.0: Warren Buffett and the Brand-TV Ecosystem

Buffett was heavily influenced in his thinking by John Burr Williams, an economist who had written a book called The Theory of Investment Value. Like Graham’s Security Analysis, Williams’s book had been written in the depths of the Depression, but it was as optimistic and as forward-looking as Graham’s was cautious.

“The key to investing,” Buffett said in a 1999 speech that was later published in Fortune, “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.”

In both its general worldview and its specific tools, Value 2.0 is beginning to fail us. As the economy changes, the moats that protect many of Buffett’s classic postwar franchises are weakening. At the same time, Buffett’s valuation framework, with its focus on mature companies generating lots of current earnings, hasn’t captured the enormous value being created in the Digital Age. While Value 2.0 was exquisite in capturing where the money was, it’s not capturing where the money is.

the pair have been slower to recognize the secondary effects that media’s decline has had on mass brands: Coca-Cola and Kraft Heinz remain large Berkshire positions.

A third of Buffett’s top fifteen publicly traded stocks are financial-services companies, including American Express, Bank of America, and, until recently, Wells Fargo. This is a real problem, because digital companies are looking at legacy banks the way a lion sizes up an aging zebra. Like GEICO, a bank’s competitive advantages arises from its low-cost position. Unlike GEICO, however, which offers its customers better deals, banks have offered customers worse deals, betting—correctly, so far—that customers would put up with them. However, those days may soon be over.

While it’s true that it’s hard to change banks when you have so many accounts with them, banks have abused their customers’ trust for so long that they are all but inviting customers to leave. Not only do banks offer below-market rates, but they also routinely ding their customers with fees. Account-opening fees, account maintenance fees, fees for using another bank’s ATM, fees for failing to maintain a minimum balance, overdraft fees—as anyone who has seen them on their monthly statement knows, the list is long. The average American pays roughly $20 in banking fees every month, more than they pay for a Netflix subscription. But at least, with Netflix, people get something.

Why is that? What is it about value investing as currently constructed that lets most tech companies slip through its net? The answer is complex, but I think it begins with Buffett’s worldview. Buffett’s career coincided with a time when the American economy was unusually stable and homogenous.

Unlike many other tech companies, Apple is relatively unambitious in terms of trying to attack new markets; as a percentage of sales, Apple spends only about one-third of what Alphabet, Microsoft, and Facebook spend on R & D. Over the last decade, the company has acted like an old-fashioned capital allocator, using much of its cash flow to repurchase its own shares in the open market.

Experience has taught them to look for steady, persistent economic farmers, safe behind their moats and castle walls. The blitzkrieg success of companies like Alphabet, Facebook, and Netflix is alien to them, and little wonder. They’d never seen anything like it until they were more than seventy years old.

Alternatively, read Berkshire Hathaway’s 1992 annual report, in which Buffett gives a condensed version of Williams’s ideas.

Chapter 4: Value 3.0 and the BMP Checklist

This company makes generic spare parts for airplanes. Like GEICO in 1951, it has a small share of a huge addressable market. Like GEICO, its competitive advantage stems from being the low-cost provider of an essential product. Even its name resembles GEICO’s: It’s HEICO, a company I came across during my wretched period of underperformance in the mid-2010s.

At the time, I was working with a talented analyst named Clint Leman. I asked Clint to write a simple computer program that used different metrics from the “look for cheap stocks” criteria I’d been using. No longer would I put price ahead of business quality as I had with Avon, Tribune Media, and the rest. Instead, I would search for businesses with superior economic characteristics, then see about price later. I also asked Clint to screen for management quality using a single simple yardstick: whether executives owned a lot of stock in the company they were running. Clint’s screen turned up a dozen names, the most interesting of which was HEICO. The company was founded in 1957 as Heinicke Instruments Company, but the story really begins in the late 1980s, when one of Larry Mendelson’s kids stumbled upon it. Larry Mendelson was a New Yorker who, while attending Columbia Business School a decade after Buffett, took the same security analysis course Buffett had. After graduation, Mendelson moved to Florida and made a lot of money in real estate, but he put his value-investing skills to work in the stock market as well. In the 1980s, his sons Eric and Victor attended Columbia as undergraduates; while they were there, Larry asked them to look for undervalued securities in their spare time. Interest rates were falling, stocks were modestly priced, and Larry was looking for a business he and his sons could take over and run. In keeping with Ben Graham’s tradition, the Mendelsons didn’t particularly care what the business did. It just needed to be cheap, poorly managed, and located in Florida, where the family wanted to stay. One day, while doing research in the Columbia law school library, Victor found HEICO, which appeared to meet the family’s criteria. The company specialized in making medical-laboratory equipment, but it had made a series of acquisitions, including one in the aerospace business. By the time Victor found HEICO, it had been public for nearly thirty years but barely made any money. Like Graham with Northern Pipe Line and Buffett with Sanborn Map, the Mendelsons saw HEICO as a company whose shares they could buy in the open market and then agitate for change. Unlike Northern Pipe Line and Sanborn Map, however, HEICO’s appeal lay not in the liquidation value of its assets, but in the latent earnings potential of its aerospace subsidiary.

As they learned more about airline spare parts, the Mendelsons discovered that HEICO could produce and sell a generic option at a 30% to 40% discount and still make healthy profits and returns on capital. The Mendelsons also found that there were few patents or intellectual-property rights attached to aerospace replacement parts. Moreover, the market for spares was huge—it’s roughly $50 billion a year today—and the aerospace industry was growing. Like American Express, investing in airline travel is a classic call on rising worldwide prosperity, which leads to a rising demand for travel.

In 1989, the Mendelsons and their allies bought 15% of HEICO’s stock in the open market. After a proxy fight almost as ludicrous as Graham’s Northern Pipe Line contest, they secured four seats on the board and named Larry Mendelson the new CEO.

He immediately sold HEICO’s lab business and focused on the market for airplane spares.

When Clint’s screen led me to HEICO in 2015, it had shipped 68 million parts without a single adverse incident, and nineteen of the world’s top twenty airlines bought parts from the company.

Part II: Tools for Picking Winners

Chapter 5: Competitive Advantage Then and Now

Go to Intuit’s site and you will see that Intuit now has 5 million online subscribers to QuickBooks, its small-business accounting product. Intuit says that the worldwide addressable market for QuickBooks is 800 million customers. Five million divided by 800 million equals less than a 1% share—I’m interested.

Chapter 6: Management: Some Things Never Change

Chapter 7: Price and Value 3.0 Toolbox

Chapter 8: Earnings Power

Chapter 9: BMP Case Studies: Alphabet and Intuit

Chapter 10: Investing in Non-Tech Companies

Part III:  Putting it All Together

Chapter 11: Buy What You Know – With a Twist

Chapter 12: Thoughts on Process and Priorities

Chapter 13: Regulation, Innovation, and Second Half of the Chessboard

The post Where the Money Is: Value Investing in the Digital Age appeared first on VII Capital Management.

This is an old book that I recently purchased used and is only available in hardcopy. It is an annotated compilation of Ken Fisher’s popular Forbes articles from 1984 to 2009. Reading it has turned me into a fan of Ken.

After recently enjoying Markets Never Forget, But People Do (2011) and Ken Fisher’s prior book, Debunkery (2010), I decided to tackle the Forbes compilation. I had already read The Only Three Questions that Still Count (2012), Beat the Crowd (2015), and How to Smell a Rat (2009), but that was some time ago. One thing I dislike about Ken’s style is that he uses dangerous words like “never” and “always” too often. His fixation with making market calls also turns me off, but I suppose that’s what “gurus” are expected to do. While I like his father better, I learned over time that Ken too is a giant, but in his own way. The record in this book shows that he has been right on the market a lot more often than he’s been wrong. I would not recommend buying the book unless you are an enthusiast. That said, I loved it so much that I typed out my 21 favorite passages below. They are timeless!

Regards,
Adriano

HIGHLIGHTED EXCERPTS

“The odds are overwhelming I will end up richer aiming for a good return rather than for a brilliant return.  Folks who seek a killing often get killed.” – Sep 22, 1986 column

“Good money management starts with sticking to a good long-term strategy.” – June 15, 1987 column

“In the long term, America and the stock market have a wonderful future.  As history as my guide, things clearly get better over the generations.  Always have.  Technology improves pervasively.  I sure wouldn’t want to go back to any prior decade.” – Feb 19, 1990 column

“Sprinkled throughout my bearish columns of the past 15 months are long-term reminders to my readers that the Nineties will be a fine decade and that bearishness cannot be justified longer term.  Yes, we are in a recession, but remember: Stocks always bottom out before the economy does.” – Dec 24, 1990 column

“As a green college graduate I was trained by my father to analyze quality.  That was his obsession.  He was an un-numbers man. No charts or tables. What interested him were the two “Ps” – people and position. Meaning, how good are the people? And how well is the firm positioned in its field. No matter how good the numbers looked, he wasn’t interested in a stock unless he saw exceptionally skilled and dedicated people running a firm with natural competitive advantages.”  – July 23, 1990 column (titled Dad, You Were Right)

“I am never absolutely sure about anything.  Portfolio strategy is an odds game.” – Feb 18, 1991 column

“Staying with this bull market, or any bull market, is sort of like hanging on to a horse when it’s bucking; it keeps trying to toss you off.” – Nov 25, 1991 column

“You can always find things wrong with the world. There is never a shortage of problems. Never has been. Nor a shortage of people who like to fixate on them. The only thing that really counts is: Will the problems hurt stock prices now?” – Mar 16, 1992 column

“In setting your cerebral scales to balance between bullish and bearish, never let your views of government, positive or negative, be more than 10% of the weight of your thinking.  Other things should weigh heavier, always.” – May 10, 1993 column

“What distinguishes highly successful investors from everyone else is what the smart ones don’t do as much as what they do.  Really sharp investors don’t get sucked in by the trend du jour.” – Dec 20, 1993 column

“A simple market truism:  Old arguments, even correct ones, don’t move markets.  Something new must arrive – a surprise or catalyst, because it is a surprise, and only that, which moves markets.” – Feb 14, 1994 column

“No one sets out deliberately to buy a stock or mutual fund at the top and panic-sell at the bottom, but it happens all the time.” – Aug 29, 1994 column

“Stay fully invested in good stocks and don’t try to time the market.” – Oct 17, 1994 column 

“Avoiding stocks just because the market isn’t cheap is a dumb idea.  The market rises just as often when it is “not cheap” as when it is.  There’s a lot of ground between not cheap and overpriced.” – Feb 13, 1995

“Predicting tops is not a part of my investing method.  I don’t even try. People who forecast market tops depend on foreseeing forces that will both materialize and make the market tumble. If the forces don’t appear, neither does the top. And even if they do appear, there may be other, unforeseen events that arise and offset the negative developments they did anticipate.” – Jun 17, 1996 column

“The difference between a few months from now and immediately can feel near infinite as the last leg of a bear market warps our perceptions.” – Nov 12, 2001 column [4 months from the historic bottom]

“It is pointless to worry about what others worry about. If you do base market judgments on those worries you will be wrong more often than right. If others worry about something, you just don’t have to because they are doing it for you. You should worry about something else – namely, what they’re not worried about.” – May 26, 2003 column

“Real bubbles are never commonly referred to as bubbles in the press until after they’ve burst. When something is commonly labeled a bubble that hasn’t burst that means there is fear of it. There is little or no fear of a real bubble. Fear, priced into markets, reduces risk.” – Jul 4, 2005 column

“Election outcomes don’t affect markets the way you’d expect them to. In inaugural years we discover that Democratic presidents are phonies and never meant most of what they said in their populist, anticapitalistic campaigns.  Inaugural years for Republican presidents remind us that they are phonies, too; they don’t do much for the economy or for investors.” – May 19, 2008 column

“In a bubble, anyone who argues pessimistically is seen as crazy. In today’s reverse bubble, when you argue optimistically you are seen as the crazy one. Bubbles are hard enough to see, but reverse bubbles are completely invisible.” – Sep 29, 2008 column

“The stock market is a discounter of known information. It is not a barometer of the current state of the economy, but a guess about where the economy (and corporate profits) will be 6 to 24 months in the future. Stock market bottoms happen, and then stocks jolt upwards, while the economy keeps getting worse – sometimes by a lot and for a long time.” – Jan 12, 2009 column

The post The Making of a Market Guru: Forbes Presents 25 Years of Ken Fisher appeared first on VII Capital Management.

This book derives from a class called Digital Investing that professor Knee teaches at Columbia Business School since 2015. It is the most insightful book I have ever read on technology investing. It is even better and more relevant than Platform Revolution (2016). Knee is a highly respected authority on the topic and his knowledge draws from decades of experience in investment banking and consulting in the technology and media spaces.

What makes this book so different is that Knee has a strong and bold opinion on most of the key players in the Big Tech space.  I forgive him for not mentioning Upstart at all, and for mentioning Accenture only once, but he’s so generous otherwise, my alma mater is lucky to have him. Chapter 8, where he gives the reasons for his confidence in Google’s dominance whatever happens, was my favorite. Instead of commenting here on his many theories and conclusions about winners and losers in the technology space (from internet aggregators, to content creators, Software as a Service (SaaS) providers, cable owners, and trading platforms), I comment selectively in the highlighted passages below.  At the very end of this review I also include a link to the only recent YouTube video I found with Professor Knee, as well as the Amazon description of each of the last three books he published before Platform Delusion.

If I could summarize Jonathan Knee’s view in one line, here is what it would be:  Buy Google, Visa, Bookings.com, and Cable companies – sell Facebook, Netflix, and Apple – short ad agencies and any ad-tech company that competes with Google.

Cheers,
Adriano

PS:  There is another outstanding book I recently read that comes close to being just as good as Platform Delusion.  It’s called The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance, and it also came out last month. The author is a professor at Cornell and the book is unlike any other on the topic.  It is much better and more relevant than Ken Rogoff’s The Curse of Cash (2016).  …when it rains [good books], it pours.

HIGHLIGHTED EXCERPTS (AA Comments in italics)

Part I: Digital Advantage and \disadvantage

Chapter 1: The Four Pillars of the Platform Delusion

Even Zoom, the video communications platform that is perhaps the most iconic success of the pandemic era, is not really a strong network effects business. By the end of 2020, the company was worth over $100 billion and its stock traded at around ten times its 2019 offering price. Zoom is a fabulous product, but its very success in eliminating any friction or complexity in adoption has severely limited how powerful its network effects can be. [AA Comment: I still use Zoom. But I’m a dinosaur. Not important who delivers it as long as it works.]

More broadly, the authors of The Business of Platforms [AA Comment: published May 7, 2019], looked at two decades of performance, from 1995 to 2015, of platform businesses and noted that relatively few had survived. Specifically, “only 17 percent (43 out of 252) remained in 2015 as independent public companies.” [AA Comment: 17 is a special number.]

“In a relatively small number of platform spaces, failure was a function of a genuine winner-take-all or winner-take-most outcome for a competitor.” [AA Comment: That’s nature. It’s like saying: Only in a relatively small number of cases does a species survive evolution. The Pareto principle (a.k.a. 80/20 rule) has been out since Vilfredo Pareto described it in 1906.  A relatively small number of companies (i.e. 17%), account for most (i.e. 83%) of the consequence (i.e. value) in nature.]

What is alarming, however, is the extent to which the euphoria triggered by the Platform Delusion has led investors to forget that, ultimately, the existence of competitive advantage is what drives the ability of any business, digital or analog, to produce consistently superior returns. [AA Comment: easy to say in retrospect and could have been said in 2015 when this course material was being assembled. I wonder for how long the professor has been bearish. In my opinion it is better to stay humble here.  That said, I like his style. I also like how well the book was referenced and researched.]

Although frequently presented as peculiar to the internet, platform business models have long been ubiquitous. [AA Comment: This is so true.  Think Sherwin Williams, O’Reilly, Old Dominion, Goldman Sachs, American Express, the Medici, Fugger, Guggenheim, Harvard, the Vatican, the Evil Axis, and Marcel Duchamp.]

Chapter 2: Network Defects: Scale in the Digital Era

…it is possible to identify the maximum number of profitable competitors. If a particular sector opportunity can sustain a competitor at a 5 percent market share, twenty market participants can thrive indefinitely. If high fixed costs dictate a 35 percent break-even market share by contrast, monopoly or duopoly are the only sustainable market structures. [AA Comment: Cool that he puts numbers on it.]

So, in ride sharing, where the ability to deliver a car within three to five minutes dominates all other customer considerations, adding drivers to the network beyond this point is of little value.

The insurance industry created a nonprofit called Insurance Services Office (ISO) fifty years ago to pool data from their property/casualty insurance members to improve their collective risk assessments. The business became a for-profit in 1996 and today represents the core asset of Verisk Analytics, a $30 billion public company. [AA Comment: Verisk is an interesting company with origins similar to Visa and Nasdaq. My only rub is that insurance is not a growth industry, but still, it is bound to be a great business and the stock has indeed done great. So has Nasdaq.]

Take a business like Ancestry.com, the world’s largest genealogical service. In addition to the fixed costs associated with developing and maintaining the platform, the company has built up a database of 27 billion family history records across eighty countries, much of it purchased or licensed. [AA Comment:  His point is that Ancestry.com benefits tremendously from network effects. The more people use it, the more valuable it becomes.]

Chapter 3: It Takes a Village: The Sources of Digital Competitive Advantage

More disturbing, as discussed in greater detail in chapter 13, is the fact that programmatic advertising allows marketers to reach New York Times readers on other websites. This reality is reflected in the dramatic reduction in absolute advertising revenue in both print and digital products and the continuous declines in advertising rates (CPMs or cost per mille, or a thousand impressions). [AA Comment: Google used to talk about programmatic advertising a couple of years ago, but they stopped doing that after it boomed. Can’t see why one day, all advertising won’t be programmatic advertising.  All that means is that a computer program is placing the adds instead of an agent on the phone, like it used to be.]

Netflix, widely viewed as a leader in customer engagement and retention, still has churn of around 3 percent each month or 36 percent annually. [AA Comment: More than a third churn out annually is quite high – at least in comparison to TurboTax, Bloomberg, Costar, or Visa. Churn is the most important metric in the economic value of a subscriber base. It’s the same with asset management and pest control.  There’s demand-side churn (customers leaving) and there is supply-side churn (employees leaving). For a service business where human interaction is critical (think Orkin Pest Control), technician churn (supply side) is as critical as customer churn (demand side). While I’m on critical metrics, Sam Walton’s favorite was “shrinkage” – the term used in retail to measure loss of inventory to theft and error and other mishaps. Low shrinkage is a reflection of strong culture.]

In the context of platform businesses, this ability to easily shift among or support the simultaneous use of multiple platforms is often given a fancy digital moniker: multi-homing. There is nothing objectionable in this term, but it is sometimes treated as an entirely novel category of phenomenon rather than simply a manifestation of weaker demand-side barriers to entry. [AA Comment: Indeed, the more aggregators there are, the less sticky a platform becomes. If most riders use Uber and Lyft interchangeable, that’s low supply-side barriers to entry.]

It is increasingly certain, given the subscriber boost from the pandemic and the Trump presidency, that the New York Times will deliver or exceed its lofty goal of 10 million subscribers in 2025. In so doing, it may finally exceed the revenue the print paper achieved a quarter century earlier in 2000. But its shareholders will likely still see a more modest bottom line. [AA Comment:  This is what I concluded about Disney when we sold it in 2015. Ten years from now, when (and if) Disney+ is most of the business, it will be a less attractive business. Knee stops short of hanging Disney in his book, which makes sense – but he leaves little doubt to the discerned reader that he believes Disney is doomed to become a less attractive company. When the future of a narrative looks worse, it’s best to sell the stock. Disney is vertically integrated in a business where aggregators rule. Its advantage in content creation has been overwhelmed by Netflix’s massive gamble. As I have been saying since 2015 – Netflix already won. I agree with Knee’s skeptical views only as one alternative angle to the problem of separating the signal from the noise. He is spotting delusions while I am trying to make dreams come true. We are bound to differ in our actions even when our minds are aligned.]

A digital New York Times in 2025 would be a smaller and less profitable business, even ignoring the cost of eliminating the printing and distribution operations.

As many significant technology businesses have few assets and little revenues, a number of competitively questionable transactions have slipped under the financial thresholds for the required government antitrust notification of the Hart-Scott-Rodino (HSR) Antitrust Improvements Act. Google had even found a loophole to avoid giving regulators a heads-up on its billion-dollar acquisition of Waze. [AA Comment: Found a loophole? Not really. Waze would have disappeared if Google didn’t buy it, because they would have to compete with Maps, and would have never been able to offer it for free for so long without Google.]

Regulators waking up to the potential dangers of big tech is welcome news. But there is a difference between identifying a problem and locating the most problematic issue and the most effective remedy. The fact that the antitrust authorities chose blocking AT&T buying Time Warner—a deal so incoherent that AT&T reversed it in less than three years—as most worthy of extensive (and failed) litigation to protect the public suggests that the chances that the government will get it right in big tech are low.

Part II: In the Land of the Giants

The five enormous companies that constitute FAANG—Facebook, Amazon, Apple, Netflix, and Google—owe their inclusion in this ubiquitous acronym to television personality James Cramer. [AA Comment: Sundar Pichai would never go on the Cramer show, but Sasan Goodarzi does. That’s about the only rub I have with Intuit.]   

Obsessing over either the precise composition or the ups and downs of FAANG distracts from a much more fundamental question: What do these businesses really have in common that investors should care about? [AA Comment: Agree. The key question is: Which is THE MOST OUTSTANDING company? He answers it throughout the book.  It’s Google, hands down.]

More fundamentally, the underlying sources of success for each of these businesses are quite diverse. Only one of the five platforms—Facebook—exhibits characteristics broadly consistent with the narrative of the Platform Delusion. [AA Comment: He states that Facebook is a victim of the delusion. In the same chapter quotes Freud! I go with Freud in predicting that the Facebook delusion is only growing, and that Zuck is not standing still. That said, why not just own more Google?]

Much is made in the press of Amazon spending more on R&D than any other company in the world. But as a percentage of overall costs, this still represents a surprisingly low number. And none of this takes into account that by reporting “Technology and Content” costs, rather than R&D like its peers, both the absolute and relative levels of spending are undoubtedly overstated when making comparisons. [AA Comment: Didn’t quite understand his point. Who overstates against what peers? Cost has never been a big part of the Amazon narrative and it still isn’t.]

Facebook spends far less in absolute terms on R&D than any of the FAANG companies other than Netflix. But Facebook and Google are the clear outliers when it comes to relative R&D spending. Both consistently dedicate north of 20 percent—and in the case of Facebook, approaching and in some years north of 30 percent—of its total costs to R&D. [AA Comment: Edwards’ R&D runs at 18% of sales. About half of it is spent on trials.]

…even Google is not only far behind Baidu in China (where Google is a distant fourth or fifth) but also behind Yandex in Russia, and it has meaningful competitors in South Korea (Naver) and Japan (Yahoo). [AA Comment: Google is probably behind North Korea too. So what? And for how long?]

Although product search is a small part of overall search, given the psychic proximity of this subset of searches to spending money, it is among the most valuable. [AA Comment:  Google product search is much better than Amazon. More choices. Better organized. As the ultimate meta search engine, Google is the aggregator of aggregators.]

LinkedIn dominates professional networks and Facebook’s belated job application feature is unlikely to change that.

Chapter 4: Facebook: The Ultimate Network [FACEBOOK]

The power amassed by Facebook, the world’s largest social network, is Exhibit A in support of the Platform Delusion—Facebook is the ultimate network effects driven platform that quickly took over the global market. Facebook is a purely digital creature, something for which the analog world offers no real counterpart. [AA Comment:  It’s most attractive attribute is that it is the purest platform play among big tech. But that can also become a weakness if and when the winds change.  Facebook is all about Direct Targeting (DT).  They do it better than anybody else, including SNAP and TWTR and PINS.  They convert more ads into sales and generate more revenues per user than anybody else. They offer the advertisers the highest ROI.  As Apple pulls cross-App data sharing and Google pulls cookies, it will become harder to get access to good direct targeting engines.  This will only make FB more supreme in direct marketing. It is unlikely though, as some analysts fear, that advertisers and brand builders, will deploy less budget towards Direct Targeting. After product search, it should continue to have the highest ROI, because nothing can beat knowing your audience well.]  

Every new user is a potential new connection for existing users, instantly improving the product with no incremental effort by the company. [AA Comment: This is the essence of network effects. It’s why platforms where creators contribute content, such as YouTube and Instagram, are precious.]

The rise and fall of MySpace—which briefly in 2006 overtook Google as the most visited site in the United States—has been well documented, but years before that there was SixDegrees.com. And who remembers Google’s Orkut, which predated both MySpace and Facebook and owned the Brazilian social market—until it didn’t.

…where the technology is viewed as still changing, consumers will be reticent to become too attached to any product or platform, particularly any one that requires a significant financial or emotional investment.

There is a good argument that Facebook was the beneficiary of propitious timing.

But if someone were offering a demonstrably better deal—free move tickets or iTunes, anyone?—how hard would it be to convince your most important user groups to join you on a new platform? [AA Comment: Making them shift is easier than keeping them engaged. Just because someone starts using another platform for its free benefits doesn’t mean they stop using Facebook.]

When it comes to customer captivity, Facebook is the ultimate Hotel California. [AA Comment:  Yep. They make it really hard, but they have nothing on me because I have never opened an account. Not being a member often restricts my ability to watch a cool video. But it is what it is. Sometimes access is available only through Facebook, but it is almost always just a search away on Google.]

With few exceptions—we can forgive Zuckerberg the Oculus VR acquisition—every major organic and inorganic investment has been directed toward enhancing or protecting the core social network franchise. [AA Comment: Forgive him for what? Zuck has been excited about virtual reality for a while.]

Facebook’s emphasis on efficiency as well as focus, however, has proven an additional tool to both protect and fully leverage the demand and supply advantages that are needed to buttress scale. [AA Comment: Focus is truly key. But Facebook is purportedly very focused on current profits, despite what Zuck says on calls.  Google is much calmer about monetization. Even PayPal is calmer. A deferral of monetization and focus on engagement, can actually make it more likely that a platform stock is underpriced. The poster child of this is Amazon.  But Google is also an example. To be fair with Facebook, WhatsApp is too.]

Facebook has long been famous for an aggressive culture of continuous improvement—which increases satisfaction and ingrains habit while making it more difficult to successfully search out a comparable alternative.

…review of the demise of Friendster shows that after a certain point in social networks, incremental participants—particularly if they are trolls, pedophiles, catfishers, scam artists, or hostile governments—can actually detract meaningfully from value.

That the government has actually filed its long-anticipated suit seeking to break up Facebook is unlikely to have a meaningful impact on the company. Most obviously, the complaint will take years to resolve and is difficult to prove and even harder to implement.

An empire-building CEO ranting to subordinates online may not be attractive, but it is not clear that it calls for government intervention. Even if one day Facebook is forced to divest the two acquired companies, it may be an “existential threat” to Zuckerberg’s social standing in Silicon Valley, but the shareholders will do just fine. [AA Comment: Agree that Facebook will be fine. Disagree his standing will diminish in Silicon Valley. People have disliked Zuck for years.]

Earlier we noted the irony of the fact that it was trust that allowed Facebook to permanently overtake the many social networks that preceded it. Another irony, not widely appreciated, is that there is strong evidence that Facebook’s enormous scale has enabled it to combat “fake news” and other subversive forces on the internet far more effectively than its smaller peers.

The good news for Facebook, or whatever alternative “social mechanic” succeeds them, is that contrary to the simplistic conceit of the Platform Delusion, the business does not rely simply on the flywheel of network effects. If it did, recent events would have ensured a swift exodus of users to any number of competing social platforms.

…focus on serving already established networks and continuously investing in tools to demonstrate the value of the platform ensured a significantly stronger level of customer captivity once scale was reached.

Chapter 5: Amazon: Can You Have Too Much of a Good Thing?

It would be almost a decade after Amazon’s founding in 1994 before it launched the “marketplace” business that does indeed benefit from network effects. [AA Comment: So what? It took T. Rowe 13 years to introduce his first mutual fund.]

But how insurmountable is this scale advantage really? … Amazon’s continuous upping of the fixed-cost table stakes in online retail is a sensible strategy to protect scale advantage. [AA Comment: Scale advantage is like late-night alcohol consumption. It starts weighing after it stops growing.]

Using Amazon as the poster child, as many do, for the case of a company for which “almost every human interaction is removed from the actual critical path in service delivery” is a stretch in light of the company’s one-million-plus employees. [AA Comment: I have often contrasted Amazon’s offerings to those of Google. One requires tremendous work to deliver the incremental dollar.  The other requires none. As  Larry Hite states in his book, The Rule (2019), the best businesses are those that make money while you sleep.]

It is the local density, not the overall size of operation, that overwhelmingly drives the economics. [AA Comment: Any good transportation analyst understands this, but it also applies to cable networks, auto parts, and pest control.]

The fact that Amazon profit margins fell in its core North American market in 2020 (as they had as well in 2019) even as the pandemic boosted sales by almost 40 percent is suggestive of the modest nature of Amazon’s scale benefits in retail.

Although Prime has been able to successfully implement membership fee increases along the way, these reflect little more than inflation rather than the full extent of incremental value the service provides.

The fact that Amazon feels a need to give away a service that is not only costly to provide but also exhibits notoriously high customer churn reflects how thin Amazon’s customer captivity is even after all the hard work.

An obscure antitrust law designed originally to protect small retailers from chain stores using their clout to impose restrictions or secure preferential terms with suppliers and manufacturers would appear to have the greatest potential application to Amazon. But that law, the Robinson-Patman Act of 1936, has been gutted by the courts and fallen into disuse by the regulators.

Why would Amazon need to buy Diapers.com—only to shut it down six years later—if the advantages of its broad platform were as deep as suggested? And how could the founder of Diapers then go on to build an alternative “platform” in just a year that was compelling enough to attract a $3 billion bid from Walmart to use as the engine of its competing e-commerce business?

One wonders whether the only thing that is stopping him [Bezos] from now buying Wayfair or Chewy—the online retail leaders in furniture and pet products, respectively—is the same thing that stopped Mark Zuckerberg from buying Houseparty or TikTok: fear of government intervention. [AA Comment: When I first read The Everything Store (2013), my biggest takeaway was how ruthless Bezos was at undercutting his acquisition targets before buying them. I believe we could see regulators questing that one day.]

In The Curse of the Mogul, my coauthors and I demonstrated that there was indeed a significant correlation between revenue growth and value creation among the largest media conglomerates over almost a quarter century. Unfortunately, that correlation was decidedly negative. The conglomerates had achieved growth largely through overpriced acquisitions and foolish internal projects. [AA Comment: Think Disney’s latest massive deal ahead of Iger’s exit and his victory lap auto-biography.]

Before turning to an examination of each of these in turn, let’s start with an obvious but highly pertinent observation. Over its history of growth, Amazon, like every other company, added the products and geographies with the greatest opportunity first, moving down the list to less-obvious opportunities. [AA Comment: Law of diminishing returns.  It implies that each incremental initiative is less attractive.  People have said this about ORLY’S and AZO’s store expansion program for decades. In reality (i.e. in practice), it does not have to work that way. I think Knee’s conclusion overlooks how the growth of the network creates new attractive growth options and degrees of freedom, that were not available before when the network (or platform), was smaller. This phenomenon is seen with Ansys, a simulation software roll-up.  The more verticals they explore, the more new verticals become available. Some of those they buy and others they pursue organically.  The stock has done great over the decades and the growth prospects look even more attractive today than they did 10 years ago.  Amphenol is another example of this.  When they had just connectors, there was less opportunity to bid on integrated solutions.  Now that they are deep into sensors as well, nobody can touch their offerings.  In their latest call on October 27^th, Amphenol’s CEO said about their penetration of the auto electronics vertical, where electric cars are a big driver of growth: “Our strategy is not to take share from other companies. It is to make things happen in the car.”]

The online home category leader Zillow took a hit to its stock a few years ago when Amazon added a web page hinting at expansion into real estate referrals. The page soon disappeared, Zillow has continued to soar, and Amazon is mostly limited to selling small prefabricated homes—with free shipping—online.  [AA Comment: Interesting he mentions Zillow and Bloomberg, but does not mention Costar.  Despite being a software and platform rollup and growing top line by 25% annually over the last two decades (half through M&A), a seasoned investment banker in the space never mentions it. That is interesting evidence that the CSGP is under-appreciated and still largely undiscovered.]

The hugely disappointing performance of Cars.com since it spun off as an independent company several years ago is reflective of this structural sectoral infirmity—as is the inability of the company to find a willing buyer even after it put itself up for sale. [AA Comment:  Cars.com was bad, but not hugely disappointing. Like Mirant and Delphi, it was spun off, with the assistance of smart bankers, to die.]

If every number one player in a market could easily become the number one player in every other market, all the markets would have a lot of number one players!

[Amazon] has taken considerable share from off-line retailers. Internationally, it faces not just these corresponding off-line retailers, but scale online players as well.

If India is Amazon’s most promising international opportunity—it certainly will be its most costly—investors can be forgiven if they don’t place much stock on the odds of the company achieving a higher return on investment than it did in China. [AA Comment: Investors can be forgiven? Just say it: You think India and China won’t work for Amazon.]

Even if Amazon lacks strong entry barriers in its original core commerce markets, it is still a great company. Whether it is worth its current valuation, however, is another question. [AA Comment: Hasn’t it always been? I’d say less so today than 10 years ago when people didn’t appreciate the strategy, nor the value of AWS.]

Today, although more goods are sold through the Marketplace than directly by Amazon, it still represents only a tiny portion of overall revenues because rather than the full price of the products sold, the company only receives a commission. [AA Comment:  They could probably charge higher commissions and get away with it. For every merchant that leaves Amazon, many more enter. This is because merchants need sales, above all, and Amazon has plenty.]

On its face, the financial wisdom of many of the additional benefits subsequently provided to Prime members, notably Prime Video, is highly questionable. Similarly, the return on investment of the move to same-day delivery, quickly mimicked by multiple competitors, seems unacceptably low.

Amazon’s formidable franchise has emerged from a combination of “relentlessness and ruthlessness” on the one hand and “a rope of many small advantages” on the other. Its aura of invincibility, however, is not justified and the potency of this mixture of attributes varies widely across markets. The overall return on investment of its future e-commerce growth trajectory is likely to remain modest. [AA Comment:  I wouldn’t be so negative.]

Chapter 6: Apple: What’s at the Core?

After Jobs’s triumphant 1997 return to the company, Ellison was the first new board member selected once the old guard was shown the door. Ellison has no doubt about what distinguishes Apple: “Steve created the only lifestyle brand in the tech industry.”

The fact that every few years brings the introduction of new luxury car brands suggests that strong incumbent brands do not represent a significant barrier to entry.

The introduction of the iPhone and iPad transformed the economics of Apple not simply because they were both wildly successful products. Rather, for the first time, the rapid adoption in both instances allowed Apple to benefit from deep network effects, which had previously eluded the company.

The real revolution began the next July when Apple introduced the much faster iPhone 3G at a $200 price point—and the App Store. At launch, the App Store carried around 500 applications, many from approved outside developers who had happily agreed to a 70-30 revenue split. Despite being “widely hailed for its beauty and functionality,”

A year after the App Store appeared, it would have 50,000 apps, which had been collectively downloaded more than 1 billion times. Ten years later the store would have over 2 million apps and 20 million registered developers. The store generated more than $100 billion of very high margin revenues over that first decade.

This led many to anticipate a replay of the earlier war between closed and open systems that had led to the resounding defeat of Apple by Microsoft and the IBM clones in the 1980s. And sure enough, smartphones powered by Android overtook iPhones in the US by 2010.

What has changed in recent years, however, is the extent to which loyalty to the Android OS has come to match or exceed this. Both operating systems retain around 90 percent of users within their respective ecosystems when they buy a new phone.

Yet ultimately Jobs knew it was all about the product. So, when he confided in Walter Isaacson that “Tim’s not a product person per se,” one wonders what Jobs really thought about the company’s long-term prospects.

…or relatively narrow niches where even great success would make a modest contribution (e.g., AirPods). Nothing, in short, is anticipated to move the needle.

Apple began to make it clear where it wanted investors to focus—and where not—in 2018. To the anger of research analysts who had long tracked the company, Apple announced in November 2018 that it would no longer report iPhone unit sales. The following quarter, Apple for the first time began reporting the relative profitability of the product and services businesses, which highlighted both how much more inherently profitable the services business was and how much faster it was growing. [AA Comment:  Not that I would dare call Apple a short, but carving out a faster growing, yet much smaller, piece of the business is how bad narratives get spun (think GM, INGR, TAP).  I can give many examples of this mental accounting practice being put to work, and most ended badly.]

Given the relative growth and profitability of services, they could account for a majority of Apple’s revenues by 2030 if current trends persist. This shift should in theory strengthen the overall Apple franchise. [AA Comment:  Ten years is too long of a time away in Tech land.]

Although it is not possible to identify precisely the extent to which the problem was the product itself or the limitations of the brand, over the years Apple has disappointed in watches, televisions, video game consoles, and more. [AA Comment: Not everyone believes that, but ok.]

As we move to the realm of ubiquitous low-priced streaming video services, the value of the Apple luxury brand is even more tenuous. Here the core value proposition is not technological or design pizazz but rather the provision of compelling proprietary entertainment content.

I subscribe to HBO to get Game of Thrones, not the other way around. [AA Comment:  Great one liner!]

Chapter 7: Netflix: Content Was Never King and Still Isn’t

“Content is king” is generally treated as a self-evident notion, universally embraced by professionals and the public alike. The origins of the phrase are alternatively attributed to media mogul Sumner Redstone and tech icon Bill Gates (neither actually coined it).

In his autobiography, Sumner Redstone, who had controlled ViacomCBS and consequently the TV network CBS and film studio Paramount Pictures, traces his epiphany about the supreme importance of content to his early days in the movie exhibition business. “You can have the most beautiful theater in the world,” Redstone realized, “but if you don’t have a hot picture, forget it.” This led Redstone to the broader point regarding entertainment viewing: “They watch what’s on it, not what it’s on!”

What modest profit the largest content players do eke out has typically come from the ability to monetize ancillary businesses in marketing and distribution that do scale. [AA Comment:  This is what Disney has done, and continues to do, best.]

Over the years, there have been plenty of arguments—with expensive consequences for a long list of short sellers from Whitney Tilson in 2010 to Andrew Left in 2019—that Netflix should not be as successful and as highly valued as it is.

In fact, the dirty little secret of the media industry is that content aggregators, not content creators, are the overwhelming source of value creation.

Although much of the public discourse surrounding Disney’s $71 billion purchase of 21st Century Fox earlier in 2019 involved the excitement over the uniting of Fox studio’s X-Men and Fantastic Four franchises with the rest of Disney’s Marvel multiverse, most of the profit of the business being purchased came from elsewhere—both the regional sports networks that Disney would be forced to divest as well as the collection of domestic and international cable networks that were kept contributed far more than the filmed entertainment division.

The structural superiority of the content aggregation business to the content creation business should not come as a surprise. The economic structure of the media business is not fundamentally different from that of business in general.

Aggregation, on the other hand, by its nature requires a large fixed-cost infrastructure to collect, manage, market, and redistribute content. This is why a cable channel with 20 million subscribers loses money but an identical one with 100 million subscribers might generate 50 percent margins.

Without the fixed-cost requirements associated with producing and distributing CDs and managing racks at Tower Records, the barriers to entry into music are not what they used to be. The detriment of increased competition simply outweighs the benefit to established businesses of lower fixed costs.

Netflix’s ability to spread the fixed costs of content, marketing, and technology across a subscriber base vastly larger than any other competitor’s is continually reinforced by superior customer service, a powerful recommendation engine, and a great, habit-forming product.

Only in the media industry, however, would it seem a paradox that owning the exclusive broadband pipe into the home at a time of exploding usage makes for a good business. Relying on dumb pipes instead of expensive content or talent is always the smart bet.

It is hard to envision a happy ending for shareholders given these continuing trends, notwithstanding the stock outperformance of not just Netflix but Disney in 2020. [AA Comment:  He seems surprised that Disney outperformed in 2020.  It hasn’t been doing that great in 2021.]

In 2018, Hulu had 25 million domestic subscribers, a little under half of Netflix’s 58 million US subscribers at the time. Just a couple of years earlier, a respected Wall Street research analyst argued that Hulu’s value was $25 billion based on a much more modest subscriber prediction for 2018. But the analyst assumed 2018 profitability. In fact, losses had accelerated along with the subscriber count, far exceeding $1 billion.

What is known is that, based on some internal Amazon documents obtained by Reuters in 2018, the number of Prime members that actually watched any video was less than a third—today, not much more than the 28 million who actually pay for a Hulu subscription.

Netflix’s decision to begin financing original films in 2015 made sense given the disproportionate share of viewing that films had always represented in Pay TV. That said, film production is a very different undertaking than producing television series.

The moral here is not that Netflix shouldn’t invest hugely in original production. Indeed, in the face of the competitive onslaught it makes absolute sense to press its relative scale to heighten the fixed-cost price of entry.

In Platform Revolution: How Networked Markets Are Transforming the Economy and How to Make Them Work for You, three consultants and academics similarly argued that Netflix has strong network effects.

It is worth noting that Netflix itself has largely eschewed claims of network effects. Reed Hastings contrasts companies like Netflix that have “normal scale economies” with “those rare businesses like LinkedIn and Facebook where there are network effects.” It was not for want of trying.

Hastings ultimately described his futile quest for network effects as a “competitive fantasy.”

As Netflix only somewhat hyperbolically likes to describe it, there are as many customized “different versions of Netflix” as there are subscribers.

This is especially true in light of the company’s decision in 2010 to stop reporting customer churn, even in the face of SEC resistance, based on the obviously specious justification that it is inadequate as a “reliable measure of business performance.”

Estimates of Netflix annual churn mostly have ranged from 20 percent to over 35 percent.

…according to Carr, “Netflix was able to find a Venn diagram intersection that suggested buying the series would be a very good bet.” This narrative is so ridiculous on its face that one would not feel a need to rebut it were various versions of this story not repeated so relentlessly. [AA Comment:  That’s an aggressive statement.]

Soon after the triumph of House of Cards, Netflix committed to a series more than twice as expensive—Marco Polo. Marco Polo was one of the first Netflix series to be canceled.

…the Nielsen ratings service claims that by 2024 it will have developed an entirely new ratings metric that incorporates digital and traditional viewing. [AA Comment: Nielsen said that 5 years ago. It is one of the biggest losers in the space.]

Birdbox and Murder Mystery are in a class of mid-budget films that are neither sequel nor spinoff that have stopped being economic for theatrical distribution—even when topped off with a big-name star (or two).85 Netflix has demonstrated that there is still a demand for some of these at least at home. What big data has not done, and will not do, is provide a template for how to make them well.

Hastings’s 2020 book with Professor Erin Meyer on the company’s culture and management philosophy, No Rules Rules: Netflix and the Culture of Reinvention, contains a number of anecdotes about programming decisions at the company. What is most notable about these descriptions is just how small a role data appears to play in practice. [AA Comment:  That is true.  I loved this book, but did not take note of this because I read it with a different purpose. The book about TikTok, on the other hand, was all about data.]

As of 2020, although most of Netflix’s new content is original production, the vast majority of what is watched remains licensed.

…the winner in most markets is someone who let others undertake what is effectively free R&D for them and only invests big once greater visibility emerges as to the shape of demand and technology requirements.

Monster.com was the original online employment classified site and one of the earliest successful internet IPOs in 1996. After going public at $7, the stock reached a peak of $91 in 2000 at a valuation approaching $10 billion. It was bought by a global staffing company for a few hundred million dollars in 2016, having long been marginalized by direct broad-based and niche competitors like CareerBuilder and dice.com as well as entirely new competitor categories like LinkedIn and Indeed. [AA Comment:  The firm I used to work at then got killed in this name.]

In SVOD, Disney appears to have committed itself to this strategy and has the assets required to achieve scale, even if the financial returns realized on the road to getting there seem bleak. None of the other emerging competitors seems to have the combination of skills, resources, or commitment required to become a long-term global Netflix competitor. [AA Comment: Many people conclude Disney will succeed, but what does success really mean? I doubt Disney’s business will be more profitable in the future than it was five years ago, no matter how much mental accounting they do.]

While it was strategically sensible for Netflix, the business of taking creative risk has always yielded paltry long-term financial returns. [AA Comment:  You can say the same about Amazon and Tesla.]

Google’s longtime chief economist, Hal Varian, wrote a strange blog post a dozen years ago arguing that a single attribute explains the “secret sauce” behind its remarkable results: learning.

This relative success with the federal regulators was achieved despite the fact that Google represents the most impregnable competitive fortress among its FAANG brethren.

Chapter 8: Google: Letter-Perfect Alphabet

Like Netflix, Google started life as a pure aggregator—as its corporate mission “to organize the world’s information” makes clear. Unlike Netflix, however, the depth of Google’s structural advantages ensured that it never needed to go into the content creation business in any serious way.

If Microsoft couldn’t make a dent with Bing after over a decade, it is small wonder that DuckDuckGo has fared no better. Those few who can still claim relevance in the market are restricted to a protected geography (Baidu in China or Yandex in Russia) or niche search use case (Amazon in product search).

…there is little question that Google’s greater familiarity with prior search behavior drives a scale advantage on the demand side by facilitating the effective customization of the selection and presentation of search results for individual users. … So to the extent that there is a direct network effect on the user side of search, it is overwhelmingly driven by the number of one’s own prior searches rather than the number of other searchers.

AdExchange, Google’s real-time bidding exchange for premium publishers and big brand advertisers, benefits from the same network effect dynamic.

Notably, AdSense and AdExchange—collectively reported as Google Network Members’ properties—Google’s businesses that benefit most strongly from network effects, are a fraction of the size of the core search business that benefits predominantly from supply-side scale. The advertising revenue from this segment is less than a fifth of the revenue from Google’s owned search properties, including Google.com, YouTube, Gmail, and Maps. And that proportion has been falling for years.

Customer loyalty, from both searchers and advertisers, to Google’s search engine is a critical factor reinforcing the benefits of scale. Users become more effective at using particular search programs with experience, and that experience makes the incumbent search engine more effective at delivering relevant results.

…the Justice Department’s 2020 antitrust suit ultimately decided to target an entirely different aspect of the business for the time being. Even if the federal government decides to revisit this topic later, or if the state lawsuit that focuses on it is successful, it will have little impact on the overall customer stickiness of Google’s franchise or of its ability to invest more than anyone else to make the experience even better.

The track record of Google, however, suggests that search represents a use case in which the integrated advantages of data-driven learning and technology are persistent and continue to grow without topping out.

This kind of virtuous cycle between Google’s learning-enhanced proprietary technology and network effect supported customer captivity among both users and advertisers on the one hand and traditional cost–based economies of scale in R&D and other areas suggest that its remarkable economic performance is likely to endure.

Until the restructuring, Schmidt conceded, “a disproportionate part of the day would be spent on moonshots.”

Many questions remain with respect to the future of Alphabet. The Economist has expressed skepticism over whether the increasingly corporate management team has the vision to transition the famously engineering-centric culture through middle age.

Although with new leadership it has accelerated growth more recently, that Google Cloud remains a distant third is reflective of the deep challenges in building a sales culture from a standing start.

As early as 2014, the company realized that an “over-glamorization” of moon shots at the expense of “methodical, relentless, persistent pursuit” of opportunities closer to home had been costly to the company.

Apart from Google’s clever government and public relations efforts, the federal government’s decision to tailor its challenge narrowly to Google’s commercial deals with Apple and others to serve as the default search engine is likely driven by one primary consideration: it’s a winner.

In its most recent 10-K, Google quietly removed its insistence that it would not pay a dividend “for the foreseeable future.”

Perhaps the most important lesson of a close study of Google is the most obvious one: wherever possible, at least when it comes to its core advertising franchise, avoid competing with it.

While there is value to analyzing the impact of each particular competitive advantage, this should not distract from the overarching insight that Google’s singularity stems from the unparalleled breadth and depth of its collection of mutually reinforcing competitive advantages.

Part III: In the Shadow of the Giants

Chapters 10 and 11 are dedicated to travel and tourism, which contribute something approaching $10 trillion to world GDP.1 Although it is not, as sometimes falsely claimed, the world’s largest industry,2 it does display a number of other characteristics that justify two full chapters. The sharing economy is responsible for a disproportionate number of the highest-profile digital IPOs of recent years. The companies that fall under its rubric represent quintessential platform companies that create value by connecting holders of excess capacity with potential users of it. Chapter 12 documents the huge variations in the attractiveness of some of these businesses, despite the obvious similarities, particularly between the two largest—Airbnb and Uber.

Chapter 9:  E-Commerce: If Amazon is the Everything Store, What’s Left to Sell?

Consumer proclivity to shop online varies dramatically by product and Amazon’s relative success online varies as starkly by category. It is notable that two of the relatively small number of large-cap consumer internet companies are e-commerce retailers in categories that one would have expected Amazon to dominate if the Platform Delusion were true.

Amazon does not and is not likely to play a leading role. As noted, while the transaction volumes in these markets have continued to swell, the economics have deteriorated. These platforms are squarely in line with the long-term underperformance of e-commerce platforms generally.

During the three years leading to 2018, the percentage of e-commerce activity overall represented by marketplace models grew by over 50 percent—jumping from only 30 percent in 2015 to approaching half of all online retail transaction value. As of 2019, marketplaces represented 57 percent of the global e-commerce market.

Research firm BTIG has noted that investors in independent marketplaces are “perpetually petrified of competition from Amazon, Facebook, and Google.” After reviewing the data, however, they concluded that “investor concerns are largely unwarranted.”

..one of the most serious charges against Amazon that is subject to regulatory scrutiny is that it actually used data from its own sellers to launch competing products—hardly an indication of an unwillingness to offend vendors on its platform. [AA Comment:  This is my biggest rub with Amazon.  It actually uses customer data to compete against the customer.  That’s not a win-win.]

At the time of its IPO a decade later, almost 90 percent of Etsy’s traffic was still secured organically rather than through search or paid channels.

Sotheby’s, arguably the leading off-line brand for expensive antiques, had lost millions trying to build an online platform—including through failed joint ventures with Amazon21 and later with eBay.

when Etsy raised its commission from 3.5 percent to 5 percent, the stock soared despite predictable seller grousing based on investors’ correct prediction that it would have no negative impact on the number of merchants.

The playbook involves copying those attributes Amazon has now established as the price of entry in e-commerce (e.g., service and shipping) but overlaying a deeply customized variation for a product category and community that is challenging for Amazon to effectively replicate. The ability of Wayfair to challenge Amazon as the leader in online furniture sales more broadly is further evidence of this.

Etsy confronted a much more direct attack with the launch of Amazon Handmade in 2015, just months after its IPO. Its shares struggled for years as it took incremental hits with every new announcement from Amazon—for instance, establishing the “Amazon Handmade Gift Shop”44 and the availability of Handmade product for immediate Prime Now delivery in certain cities.45 Performance only turned around when investors noticed that Etsy’s organic growth was actually accelerating in the face of the Amazon onslaught.46 This suggested the surprising possibility that Amazon’s marketing efforts served mostly to draw attention to the category, benefiting Etsy as the category leader!  [AA Comment:  I call this the Robert Wilson Theory. It happened to Intuit when Microsoft came after its accounting software, Quicken, and with Edwards when Medtronic came after its heart valves.]

If Etsy and 1stDibs demonstrate how the combination of strong network effects bolstered by product complexity and fragmented buyers and sellers can yield remarkably resilient digital marketplace franchises, their example does not demonstrate that these qualities necessarily imply invincibility

Despite the intuitive appeal of selling auto parts online, as a category overall, it is one of the least e-commerce enabled.

Amazon launched a vehicle portal in 2016 that offers increasingly complex tools to identify the right part for specific models along with reviews and advice. This level of functionality has become table stakes for anyone looking to compete in the sector.

The four giant retailers would make a huge mistake if they simply rested on their structural advantages. With smart investments that leverage their unique assets, they should be able to maintain long-term growth and above-average financial returns—even as pure digital continues to capture some more market share.

Some estimates suggest that Amazon and eBay divide a $10 billion marketplace business 60-40, and in certain product and customer categories, eBay probably remains the leader.

As Amazon faces attack from broad-based off-line incumbents like Walmart and Target, who are pursuing their own hybrid strategies, specialization and complexity will continue to provide meaningful protection for incumbents and opportunity for innovative insurgents.

Chapter 10: Fly Me to the Moon: Who Makes Money When Air Travel Goes Digital?

In the larger consumer services sectors, Amazon’s track record is even weaker. Its financial services initiatives in payments, lending, and credit cards have at best failed to make a dent and often, as in the case of Amazon Wallet, have completely collapsed.

In addition to the substantial off-line investment required to establish and maintain a consumer brand, all of these businesses needed to dedicate substantial resources to secure a favorable relative position at the gateway to most consumer journeys: Google.

…when Google bought its own metasearch company, ITA Software, in 2011 to power its flight-search tools, this accelerated the increasing importance of the metasearch channel.

Unlike OTAs, GDSs’ scale advantages are strongly reinforced by strong customer captivity on both sides of the market. Remember that GDSs started life as among the first enterprise software companies on record, an industry characterized by long-term contracts and high switching costs.

Amadeus, the overall leader in this segment as well as the industry, now earns over 40 percent of revenues from IT solutions.

Like the airlines’ establishment of the GDSs, the original credit card companies were created and owned by the banks themselves. Although these companies did well after they achieved their independence, many expected that Visa and Mastercard would be disintermediated with the birth of the online payments industry. In the early days of first mover PayPal, the company tried to do just that by incentivizing customers to use their bank account information rather than credit card numbers. But in 2016, PayPal eventually realized that trying to go around rather than leveraging the incumbent credit card networks would dramatically slow its own growth—and most significantly was creating opportunities for fast followers like Apple Pay and Android Pay.38 The resulting growth of PayPal39 and of the broader online payments sector that has emerged has only served to accelerate the value appreciation of the credit card networks. The shares of both Visa and Mastercard appreciated more than ten times over just the last decade. And while the new online payments sector has exploded, with not just PayPal but dozens of internet unicorns created, none of these new platforms come close to the value of either of these two over fifty-year-old incumbents. Indeed, that entire industry is probably smaller than the combined value of Visa and Mastercard.

Chapter 11: “To Travel is to Live!” How Priceline Became Worth $100 Billion

What is now Booking Holdings started life in 1997 as Priceline .com, the “Name Your Own Price” business made famous by commercials starring William Shatner. Although the company only changed its name in 2018, almost two decades after it went public, the reliance on the original sketchy business model had been minor for over a decade and the connections to the sketchy founder completely severed for even longer.

By the time Walker left the company and resigned from the board at the end of the year, Priceline’s shares had sunk to little over $1.13. He sold most of his remaining stake in the company over the next summer, largely severing his ties. … Icahn’s continuing enmity for Walker led him to be one of the few winners from Priceline’s stock collapse; he shorted it all the way down.

Shortly after 9/11, General Atlantic pulled the plug on funding. The failure of these organic efforts laid the groundwork for the transactions that would transform the company.

But Booking, although it has diversified into metasearch and some mostly related software businesses, is still overwhelmingly an OTA. The ability of this single company to dwarf the size not only of the entire GDS industry but all the other public companies in the OTA sector combined is attributable primarily to one factor: the difference between hotels and airlines.

When it comes to product complexity, hotels are a different matter altogether. Visiting New York for a romantic getaway? There may be only a few airlines flying your route, but once you arrive, there are almost seven hundred different hotels, of which almost five hundred are in Manhattan. And these hotels have more than a hundred thousand rooms, only some with a view.

For example, there are many drivers of the respective fates of the world’s two largest financial data providers, Reuters (later Thomson Reuters and now Refinitiv) and Bloomberg. But the single most important factor that enabled Bloomberg to overtake Reuters even with a century-long head start was that Bloomberg targeted fixed-income markets while Reuters’s historic core franchise was foreign exchange. Not only do the number of outstanding bonds dwarf the number of stocks, but the number of financially relevant terms of each—from call dates and premiums to indentures and change of control terms—is vast. Notably, this very complexity lends itself to the development of sticky software and analytic tools to track, manage, and compare the various securities. [AA Comment: It’s one of the reasons Moody’s and S&P add so much value.]

The Hotel Association of the City of New York represents more hotels than the International Air Transportation Association represents airlines globally.

Where airlines are able to enforce a roughly flat $5 per flight fee, with the GDSs able to retain at least half from all but the largest travel agents, hotels typically pay travel agent commissions of between 15–30 percent with the GDSs receiving a tiny portion for the use of their distribution infrastructure.

The bad news for the OTAs is that the largest hotel chains keep commissions closer to 10 percent.

The good news is that the top five hotel brand companies only control around half the US’s hotel rooms (the top four airlines control two thirds of the market) and far less internationally.

Best Western CEO David Kong conceded, “We basically repeated the same mistake again.”

From the end of 2009, the year that it permanently overtook Expedia’s equity value, until the end of 2019, just before COVID-19 disproportionately devastated all the travel-related equities, Booking Holdings shares had grown almost tenfold. That’s more than double the compound growth rate of the overall market. Meanwhile, Expedia actually lagged the market over this period.

Expedia relies more on low-margin airline bookings. Expedia’s revenues are also much more derived from the US, the market in which both the airline and hotel industries are most concentrated.

A subtler but equally notable distinction between the two businesses, however, relates to two different ways of selling hotel rooms—the merchant model and the agency model.

With the agency model, all that needs to be agreed on is the commission, but merchant deals involve negotiating a more detailed contract covering the net price and the inventory that will be made available. When trying to build scale quickly in a business characterized by network effects, speed is critical.

Booking had a significant advantage over companies like Expedia who were committed to the merchant model as the “superior” approach. Expedia had looked at both Active and Booking but passed because, as former CEO Dara Khosrowshahi conceded, “we were attached to the merchant model.”49 Specifically, the company had become used to benefiting from the attractive working capital characteristics of holding on to travelers’ money and the higher room markups available.

Booking Holdings has built a powerful franchise benefiting from both demand- and supply-side scale and reinforced by the customer captivity of those hotels who have come to rely on its marketing might and various software tools to attract and manage customers. But it turns out that even Booking, which dwarfs the entire GDS industry and all of its OTA competitors combined, is not the biggest kid on the travel industry value chain block. That moniker belongs to our old friend Google. When Google has a bull’s-eye on your business, you have every reason to be very afraid.

Within what quickly became a crowded space, TripAdvisor stood out for the intrinsic power and ingenuity of its model. Founded in 2000, by the time it went public in 2011, the site boasted over 50 million reviews and had established itself as an indispensable content destination for prospective travelers. The overwhelming traffic demonstrated the network effects of the model—travelers want the most recent relevant reviews of properties they are considering and reviewers want to share with the widest possible audience. As recently as 2018, the Guardian newspaper said, “TripAdvisor is to travel as Google is to search, as Amazon is to books, as Uber is to cabs—so dominant it is almost a monopoly.”

TripAdvisor remains a metasearch company and it relies on advertisers (of whom Booking and Expedia are by far the largest) who want access to the users planning to take a trip. And although the strength of its unique network effects driven review content helps its position in organic search results, nothing provides a long-term solution to sitting between Google and your two biggest customers, all of whom have their own competing metasearch capabilities.

The failure of TripAdvisor as a network effects driven digital platform to deliver the kind of performance predicted by the Platform Delusion highlights the critical importance of other structural attributes—here the lack of diversity of key network participants and low switching costs—in determining success.

Chapter 12: It’s Nice to Share, Sometimes: Why AirBNB Will Always be a Better Business than Uber

The basic economic problem of how to optimize asset utilization is not new. In the case of assets under shared ownership, this topic captured the attention of economists almost two hundred years ago under the rubric of the “tragedy of the commons.”

…the existence of network effects in itself tells an investor relatively little about the attractiveness of a particular business.

…even between apparently similar business models within a relatively narrow definition of sharing platforms, there is significant variability in quality.

Although Uber had consistently been valued at a multiple of Airbnb, the key market and product attributes that drive sustainable franchise value suggest that it is Airbnb that has always been the better business.

…it is far from clear that the ride-sharing market—unlike the space-sharing market—is really global. As a result, in any given market, Airbnb is likely to face the same handful of players while Uber is more likely to also confront significant local or regional champions.

Two primary attributes are responsible for the superiority of Airbnb over Uber: product/service complexity on the demand side and the fixed-cost requirements on the supply side. The former determines how many network participants are needed for a viable product and the extent to which additional network participants continue to enhance the product. The latter determines basic break-even economics and the relative financial advantage of being larger than competitors.

In ride hailing, other than price, the ability to deliver a car within three to five minutes dominates all other customer considerations.

In the short-term lodging market, by contrast, there are many more salient product characteristics and market segments.

…evidence suggests that more listings not only attract more travelers but also drive higher occupancy rates. This dynamic reinforces the value of relative network scale on the demand side for Airbnb that is far greater than for Uber.

…some markets, like Brazil, competitors number in the hundreds, representing a mix of global giants like China’s Didi and low-cost services with basic homegrown apps.

…by being a fast follower, Lyft historically has been able to free-ride on Uber’s investments to clear the regulatory way for the service.

…although a small minority of riders overall currently use multiple ride-hailing apps, that percentage is growing fast and varies widely by geography and demographic. Among my MBA students in New York City, it is already greater than 90 percent.

…the fact that Booking claimed in 2018 to have surpassed Airbnb in alternative accommodations listings, but generated only $2.8 billion of revenue from them that year compared to Airbnb’s $3.6 billion suggests the inherent value of specialization within the category.

Chapter 13: Mad Men, Sad Men.  Advertising and AdTech Meet the Internet

The precipitous fall in how much an advertiser will pay for a digital impression corresponds to the exponential expansion in available online advertising inventory. What’s more, now that technology allows users to be followed around the internet by advertisers, attracting a unique audience only gets you so far: programmatic advertising software can deliver the exact same users when they are on some other site at a lower price.

Online advertising on both desktop and mobile had been facing a relatively steady decline in their respective rates of growth for almost a decade by the time digital came to overtake traditional media in 2019. More concerning is the extent to which the growth has been disproportionately captured by Google and Facebook. Some analysts have tried to demonstrate that in some years, all of the net growth in digital has accrued just to these two players—or that the rest of the digital advertising universe was actually shrinking.

The slightly longer answer is that these two businesses operate in exceptional domains where technology provides the ability to leverage their relative scale to deliver continuous, uncapped improvements in the effectiveness of the advertisements that they deliver. It is not just that they both have loads of data, it is that they have data of the kind that is uniquely relevant to advertisers. Netflix, with over 200 million subscribers glued to their screens around the world, generates lots of data. But it historically hasn’t bothered with advertising not only because of the risk of alienating its customer base but also because the data about what shows and movies you like is just not that pertinent to advertisers.

Your web of social interactions and communications (and increasingly what you buy online and off-line) is the exclusive province of Facebook. This is the kind of data that machine learning and, yes, artificial intelligence can transform into increasingly accurate predictions about which ads will be most impactful to which users. So Google and Facebook dominate online advertising because they deliver an increasingly more effective product than anyone else can.

In 2020, Google announced that it intends to eliminate third-party cookies from its dominant Chrome browser by 2022. This may be good for your privacy but it is also definitely good news for Google’s business.

By January 2017, Fred Wilson of Union Square Ventures was predicting that the “adtech market will go the way of search, social and mobile as investors and entrepreneurs concede that Google and Facebook have won and everyone else has lost.”

No industry has been more impacted by the transformation of the advertising industry landscape than the giant advertising agencies. As they face their collective existential crisis, the sector has overwhelmingly decided to literally bet its future on the anticipated adtech-martech convergence.

…the relative growth of online has driven and continues to drive decreases in the relative share of advertising going to branding rather than performance campaigns.

Fortune 500 companies that dominate ad holding companies’ client lists—the CPG giants remain a quarter of their revenues—themselves now represent a much smaller fraction of overall advertising.

Increasingly, brands themselves—most recently these include McDonald’s, Nike, PayPal, and Walmart—are making adtech and martech acquisitions.

This confusing cacophony of technologies seems a tailor-made opportunity for a different kind of business from ad agencies to exploit: consultants. [AA Comment:  He mentions Accenture once after this comment, but only as part of a list of consultants.]

…the consultant’s inorganic growth has not just been through technology buys but through the purchase of creative agencies as well.

Interpublic, Publicis, and Dentsu have collectively spent well over $10 billion—in the case of Publicis, almost as much as all of their previous acquisitions combined—on data-driven marketing solutions companies.

The case of Publicis is particularly instructive. In 2015, the company purchased digital marketing consultant Sapient for $3.7 billion. At the time, Publicis claimed that the combination would represent the “agency of the future” by establishing itself as “a leader at the convergence of marketing, commerce, consulting, and technology.” Less than two years later, the company would be forced to write down $1.5 billion of the purchase price after the hoped-for benefits failed to materialize.

In adtech, the opportunity to create a scale player to aggregate the fragmented inventory outside of the two massive walled gardens has been realized by the largest demand-side platform (DSP), The Trade Desk (TTD). Founded by two former Microsoft executives, TTD outflanked competitors by positioning itself as a friend to the advertising holding companies, eschewing efforts to disintermediate them by going directly to their clients. This allowed TTD to quickly gain relative scale by aggregating these massive sources of advertising demand and attracting publishing partners offering placement. The resulting network effects were reinforced by the supply-side scale benefits from continuous investment in enhanced software tools, the captivity of close customer relationships reflected in percent customer retention, and clear opportunities to leverage their transactional data to drive continuous improvement. [AA Comment:  TTD has a high revenue concentration with the agencies that are being disintermediated.]

In little more than a decade, TTD’s market value has grown to exceed $20 billion and dwarfs the dozens of competing independent DSPs.35 But for all its success and structural advantages, TTD in 2020 generated far less than $1 billion of revenue. Its platform placed only about $4 billion of digital advertising spending out of 2020 US spending in the category of over $150 billion. While this suggests a large potential untapped market, it also highlights how limited the opportunity outside of the massive walled gardens (which have their own huge competing DSPs) really is today in adtech. One related area that has driven a recent minor renaissance in adtech has been the explosion in the number of connected TVs, where Google and Facebook do not have the same lock on the market. This has spawned a sudden burst of both deal activity and significant new investments from independents like TTD and venture firms. [AA Comment: TTD COMPETES WITH Google’s DSP. As Knee pointed out before but did not repeat here, that’s a precarious position.]

One interesting success story is that of the standalone software business that remained after Acxiom sold its marketing solutions business to ad giant Interpublic for $2.3 billion in 2018. [AA Comment:  Not so sure of that. Axiom looks good inside Interpublic, but it was not that great when it was independent. It was frequently vulnerable to regulatory and competitive attacks, which is probably why it sold to an agency.  That said, Interpublic is the most successful agency for now.].

Chapter 14: Big Data and Artificial Intelligence: When They Matter and When They Don’t

A platform that has more information about similarly situated borrowers’ actual risk profile because it has serviced more of these loans should be better at pricing the risk of a given borrower. A less sophisticated platform might attract borrowers by offering better terms than their risk justifies but, once the resulting default rates become evident, lenders will flee the platforms. Over time as the relative superiority becomes clearer and relative market share follows, this data advantage should grow.

Interestingly, in one segment of the market, it appears that there is meaningful incremental value from data beyond simple credit scores. For borrowers with lower credit scores, additional data analysis can yield significant insight into the probability of repayment. Yet, ironically, LendingClub sought to distinguish itself by operating exclusively in that portion of the market where big data add no appreciable value.

Exhibit A for this view of the coming horizontal world order presented in Competing in the Age of AI is the remarkable turnaround at Microsoft engineered by CEO Satya Nadella. The company had lost half of its value from its highs of 1999 to the lows of 2009. The shares grew almost tenfold over the subsequent decade, becoming in 2019 the third company (after Apple and Amazon) to reach a trillion dollars in market capitalization. In the chapter called “Becoming an AI Company,” Professors Iansiti and Lakhani demonstrate how Nadella reoriented and refocused the company during this period.

…citing Google’s entry into the auto industry, Iansiti and Lakhani argue that traditional industry boundaries are fast disappearing and that the power of AI will drive the emergence of massive enterprises with continuously increasing, mutually reinforcing competitive advantages of “scale, scope, and learning.”21 In this new world of “unprecedented scale,” “specialized capabilities” will necessarily become “less relevant and less competitive.”

What was truly revolutionary about the SaaS model was that it allowed a single instance of the software to serve multiple clients simultaneously, a so-called multitenant architecture. And what vastly expanded the market potential was the increasing acceptance, and ultimately preference, of even global multinational businesses for SaaS applications.

One of the earliest SaaS companies was Salesforce. The company was founded in 1999 by a voluble and brilliant former Oracle employee, Marc Benioff, who had been inspired to build a company that delivered business software as securely and reliably as Amazon delivered consumer products.

…as suggested by Professors Iansiti and Lakhani, although the early SaaS applications were specialized, as the industry develops, the superiority of horizontal applications becomes increasingly clear by applying AI to centralized capabilities across vertical use cases.

Like the conventional wisdom underlying the Platform Delusion itself, the truisms of the SaaS revolution are all demonstrably false. [AA Comment:  Demonstrably false? I don’t agree.]

For automotive dealerships, to name one example, the market for dealer management systems (DMS) continues to be as dominated by the same two traditional industry leaders (CDK and Reynolds and Reynolds) today as it was in 2000. [AA Comment: CDK has been a terrible stock.]

In 2018, the leading global ERP provider, SAP, announced that it was effectively giving up any attempt to compete in the arena by agreeing to serve as a BlackLine reseller.

The BlackLine case highlights not only the continuing, perhaps even increasing, value of specialization in the age of AI but also the essential role of human judgment in deciding when applying machine learning techniques is a good use of corporate resources and when it is a costly distraction.

…often it is in the context of specialized data sets that machine learning can yield the most compelling insights.

EPILOGUE – START-UP FEVER: IS IT A CURE OR A DISEASE?

The ability of Wayfair to thrive in the shadow of Amazon in the relatively mundane online furniture market reflects the value of specialization versus absolute size. And sometimes just not being one of the tech titans can be a source of advantage by establishing the alternative independent source, as in the case of The Trade Desk, or where trust and data security is critical, as in the case of LiveRamp.

There are very few massive markets, most notably search, that lend themselves to winner-take-most dynamics. Even social media, which in the form of Facebook has many of the same structural barriers as Google, has shown itself to be much more vulnerable to targeted geographic-, demographic-, and product-based competitive attack. [AA Comment:  In other words, just own Google.]

…most justified is in product categories that essentially did not exist previously.

…the good news and the bad news is that the ambitions of the most-sought-after MBA graduates have changed dramatically. Today over 50 percent of Harvard Business School’s graduates join small, earlier stage businesses, with over 10 percent of the class of 2020 for the first time electing to do something on their own. Almost 20 percent of Stanford MBAs actually start their own businesses and fewer than 1 percent go into investment banking anymore.

YOUTUBE VIDEO

September 7, 2021:  Columbia’s Knee on the Big Tech ‘platform delusion’ (2,977 views):  https://www.youtube.com/watch?v=UrjxaGVWCLs

OTHER BOOKS BY KNEE

• The Accidental Investment Banker: Inside the Decade that Transformed Wall Street (2006)
  This tell-all chronicles Knee’s time at Goldman Sachs and Morgan Stanley, revealing a world that rivals 24 in intrigue and drama.” Investment bankers used to be known as respectful of their clients, loyal to their firms, and chary of the financial system that allowed them to prosper. This tell-all chronicles Knee’s time at Goldman Sachs and Morgan Stanley, revealing a world that rivals 24 in intrigue and drama.” Investment bankers used to be known as respectful of their clients, loyal to their firms, and chary of the financial system that allowed them to prosper.

• The Curse of the Mogul: What’s Wrong with the World’s Leading Media Companies (2009)
  If Rupert Murdoch and Sumner Redstone are so smart, why are their stocks long-term losers? We live in the age of big Media, with the celebrity moguls telling us that “content is king.” But for all the excitement, glamour, drama, and publicity they produce, why can’t these moguls and their companies manage to deliver better returns than you’d get from closing your eyes and throwing a dart? The Curse of the Mogul lays bare the inexcusable financial performance beneath big Media’s false veneer of power.By rigorously examining individual media businesses, the authors reveal the difference between judging a company by how many times its CEO is seen in SunValley and by whether it generates consistently superior profits. The book is packed with enough sharp-edged data to bring the most high-flying, hot-air filled mogul balloon crashing down to earth.

• Class Clowns: How the Smartest Investors Lost Billions in Education (2016)
  The past thirty years have seen dozens of otherwise successful investors try to improve education through the application of market principles. They have funneled billions of dollars into alternative schools, online education, and textbook publishing, and they have, with surprising regularity, lost their shirts. In Class Clowns, professor and investment banker Jonathan A. Knee dissects what drives investors’ efforts to improve education and why they consistently fail. Knee takes readers inside four spectacular financial failures in education: Rupert Murdoch’s billion-dollar effort to reshape elementary education through technology; the unhappy investors—including hedge fund titan John Paulson—who lost billions in textbook publisher Houghton Mifflin; the abandonment of Knowledge Universe, Michael Milken’s twenty-year mission to revolutionize the global education industry; and a look at Chris Whittle, founder of EdisonLearning and a pioneer of large-scale transformational educational ventures, who continues to attract investment despite decades of financial and operational disappointment. Although deep belief in the curative powers of the market drove these initiatives, it was the investors’ failure to appreciate market structure that doomed them. Knee asks: What makes a good education business? By contrasting rare successes, he finds a dozen broad lessons at the heart of these cautionary case studies. Class Clowns offers an important guide for public policy makers and guardrails for future investors, as well as an intelligent exposé for activists and teachers frustrated with the repeated underperformance of these attempts to shake up education.

The post The Platform Delusion: Who Wins and Who Loses in the Age of Tech Titans appeared first on VII Capital Management.

On his new book, The Outstanding Factor: Making Dreams Come True in the Stock Market

Published on August 31, 2021 (Amazon Link)

Interviewer:  I enjoyed your book very much. Congratulations for the achievement. How would you say this book is different from the original letters you wrote between 2014 and 2017 and published as a compilation in 2018?
Adriano:  Glad you enjoyed it.  So this new book does include those same concepts in the letters, but I added new examples and improved some of the passages. One of the main inspirations for this book was the question I get repeatedly: How do you find them?  I attempted to answer this question in the introduction and by including a chapter for each of ten examples of outstanding companies in Part IV of the book.  In the introduction I tell my story and explain my views on how to find the outstanding factor that makes dreams come true.  This factor refers to the phenomenon which occurs when an amazing culture combines with an incredible business in secular growth.  While I emphasize the importance of focusing on the endgame throughout the book, I believe the introduction adds valuable context and helps to justify my conviction in what we do and why it is different. I often hear people say that we are like other quality-growth investors, but this book shows why I do not agree with that.  I also discuss the role of purpose in what I do, and the hazards that investors invariably face when the tide changes.  I even broach some controversial topics like short selling and the conflicts of interests in the brokerage and the media industries. Finally, in the last part of the book, I provide my updated library with over 400 book titles. I organized this part into 6 chapters, and as a bonus, I include my top 5 picks for each of 11 genres.

Interviewer:  You mention in the Foreword that you believe first person singular is the better form of communication.  Why do you say that?
Adriano: I am the author of all of our letters, but it wasn’t my practice for me to sign them.  Like other funds do, I wrote my letters with the proverbial “we,” signed by Victori Capital.  We figured this would promote a sense of participation among our team members (which I suppose it did), but I’ve come to realize that our customers actually prefer to hear from the person responsible, not a company. That’s the main reason why I wrote this book in first person singular and started signing my investor letters as of Q2-2021.  While nothing has really changed in how we operate as a team, I think that this new communication approach will help me get closer to my customers. It took me some years to figure this out, but “my team and I” is more powerful than “we”.

Interviewer:  Your paperback has 323 pages, but I noticed that quite a few were dedicated to the Library.  Have you really read all those 400+ books?
Adriano:  Yes I have, but this was during a span of nearly 30 years.  Some of those books, such as Peter Lynch’s classic, One Up On Wall Street, or Phil Fisher’s Common Stocks and Uncommon Profits, I have read more than once – and it was more special the second time.  As I mention in the Introduction, I can read at incredible speeds using audio. I use the Kindle’s robot voice to do this, and it works, especially when I follow along with my eyes. The Kindle lets me highlight while listening, then export passages to email. It’s not an exaggeration to say that the improvements in this technology have changed my life. In the first proof of the book, I had merely listed the titles by category, but then I had the idea of listing my top 5 lists at the start of each chapter. Anyway, I have picked up my pace of reading since working from home – so this list includes many recent titles. Now I am discovering old history books that expose how narratives about history change with time. Who knows this fascination will inspire my next book?

Interviewer:  What’s Big Seven Press, in Greenwich, CT?  Is that your publishing company?
Adriano:  When I was getting ready to publish, a friend suggested I look into forming my own printer, instead of using Amazon’s designated name. To do that, he explained, all one needs to do is purchase an ISBN number under the name of a printing company. While it cost a little bit of money, it turned out to be much easier than I thought to start Big Seven Press.  The name doesn’t have any particular meaning outside of my fascination with the number seven since childhood. Bizarrely, our office address when we started Victori Capital was 777 Post Road in Darien Connecticut.  Today its 177 Broad Street in Stamford.  I was born on the seventh, as were my wife and her sister. Both my parents and my wife’s parents, as well as my brother and I, were all married on the seventh. I am not a superstitious person, but you can’t make this stuff up.

Interviewer:  Going back to your bullish comment earlier, can you explain why you are bullish?
Adriano:  When it comes to being bullish, my reasons are rarely related to the macro backdrop.  This is because throughout my career as well as in my extensive readings of market history, I have observed the earnings power and market value of outstanding companies can increase at astonishing rates even as the market goes through its typical cycles. I don’t believe it is possible, and neither is it useful, for investors to focus on unknowables such as interest rates, inflation, elections, and geopolitics.  As the September 11 attacks early in my career taught me, and the COVID-19 pandemic confirmed, anything can happen in the short term.  The key, in my opinion, is to focus on those few companies that will become dramatically more valuable than the averages.  Peter Thiel calls it “exponential dominance” in his book Zero to One.  Those who can’t dismiss short-term noise for what it is, or who frequently trade the news, are unlikely to benefit from exponential dominance, because it only delivers in time, over the long-term.  All that said, I am not that concerned about the macro backdrop.  I don’t think the onset of inflation is that bearish, mostly because it is coming after an extended period of deflation, but my personal opinions on inflation are not that critical to what we do. What really makes me bullish on the future is how the distancing of the winners from the losers is accelerating due to technology.  The type of companies we target are benefitting disproportionately from this phenomenon, and the passing of time will only make it more pronounced. When durable, serial compounding by outstanding companies is the ultimate target, the passing of time matters much more than the timing of the entry. Of course timing matters, but it matters nowhere near as much as people who focus on averages tend to assume.

Interviewer:  Thanks for that.  Is there anything else you would like to share?
Adriano:  Yes.  My 15 year old son, who loves computer art, made the book cover. I had some crazy ideas about it, but decided to back off and let my son exercise his creative muscle.  When he showed me the final product, I immediately loved it! Being a Bauhaus devotee myself, I was pleased when he told me the minimalistic style was intentional.

Have a great weekend!
Adriano

The post The Outstanding Factor: Making Dreams Come True in the Stock Market appeared first on VII Capital Management.

This classic was first published in 1972 and does not exist in digital format.  “As I write these words, 100 to 1 in the Stock Market is out of print,” says author Marshall Glickman in a the Publisher’s Note to the 2014 edition, “and the lowest priced copy sells on Amazon for $683!” Recently-retired fund manager Chuck Akre mentions the book about 3 minutes into a 58-minute 2017 interview on YouTube (link).  “In 1972 I came across a book that was reviewed in Barron’s called 100 to 1 in the Stock Market, written by a Boston investment manager whose name was Thomas Phelps,” Akre recounts, “and what was interesting to me was that it made me come around and focus on the idea of compound returns.”

The New York Times was not as enthusiastic as Chuck Akre when they reviewed the book in 1972 (link).  Their complaint that “some of the stock choices may be a bit tendentious” and their conclusion that the approach is only “sound enough,“ suggests they missed the point. At least the reviewer repeated Phelps’ warnings that “no single formula works in investing,” and that “above all, no investor should ever marry a stock.” Incidentally, this same 1972 article shows the book selling for $6.95, meaning it too was basically a 100-bagger through its 2014 peak price. The most expensive 1972 edition I found today is going for $103.95 on eBay (link). Not surprisingly, the seller’s note states that it may show signs of wear plus highlighting and writing – which sounds about right.

Pages 142 and 143 of my Not for Sale 2014 Edition: CHAPTER XV: PROFITS IN ETHICS

Even though it took some grit to type out the highlighted excerpts below, I find Phelps’ style of writing so witty and brilliant that I enjoyed the task. As it is clear from the onset, the book’s main message is that if you want to make your dreams come true in the stock market, the thing to do is focus on identifying the highest quality growth companies to own for the long-term, and hold them for as long as they remain high quality growth companies. We know from experience that Phelps’ message is simple and easy to understand, yet hard to execute.

Tragically, Phelps (1923-1992) did not quite practice as a professional investor what he preached after his retirement. In Chapter XXII he writes: “Have I lived by this principle myself? The answer is sadly no.  We are too soon old, and too late smart.  Good judgement comes from experience.  And experience comes from bad judgement. I have had a great deal of experience.” It’s safe to assume Phelps died wealthy, but his example serves as a warning to those who think it’s easy to stick with a concept just because you understand it. In the first chapter Phelps reminds us of George Baker’s (1984-1931) dictum: “To make money in stocks you must have the vision to see them, the courage to buy them, and the patience to hold them.”  And patience, Phelps quips, is the rarest of the three.

In chapter VII, on trees not growing to the sky, Phelps gives an example of how big things can get if they sustain strong growth over decades. “To grow at a rate of 20 percent compounded annually for fifty years, a company must be 9,100 times as big at the end of the period as it was at the beginning. If you project that kind of growth for a company with $100 million of annual sales, you must expect those sales to reach $910 billion annually by 2021.” While trees do indeed stop before reaching the sky, companies are not quite like trees.  Take Walmart’s 50-year record as an example.  Its sales grew at a compounded annual rate of 15%, from $78 million in fiscal 1971 to $560 billion in fiscal 2021, making it today’s largest company in the world. But Amazon, which started in 1994 with only $20 thousand in sales, is expected to surpass Walmart within the next two years, with no sky in sight.

To those with interest in investing, I recommend this precious book, especially the passages I reproduced below.  Like Phil Fisher’s, Thomas Phelps’ writings confirm that what we do at Victori is not new and has worked remarkably well throughout the ages. It truly does make dreams come true. So whether you choose to skip Phelps’ tendentious and outdated stock examples or not, this may still rank as one of the most valuable investment books you can ever read.

Thank you Thomas W. Phelps.

Cheers,

Highlighted Passages:

PUBLISHER’S NOTE

Even at $683, this book is a tremendous bargain for it has the potential to dramatically improve your long-term financial life.

The is no greater way to increase your wealth than to share in the equity and profits of a highly successful business.

PREFACE

This is a story – fact, not fiction.

Starting with 1932 a different stock could have been bought in each of thirty-two different years, and every dollar invested would have grown to $100 or more by 1971.

CHAPTER I: ASK, AND IT SHALL BE GIVEN TO YOU

Most try to make a few points quickly on their stock market speculations, or content themselves with 4 or 5 percent on their savings.  Not one in a thousand seriously plans and acts as one must to make a fortune.

Most can’t resist the urge to cash in their winnings, however small. Others sell a good stock to get into something that seems better, perhaps because it is moving. Theirs is the fate of the dog in Aesop’s fable. You remember, the dog lost the piece of meat in his mouth by snapping at a seemingly larger piece reflected in the water.

It would be hard to find a worse slogan that “You’ll never go broke taking a profit.”

“Except to learn from experience,” Mr. Pettit replied. “In 1925 I personally owned 6,500 shares of Computing-Tabulating-Recording (now IBM). At the time there were only 120,000 shares outstanding. I sold mine for a million dollars – a lot of money in those days. Today they would be worth two billion dollars.  What did he learn from that experience?  Two things: (1) Sty with your most successful stock investments as long as the company is increasing their earnings. (2) Never forget that people whose self-interest is diametrically opposed to your own are trying to persuade you to act every day./

Try to identify people whose interests align to yours.

Many stocks have grown in the last fifteen years at rates which if continued will produce one-hundredfold appreciations in another fifteen or twenty years.

You don’t have even a thousand dollars? Sorry, there is no hope for you. I have it on the word of Andrew Carnegie: “You want to know if you will be rich,” he said, “the answer is, Can you save money?”

CHAPTER II: SIMBAD’S VALLEY OF DIAMONDS

Except by hindsight these 100-to-1 opportunities in the stock market are hard to spot.

There is another reason why professional investors, except those managing discretionary accounts, should de-emphasize market timing.  This is because even if the market forecaster is right, he seldom can persuade other to act on his opinion. No one intends to buy stocks at the top of the market, or to sell them at the lows. … since bull markets and bear markets are to a considerable extent manifestations of mass psychology it is fatuous for anyone to believe he can persuade a representative group to sell stock when the mass psychology is bullish, or to buy when it is bearish.  The wise investor, who understands this, concentrates on stock selection. Most investors are far less emotionally involved in deciding which stock to buy or sell than they are in deciding whether the market is going up or down. To clinch the argument, it is readily demonstrable that far more money can be made by good stock selection than by good stock market timing.

CHAPTER III: LEARNING FROM ELEPHANTS

Forty-six years ago, when I was paying my way through equatorial Africa by shooting elephants for ivory, I learned this simple principle: When looking for the biggest game, be not tempted to swing at anything small. Elephants’ ears are very keen.  Never after firing a single shot at a guinea hen, a colobus monkey, or an antelope did I see an elephant that day.

Few investors, private or professional, seek the big game. They focus on chances to make five points here and ten points there.  They rush to buy on information that the next quarter’s earnings will show a good increase, or to sell when they hear that profit gains have slackened.

A problem well-defined is half solved.

The only thing worse than making an investment mistake is refusing to admit it and correct it. Usually the faster an error is rectified the less it costs. But it is still an error, a lost opportunity, compared with buying right and holding on.

The big risk in correcting errors in the stock market is that stocks look best to so many of us when their prices are highest, and worse when their prices are lowest. Almost irresistibly we are tempted to shoot where the rabbit was, to do what hindsight shows would have been the right thing to do yesterday, last year, or even five or ten years ago.

Good stocks do rise, and rise, and rise.

Another often unrecognized investment fallacy is that avoidance of risk is more important than seizure of opportunity.

To go from one to 100 in twenty-five years the price of a stock must increase at a compound annual growth rate of more than 20 percent, not including dividends. The seller of such a stock after twenty years gets less that 40 for one before taxes and brokerage commissions. The remaining 60 for one comes in the last five years if the rate of price increase is constant.

There is no reason, of course, to sell at any time just because one has a big profit, even a 100-to-one profit. In fact one of the basic rules of investing is: Never if you can help it take an investment action for a non-investment reason. What are some of the non-investment reasons for which tens of thousands of investors go wrong?  Let me cite a few:

1. My stock is “too high.”
2. I need the realized capital gain to offset a capital loss.
3. My stock is not moving. Others are.
4. I cannot or will not pump up more money to meet my margin call.
5. Taxes will be higher next year.
6. New management.
7. New competition.

Much has been said since 1932 about keeping investors fully informed. I sometimes wonder if we are not told more than is good for us.

Investors should beware of confusing cynicism with sophistication.

If you really think a stock is attractive, buy it at the market. Then if it becomes available at a lower price, buy more if you can.

It is not necessary to buy little-known stocks in the dark of the moon to get hold of a fortune-maker.

Thinking too much about what the market is going to do can be expensive, even when one is right.

For sixteen years, from 1952 to 1968, the stock failed to keep up with the Dow Jones Industrial Average. Few if any clients would have stayed with an investment advisor through such a period.

Good timing and good selection is better than either alone, but bear market smoke gets into one’s eyes and blinds him to buying opportunities if he is too intent on market timing. And the more successful one is at market timing, the greater the temptation to rely on it and thus miss the much bigger opportunities in buying right and holding on.

You must know yourself well enough to know that you will not switch policies mid-stream.

Most deception is bad bu8t self-deception is the worse because it is done against such a nice guy.

CHAPTER IV: LEMMINGS FOLLOW THE CROWD

To make the most money in the shortest possible time, you should buy a good stock when nobody likes it. The difficulty is that good stocks seldom are without friends.

There is a Wall Street saying that a situation is worth more than a statistic

What makes a stock good? When asked that question most people think of earnings. They are right, to a point. A stock can also be good because of assets even though those assets are earning nothing at the moment.

CHAPTER V: FORESIGHT VS. TENACITY

Again and again this survey of the big winners in the stock market emphasizes that it is more important to be right than quick.

In the stock market fortune wears many disguises.

How did Tampax look to investors thirty years ago? … Hardheaded investors discounted the company’s future because “they’ll never be able to advertise it.”

Wall Street has its fads and fashions just as Paris does. A stock that is not in vogue may do a great job for its owners without attracting much speculative attention.

CHAPTER: VI WE’D DIE FOR DEAR OLD GLOBE & RUTGERS

No highlights.

CHAPTER VII: THE TREE DOES NOT GROW TO THE SKY

Everyone can see the past. Hence, stocks that faithfully earn next year what they earned last years tend to be fully priced.

It is true that time is on the side of the growth stock buyer if the growth and the expectation of growth continue.

The mere fact that a stock has been a growth stock for ten or fifteen years is no warranty that it will continue to grow even one more year.

To grow at a rate of 20 percent compounded annually for fifty years, a company must be 9,100 times as big at the end of the period as it was at the beginning. If you project that kind of growth for a company with $100 million of annual sales, you must expect those sales to reach $910 billion annually by 2021.

To win in the stock market, as well as in checkers, one must think at least one move further ahead than the other fellow.

CHAPTER VIII: HOW TO ARGUE AND WIN

The point is not that any of the men involved were willfully misleading the public. I believe they were all sincere. But those three experiences taught me this: (1) Never mind opinions, and (2) No one knows or ever can know for sure what the future holds.

Don’t be dismayed by a loss. Recognize it as one of the costs without which you could not have net gain.

I know of no rule, system or philosophy that will keep an investor from making mistakes or hold him harmless when he is wrong.

One of the most persistent illusions of the business of investing is that information is all you need to make money. Organizations that sell information foster that illusion.  It is good for their business.

If information is everything, how can two informed professionals come to opposite conclusions about the same security at the same price at the same instant in time? … no one can be informed about the future.

Joseph Kennedy once said to me: “If I had all the money that has been lost on inside information I’d really be rich.”

Even if one’s information is complete and accurate, it can still be misleading investment wise if it is late.

CHAPTER IX: FIGURING THE ODDS

The principle of relative values is at least as old as the Bible.

Late in 1961 when the stock market was exuberant I remarked to the first chairman of the SEC, Joseph P. Kennedy, “People don’t care about dividends anymore.” “Where are these people,” Mr. Kennedy challenged. “I never met one.”

Most great advances in the stock market result from some combination of rising earnings and rising price-earnings ratios.

Buying right will do you little good unless you hold on. But holding on will do you little good – and may do you great harm – unless you have bought right.

In the bright light of hindsight it can often be seen that the stock market has gone to unjustified extremes. It is much safer for the investor to proceed on the basis that these unwarranted extremes result from the common human inability to foresee the future rather than from stupidity. As a matter of fact, in the stock market money tends to move from stupid to intelligent hands.

CHAPTER X: THE QUALITY OF EARNINGS IS STRAINED

One of the worst delusions of the investment business is the uncritical us of price-earnings ratios.

I am reminded of the World War I veteran who lost his job and turned to beggi9ng under a placard reading:

Three years in the trenches.
Two wounds.
One wife.
Four children.
Seven months out of a job.
Total seventeen.
Please help.

Do we perhaps pay lip service to these differences [in quality of earnings] while using statistical procedures which ignore them?

The business of the stock market is to cash in on the future now.

Scrupulous attention to the wide potential variation in quality of earnings may some day save your life. … How can you as an individual investor adjust or correct reported earnings for such differences in quality? In reading annual reports you can look for such variables as I have just cited. It is no jab for an amateur, though, particularly not after a big dinner.

CHAPTER XI: MANIPULATION DESPITE THE SEC

Shooting where the rabbit was is one of the most common investment errors.

The moral of all this takes us back to Mr. Barron’s, “The fact without the truth is false. Always connect.”

In Africa, where there are no antelope there are no lions.

CHAPTER XII:  KEEP YOUR EYES OPEN ON THOSE RANDOM WALKS

I have been in both camps. My conclusion after forty-four years of observation and study is that technical work is not an alternative to fundamental security analysis.

When a stock persistently fails to act the way it should on the basis of the information I have, I conclude that I am missing something and redouble my efforts to find out what it is.

“The trouble with economics and finance,” Mr. du Pont said, “is that we are always working with dirty test tubes.”

Chart-induced excesses in the market should be welcomed as providing investment opportunities for those who understand the fundamentals of the situation.

The greatest danger in chart, to my mind, is the temptation to use them as a guide to trading, thereby losing sight of the greater opportunities to buy right and hold on.

By perfect timing on those major swings you would have increased your starting capital fortyfold. Meantime hundreds of stocks had risen more than one hundredfold. Were you aiming at the right target?

CHAPTER XIII: EXPERIENCE SOMETIMES A POOR TEACHER

We used to have a boxer named Prince. He was dumb but not stupid. Not being that smart, Prince confused memory with reasoning, and acted on memory. In the stock market many people seem to do that too. They do now what hindsight shows would have been profitable if they had done it ten days, ten months, or ten years earlier, under quite different conditions. They shoot where the rabbit was. I have done it myself.

When asked how much it cost to run his yacht, the Corsair, Mr. Morgan replied, “If it matters, you can’t afford it.”

Catching swings in the market, even when one is reasonably successful at it, makes pennies compared with the dollars garnered by those who buy right and hold on.

CHAPTER XIV: WHY COMPUTERS WON’T RUN THE WORLD

Nothing is worth anything unless someone wants it. Anything is worth what someone will give you for it and no more.

In business, it is bad luck to tell people what they should want instead of giving people what they do want. This is what we mean when we say the customer is king. There has never been a successful revolution against him.

CHAPTER XV: PROFITS IN ETHICS

A man who will steal for you will steal from you. Ask yourself whether the company is which you contemplate investing is contributing to making this world a better place.

The moral cancer thus introduced cannot be extirpated simply by removing the evil genius at the top. It may take a generation under a good management to purge the organization of the unprincipled sharp-shooter brought in by a bad management. Hence it is unwise to look for a quick turnaround in an organization whose management has demonstrated a lack of moral principle.

Man is the creature most difficult to keep in jail because man makes the jail.

The best defense against them [unethical people] is to run away from them as fast as possible at the first hint of sharp practice.

Bet on men and organizations fired by zeal to meet human wants and needs, imbued with enthusiasm over solving mankind’s problems. Good intentions are not enough, but when combined with energy and intelligence the results make it unnecessary to seek profits. They come as a serendipity dividend on a well-managed quest for a better world.

CHAPTER XVI: THE ALMIGHTY EGO VS. THE ALMIGHTY DOLLAR

Egonomics is the art of judging every issue, making each decision, on the basis of what it will do for your ego.

The story of the school boy illustrates how an egonomist’s mind works. “What’s two plus two?” his teacher asked. “Am I buying or selling?” the puil replied.

What does egonomics have to do with investing? A very great deal. I don’t like it and wish it were no so. But as my realistic partner, Hardwick Stires, puts it, “This is the way things are. If you can’t abide it, you can shoot yourself.”

In a free society those who direct the investment of people’s money into ventures showing far below average rates of return on the capital required are sabotaging our economy, whether they know it or not.

The last emotion to die is pride.

Profits are the reward of human spirit and high endeavor – of great leadership.

My judgement was right. The stock never proved a bargain at any price.

CHAPTER XVII: NO INFLATION-CONTROL PILL

Now that so many democratic governments have assumed or accepted responsibility for the economic climate, the need for more widespread understanding of money is vital and urgent.

The practical question is not whether we should have inflation or not but how much, how fast. What does this mean to common stocks? The short answer is that inflation makes stocks rise.

Inflation is most bullish on common stocks when it follows a deep depression and is not generally expected. Rising demand for goods and services can be met by putting idle production facilities to work. But when inflation persists for long enough so that everyone is aware of it, and when the rate of inflation becomes high enough to be a political liability for whoever is in power in Washington, it is no longer automatically beneficial to corporate earnings and may become detrimental to them.

There is nothing good or bad about debt and interest per se despite the Puritanical injunction, “Neither a borrower nor a lender be.” Many people have been ruined by debt. Many others have made their fortune with borrowed money. … To my mind it is just as bad a mistake for a businessman not to borrow when he could do so profitably as it is for him to borrow unprofitably. A businessman, did I say? I mean anyone.

When any rule, formula, or program becomes a substitute for thought rather than an aid to thinking, it is dangerous and should be discarded.

Actually people did believe twenty-five years ago that interest rates would be permanently low. Why else would they have bought long-term bonds to yield 2-1/2 percent or less? … After such a prolonged decline people who confuse memory with reasoning, as most of us do, are sure interest rates will never rise again.

If these examples seem tedious and complicated, I can assure you they are simple compared with the actual investment problem encountered every day. All I am trying to show is the impossibility of proving in advance, mathematically, how any investment will work out. The bigger your computer, the more sophisticated your program, the more varied the assumptions you can evaluate. But when all is said and done, the future is still unknown and always will be.

CHAPTER XVIII: PICKING THE RIGHT ONE

The master plan is to buy right and hold on.

CHAPTER XIX: WHERE TO LOOK FOR THE BIG WINNERS

Low-priced stocks, like the poor, are always with us.

Money won at Russian roulette may buy as much groceries as money earned any other way, but as a means of earning a livelihood Russian roulette has a well-deserved place at the bottom of the totem pole.

Opportunities to profit by capital leverage are easy to fin. What is hard is deciding whether the added profit potential out ways the added risk.

It is vitally important that the high rate of return be protected by a “gate” making entry into the business difficult if not impossible. .. Just be sure the gate is strong and high.

Thousands of investors have owned one or another of these 100-to-one “high-gate” stocks at some time or other in the last forty years. Probably not one in a thousand has held his winner until it increased one hundredfold in value.

To increase one hundredfold in value in forty years a stock’s price must advance at the compounded annual rate of 12.2 percent. The rates of increase required to multiply a stock’s value by 100 in fewer years than forty are these:

• 35 years – 14 percent
• 30 years – 16.6 percent
• 25 years – 20 percent
• 20 years – 26 percent
• 15 years – 36 percent

Long-term capital growth is tied to long-term earnings growth.

CHAPTER XX: GETTING AWAY FROM IT ALL

Money, interest, and inflation all have an important bearing on the investment climate in which your investment favorites will run. But the most significant factor of all is people and their views. What are hopes, their aims, their beliefs?

CHAPTER XXI:  ITS NOT TOO LATE

No excerpts.

CHAPTER XXII: CHEER FOR THE YOUNGER GENERATION

Figures never tell the whole story of any company.

Every human problem is an investment opportunity if you can anticipate the solution. Except for thieves, who would buy locks?

CHAPTER XXIII:  HOW TO AVOID MISSING THE BOAT NEXT TIME

The basic reason so few of us have ever made $100 on a $1 investment is that we have never tried to do so. In a sense we have been brainwashed into looking for and acting on types on information that have little or nothing to do with multiplying one’s investment one hundredfold.

Much investment research is misdirected from the point of view of one wanting to increase his capital rather than “play the market.”

Brokers live on commissions on transactions. I know because I was a broker for eleven years, and a partner at that. There are two primary ways to generate commission business. One is to give such good service, including investment advice, that more and more people come to the brokerage house to do their buying and selling. The other way to generate commissions is to point out reasons why the clients the firm already has should sell the stocks they own and buy other stocks. I used to try to do both.

In life the finish line is death, and at that time all potential capital gains tax liability on unrealized gains is forgiven, at least under the law in 1971.

It is a paradox that the investor seeking to multiply his capital by 100 actually runs less risk than the individual trying to make five points or even double his money. There are at least five reasons why this is so:

1. There is always a market for the best of everything. … That is as true of stocks and bonds as it is of real estate and antiques.
2. Buying for maximum long-term growth avoids the pitfall of underestimating other people.
3. When you buy a stock with a superior profit margin, an above-average rate of return on invested capital, and sales that are growing faster than the industry’s or the country as a whole, you have time on your side.
4. In real life anyone smart enough to make a better mouse trap would not stop there.
5. “Don’t marry a man to reform him,” a wise mother counselled her daughter. It is seldom profitable to marry a stock to reform it either.

Perhaps the greatest advantage of all in buying top quality stocks without visible ceilings on their growth is that when we do so we give ourselves the chance to profit by the unforeseeable and the incalculable.

As editor of Barron’s I worked with a Harvard professor on a business index in the mid-1930s. His final conclusion was that the secular trend in America was inclined slightly downward.

The investor dedicated to buying right and holding on picks managements, products, and processes he thinks able to cope with the unforeseeable as it hoves into view.

One of every man’s primary investment objectives should be to make as much money as possible while paying as little taxes as possible under whatever laws are in effect at the time.

Wall Street lives on activity. Every transaction carries a commission. Since the customers demand action, and since action pays the rent, why not give them what they want? … Getting out of a threatened stock until the situation has clarified is not only good for business but may save the customer’s shirt as well. If the broker or investment counselor advises a sale he at least shows that he is aware of what is going on in the world. Not to act might well lose the account, especially if the stock acted badly for the next year or two.

“Everyone tells me to get into cash,” my client said at our last meeting. “What makes you think you know better?”

My case was like that of the man who died in a traffic accident where he had the green light.

CHAPTER XXIV: “BUY RIGHT AND HOLD ON” IN PRACTICE

Only the most exceptional individuals have the will power to adopt such a course and hold to it through the bad years that punctuate almost every stock rise.

Excessive diversification dodges rather than solves the investment problem.

CHAPTER XXV: DO IT YOURSELF?

Lawyers have a saying that anyone who tries to be his own lawyer has a fool for a client.

Stubbornness is no substitute for savvy in investing.

Every sale should be recognized as a confession of error – a lost opportunity. There will be many such errors, of course. Making money is not easy and never will be.

CHAPTER XXVI: A SENSE OF VALUES

Many a man is on relief because he paid too much for what he correctly foresaw.

Time is an often overlooked element in value.

In a free society, life is a series of trades.

Someone wrote a popular play years ago about a young man who breathed new life into an ailing soap business by cutting the cakes in half and doubling the price. Enough people inferred that the higher-priced soap must be better for their skins to make them avid victims of his trickery.

In these and so many other ways, stock trading is more a study in psychology than in finance and economics.

CHAPTER XXVII: WHAT MAKES A STOCK GROW

What makes a stock grow? Look for these possibilities:

1. Reinvesting earnings at a constant or rising rate of return on invested capital.
2. Investing borrowed money to earn more than the cost of capital.
3. Acquiring other companies by exchange of high P/E stock for a low P/E stock.
4. Increasing sales without having to increase invested capital.
5. New inventions, processes, or formulas for filling human needs not previously met, or for doing essential jobs better, and/or cheaper.
6. Contracts to operate facilities for others.
7. Rising price-earnings ratios.

If we knew in advance that a research project was going to pay out, it was not research but only product development.

CHAPTER XXVIII: REAL GROWTH – HOW TO SPOT IT AND EVALUATE IT

Earnings power is competitive strength. It is reflected in above-average rates of return on invested capital, above-average profit margins on sales, above-average rates of sales growth.

A little learning is a dangerous thing.

Much can never be foreseen or even imagined. The one way to benefit by it is to buy the best stock or stocks you can with no intention of selling them until they turn bad. If history is any guide, some will end up in your high bracket estate.

To buy right requires vision and courage – faith that is evidence of things not seen, things not susceptible to mathematical proof.

In Alice in Wonderland one had to run fast in order to stand still. In the stock market, the evidence suggests, one who buys right must stand still in order to run fast.

The post 100 to 1 in the Stock Market: A Distinguished Security Analyst Tells How to Make More of Your Investment Opportunities appeared first on VII Capital Management.

Written in the 1980s by the fabled Fidelity portfolio manager, this book was responsible for sparking my interest in fund management.  At the time I first read it, I was still in graduate school, preparing for a career in Aerospace Engineering.  I believed then in Lynch’s argument that, “anyone could do it,” and I took the plunge by opened an e-trade account in my mid-20s.  At 52 years and still doing it, I have come to respect experience and long track records more than I used to when I was younger.  That said, I agree with what Gautam Baid stated in his book, The Joys of Compounding (Victori review): “Knowledge comes from experience, but it doesn’t have to be your experience.”

Lynch is famous to this day for having one of the best track records in the business. He put up an annualize return of 29% from the late-1970s, when he was in his mid-20s, through his retirement in 1991, at just 46. Tragically, Fidelity found that the average investor in Lynch’s fund actually lost money because they redeemed in periods of underperformance. But at least they did better than the investors who chased high flyers from the previous generation.  Kenneth Heebner, for example, ranked as America’s No. 1 fund manager in the 1990s before losing his touch and most of his assets. According to one article from 2013 (link), the then-71 year old manager never lost his swagger after ranking at the bottom of his peer group by losing 6% on average in the decade through 2007.  This other article from 2008 (link) reports that the “legendary fund manager goes from penthouse to outhouse,” and this one from 2016 (link) says Heebner’s “venerable Boston mutual fund shut its doors after 48 years.”  Go back another generation (to the 1960s Go-Go years), and there are even more glaring examples of Wall Street’s proclivity for roadkill, including Gerald Tsai (Wikipedia link), who helped build Fidelity into the behemoth it is today, but his fund, which was packed with the glamour stocks of the day, lost 90% of its value in 1969.  After that, Tsai left Fidelity and started his own fund, Tsai Management, but in 1973 sold the firm and retired.  Later Tsai resurfaced as the CEO of American Can Company, so I am sure he did ok.  The bottom line is that Lynches best trade ever may have been to exit the business while he was still on top.

One of the key lessons I learned from Lynch’s story and that of other Wall Street legends is that it not only pays to avoid glamour stocks, but also the glamour managers.  As I look around today, I see some highly successful, and still young, glamour-stock fund managers who would probably do best to follow Lynch’s example of leaving while the going is still good. At the end of the book Lynch offers a list of analysts and fund managers of his time. I highlighted these two lists and reproduced it below because I was impressed by how few of the names I know.  While it was before my time, it reminded me of an old saying my late father in law often uttered:  “The cemetery is full of irreplaceable people.”  By extrapolation, I’d say that if there were a cemetery for Wall Street firms, it would also be packed.

One Up on Wall Street has become timeless for its classic one-liners. Phrases like “dumb money is only dumb when it listens to the smart money,” or “Investing without research is like playing stud poker and never looking at the cards,” or “you don’t have to kiss all the girls,” remain lexicons to this day. Here are my top 5, but I underlined dozens in the highlighted passages below:

• “It’s obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics.”
• “When in doubt, tune in later.”
• “Sometime in the next month, year, or three years, the market will decline sharply.”
• “Selling an outstanding fast grower because its stock seems slightly overpriced is a losing technique.”
• “I hear every day that AIDS will do us in, the drought will do us in, inflation will do us in, recession will do us in, the budget deficit will do us in, the trade deficit will do us in, and the weak dollar will do us in. Whoops. Make that the strong dollar will do us in. They tell me real estate prices are going to collapse. Last month people started worrying about that. This month they’re worrying about the ozone layer. If you believe the old investment adage that the stock market climbs a “wall of worry,” take note that the worry wall is fairly good-sized now and growing every day.”

My favorite part though, was the list of twelve silliest (and most dangerous) things people say about stocks:

1. IF IT’S GONE DOWN THIS MUCH ALREADY, IT CAN’T GO MUCH LOWER
2. YOU CAN ALWAYS TELL WHEN A STOCK’S HIT BOTTOM
3. IF IT’S GONE THIS HIGH ALREADY, HOW CAN IT POSSIBLY GO HIGHER?
4. IT’S ONLY $3 A SHARE: WHAT CAN I LOSE?
5. EVENTUALLY THEY ALWAYS COME BACK
6. IT’S ALWAYS DARKEST BEFORE THE DAWN
7. WHEN IT REBOUNDS TO $10, I’LL SELL
8. WHAT ME WORRY? CONSERVATIVE STOCKS DON’T FLUCTUATE MUCH
9. IT’S TAKING TOO LONG FOR ANYTHINGTO EVER HAPPEN
10. LOOK AT ALL THE MONEY I’VE LOST: I DIDN’T BUY IT!
11. I MISSED THAT ONE, I’LL CATCH THE NEXT ONE
12. THE STOCK’S GONE UP, SO I MUST BE RIGHT, OR . . . THE STOCK’S GONE DOWN SO I MUST BE WRONG

Incidentally, Lynch mentions hedge fund manager Robert Wilson in the body of the book, but only as part of his criticism of short selling.  Wilson isn’t even included in Lynches fund manager list, which is not fair. While Lynch’s 22-year career of annualized returns in the high 20s (pre-tax) during the great bull market of the 1980s is undoubtedly impressive, Roemer McPhee’s book, Killing the Market (Victori review), claims Wilson compounded his net worth (after tax) at an astonishing annual rate of 35% in 14 years (1963-1977), which encompassed the 1969 growth crash that killed Tsai and the inflation scare of the 1970s that killed many more. Moreover, before Wilson died at 2013 at 87, he gave all his money away, over $800 million. According to Wealthy Persons (link), a website focused on Celebrities, Lynch turned only 77 in January 2021, weighs only 180 pounds, and has a net worth of only $450 million.  Moreover, the Lynch Foundation, gave away only $8 million in 2013.  The Foundation supports education, religious, cultural, and historic organizations, plus hospitals and medical research. While that too is impressive, Wilson is said to have given away more than $600 million to environmental preservation organizations, including Nature Conservancy and the World Momentus Fund.  Born in 1926 and more frugal than Buffett, Wilson once told a reporter that “one of the dumbest things you can do with money is spend it.” May he rest in peace.

In conclusion, even though Peter Lynch’s book was written more than three decades ago, and even though the fund management business has changed dramatically since ETFs were introduced in the 1990s, it is definitely a worthwhile read. It shows how some things never really change, and it offers one of the best collection of stock stories I have come across.  For those interested in investing who have not read it, or have read it only once a long time ago, I recommend it.

Best regards,

Adriano

Highlighted Passages:

Introduction to the Millennium Edition

Never before has the market recorded more than two back-to-back 20 percent gains.

All along I’ve been technophobic. My experience shows you don’t have to be trendy to succeed as an investor. In fact, most great investors I know (Warren Buffett, for starters) are technophobes. They don’t own what they don’t understand, and neither do I. I understand Dunkin’ Donuts and Chrysler, which is why both inhabited my portfolio. I understand banks, savings-and-loans, and their close relative, Fannie Mae. I don’t visit the Web. I’ve never surfed on it or chatted across it. Without expert help (from my wife or my children, for instance) I couldn’t find the Web.

To my mind, the stock price is the least useful information you can track, and it’s the most widely tracked. When One Up was written in 1989, a lone ticker tape ran across the bottom of the Financial News Network.

Prologue: A Note from Ireland

I’ve always believed that investors should ignore the ups and downs of the market.

When you sell in desperation, you always sell cheap.

To all the dozens of lessons we’re supposed to have learned from October, I can add three: (1) don’t let nuisances ruin a good portfolio; (2) don’t let nuisances ruin a good vacation; and (3) never travel abroad when you’re light on cash.

prefer to write about something you might find more valuable: how to identify the superior companies. Whether it’s a 508-point day or a 108-point day, in the end, superior companies will succeed and mediocre companies will fail, and investors in each will be rewarded accordingly.

Introduction: The Advantages of Dumb Money

But rule number one, in my book, is: Stop listening to professionals! Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert.

Dumb money is only dumb when it listens to the smart money.

In my business a fourbagger is nice, but a tenbagger is the fiscal equivalent of two home runs a

The first stock I ever bought, Flying Tiger Airlines, turned out to be a multibagger that put me through graduate school.

The effect is most striking in weak stock markets—yes, there are tenbaggers in weak markets.

The more right you are about any one stock, the more wrong you can be on all the others and still triumph as an investor.

Part I: Preparing to Invest

There’s no such thing as a hereditary knack for picking stocks.

The Lynch Law, closely related to the Peter Principle, states: Whenever Lynch advances, the market declines.

Distrust of stocks was the prevailing American attitude throughout the 1950s and into the 1960s, when the market tripled and then doubled again. This period of my childhood, and not the recent 1980s, was truly the greatest bull market in history, but to hear it from my uncles, you’d have thought it was the craps game behind the pool hall. “Never get involved in the market,” people warned. “It’s too risky. You’ll lose all your money.”

As I look back on it now, it’s obvious that studying history and philosophy was much better preparation for the stock market than, say, studying statistics. Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.

As for Will Rogers, he may have given the best bit of advice ever uttered about stocks: “Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”

To the list of famous oxymorons—military intelligence, learned professor, deafening silence, and jumbo shrimp—I’d add professional investing.

“Gentlemen prefer bonds.”—Andrew Mellon

Is This a Good Market? Please Don’t Ask

During every question-and-answer period after I give a speech, somebody stands up and asks me if we’re in a good market or a bad market.

I always tell them the only thing I know about predicting markets is that every time I get promoted, the market goes down. As soon as those words are launched from my lips, somebody else stands up and asks me when I’m due for another promotion.

Obviously you don’t have to be able to predict the stock market to make money in stocks, or else I wouldn’t have made any money.

Since the stock market is in some way related to the general economy, one way that people try to outguess the market is to predict inflation and recessions, booms and busts, and the direction of interest rates. True, there is a wonderful correlation between interest rates and the stock market, but who can foretell interest rates with any bankable regularity?

Of course, I’d love to be warned before we do go into a recession, so I could adjust my portfolio. But the odds of my figuring it out are nil. Some people wait for these bells to go off, to signal the end of a recession or the beginning of an exciting new bull market. The trouble is the bells never go off. Remember, things are never clear until it’s too late.

THE COCKTAIL THEORY If professional economists can’t predict economies and professional forecasters can’t predict markets, then what chance does the amateur investor have? You know the answer already, which brings me to my own “cocktail party” theory of market forecasting,

In the first stage of an upward market—one that has been down awhile and that nobody expects to rise again—people aren’t talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, “I manage an equity mutual fund,” they nod politely and wander away.

Stage two: When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it’s likely that the market is about to turn up. In stage two, after I’ve confessed what I do for a living, the new acquaintances linger a bit longer—perhaps long enough to tell me how risky the stock market is—before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market’s up 15 percent from stage one, but few are paying attention.

In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening.

In stage four, once again they’re crowded around me—but this time it’s to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they’ve all gone up.

Part II: Picking Winners

Investing without research is like playing stud poker and never looking at the cards.

THE SIX CATEGORIES Once I’ve established the size of the company relative to others in a particular industry, next I place it into one of six general categories: slow growers, stalwarts, fast growers, cyclicals, asset plays, and turnarounds.

THE SLOW GROWERS Usually these large and aging companies are expected to grow slightly faster than the gross national product. Slow growers didn’t start out that way. They started out as fast growers and eventually pooped out, either because they had gone as far as they could, or else they got too tired to make the most of their chances. When an industry at large slows down (as they always seem to do), most of the companies within the industry lose momentum as well. Electric utilities are today’s most popular slow growers, but throughout the 1950s and into the 1960s the utilities were fast growers, expanding at over twice the rate of GNP.

In the 1970s, as the cost of power rose sharply, consumers learned to conserve electricity, and the utilities lost their momentum.

Now even computers are slowing down, at least in the mainframe and minicomputer parts of the business. IBM and Digital may be the slow growers of tomorrow.

THE STALWARTS Stalwarts are companies such as Coca-Cola, Bristol-Myers, Procter and Gamble, the Bell telephone sisters, Hershey’s, Ralston Purina, and Colgate-Palmolive.

THE FAST GROWERS These are among my favorite investments: small, aggressive new enterprises that grow at 20 to 25 percent a year. If you choose wisely, this is the land of the 10- to 40-baggers, and even the 200-baggers. With a small portfolio, one or two of these can make a career.

I’ve already mentioned how electric utilities, especially the ones in the Sunbelt, went from being fast growers to being slow growers. In the 1960s plastics was a high-growth industry. Plastics were so much on people’s minds that when the word “plastics” was whispered to Dustin Hoffman in the movie The Graduate, the word itself became a famous line.

THE CYCLICALS A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion. In a growth industry, business just keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again.

Cyclicals are the most misunderstood of all the types of stocks. It is here that the unwary stockpicker is most easily parted from his money, and in stocks that he considers safe.

Timing is everything in cyclicals, and you have to be able to detect the early signs that business is falling off or picking up. If you work in some profession that’s connected to steel, aluminum, airlines, automobiles, etc., then you’ve got your edge, and nowhere is it more important than in this kind of investment.

TURNAROUNDS Turnaround candidates have been battered, depressed, and often can barely drag themselves into Chapter 11.

There’s the restructuring-to-maximize-shareholder-values kind of turnaround, such as Penn Central. Wall Street seems to favor restructuring these days, and any director or CEO who mentions it is warmly applauded by shareholders. Restructuring is a company’s way of ridding itself of certain unprofitable subsidiaries it should never have acquired in the first place. The earlier buying of these ill-fated subsidiaries, also warmly applauded, is called diversification. I call it diworseification.

THE ASSET PLAYS An asset play is any company that’s sitting on something valuable that you know about, but that the Wall Street crowd has overlooked. With so many analysts and corporate raiders snooping around, it doesn’t seem possible that there are any assets that Wall Street hasn’t noticed, but believe me, there are. The asset play is where the local edge can be used to greatest advantage.

HIGHFLIERS TO LOW RIDERS Companies don’t stay in the same category forever.

Advanced Micro Devices and Texas Instruments, once champion fast growers, are now regarded as cyclicals.

Getting the story on a company is a lot easier if you understand the basic business.

If it’s a choice between owning stock in a fine company with excellent management in a highly competitive and complex industry, or a humdrum company with mediocre management in a simpleminded industry with no competition, I’d take the latter. For

You never find the perfect company, but if you can imagine it, then you’ll know how to recognize favorable attributes, the most important thirteen of which are as follows: (1) IT SOUNDS DULL—OR, EVEN BETTER, RIDICULOUS The perfect stock would be attached to the perfect company, and the perfect company has to be engaged in a perfectly simple business, and the perfectly simple business ought to have a perfectly boring name. The more boring it is, the better.

(2) IT DOES SOMETHING DULL I get even more excited when a company with a boring name also does something boring. Crown, Cork, and Seal makes cans and bottle caps. What could be duller than that? You won’t see an interview with the CEO of Crown, Cork, and Seal in Time magazine alongside an interview with Lee Iacocca, but that’s a plus. There’s nothing boring about what’s happened to the shares of Crown, Cork, and Seal.

(3) IT DOES SOMETHING DISAGREEABLE Better than boring alone is a stock that’s boring and disgusting at the same time. Something that makes people shrug, retch, or turn away in disgust is ideal. Take Safety-Kleen. That’s a name with promise to begin with—any company that uses a k where there ought to be a c is worth investigating. The fact that Safety-Kleen was once related to Chicago Rawhide is also favorable (see “It’s a Spinoff” later in this chapter).

(4) IT’S A SPINOFF Spinoffs of divisions or parts of companies into separate, freestanding entities—such as Safety-Kleen out of Chicago Rawhide or Toys “R” Us out of Interstate Department Stores—often result in astoundingly lucrative investments.

(5) THE INSTITUTIONS DON’T OWN IT, AND THE ANALYSTS DON’T FOLLOW IT If you find a stock with little or no institutional ownership, you’ve found a potential winner.

(9) IT’S GOT A NICHE I’d much rather own a local rock pit than own Twentieth Century-Fox, because a movie company competes with other movie companies, and the rock pit has a niche. Twentieth Century-Fox understood that when it bought up Pebble Beach, and the rock pit with it.

(10) PEOPLE HAVE TO KEEP BUYING IT I’d rather invest in a company that makes drugs, soft drinks, razor blades, or cigarettes than in a company that makes toys. In the toy industry somebody can make a wonderful doll that every child has to have, but every child gets only one each. Eight months later that product is taken off the shelves to make room for the newest doll the children have to have—manufactured by somebody else.

(11) IT’S A USER OF TECHNOLOGY Instead of investing in computer companies that struggle to survive in an endless price war, why not invest in a company that benefits from the price war—such as Automatic Data Processing?

(12) THE INSIDERS ARE BUYERS There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it. In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy.

Stocks I’d Avoid:  If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys.

BEWARE THE NEXT SOMETHING Another stock I’d avoid is a stock in a company that’s been touted as the next IBM, the next McDonald’s, the next Intel, or the next Disney, etc.

BEWARE THE WHISPER STOCK I get calls all the time from people who recommend solid companies for Magellan, and then, usually after they’ve lowered their voices as if to confide something personal, they add: “There’s this great stock I want to tell you about. It’s too small for your fund, but you ought to look at it for your own account. It’s a fascinating idea, and it could be a big winner.”

BEWARE THE MIDDLEMAN The company that sells 25 to 50 percent of its wares to a single customer is in a precarious situation. SCI Systems (not to be confused with the funeral-home firm) is a well-managed company and a major supplier of computer parts to IBM, but you never know when IBM will decide that it can make its own parts, or that it can do without the parts, and then cancel the SCI contract.

When you buy a stock in a fast-growing company, you’re really betting on its chances to earn more money in the future.

Here are some pointers from this section:

• Understand the nature of the companies you own and the specific reasons for holding the stock. (“It is really going up!” doesn’t count.)
• By putting your stocks into categories you’ll have a better idea of what to expect from them.
• Big companies have small moves, small companies have big moves.
• Consider the size of a company if you expect it to profit from a specific product.
• Look for small companies that are already profitable and have proven that their concept can be replicated.
• Be suspicious of companies with growth rates of 50 to 100 percent a year.
• Avoid hot stocks in hot industries.
• Distrust diversifications, which usually turn out to be diworseifications.
• Long shots almost never pay off.
• It’s better to miss the first move in a stock and wait to see if a company’s plans are working out.
• People get incredibly valuable fundamental information from their jobs that may not reach the professionals for months or even years.
• Separate all stock tips from the tipper, even if the tipper is very smart, very rich, and his or her last tip went up.
• Some stock tips, especially from an expert in the field, may turn out to be quite valuable. However, people in the paper industry normally give out tips on drug stocks, and people in the health care field never run out of tips on the coming takeovers in the paper industry.
• Invest in simple companies that appear dull, mundane, out of favor, and haven’t caught the fancy of Wall Street.
• Moderately fast growers (20 to 25 percent) in nongrowth industries are ideal investments.
• Look for companies with niches.
• When purchasing depressed stocks in troubled companies, seek out the ones with the superior financial positions and avoid the ones with loads of bank debt.
• Companies that have no debt can’t go bankrupt.
• Managerial ability may be important, but it’s quite difficult to assess. Base your purchases on the company’s prospects, not on the president’s resume or speaking ability.
• A lot of money can be made when a troubled company turns around.
• Carefully consider the price-earnings ratio. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money.
• Find a story line to follow as a way of monitoring a company’s progress.
• Look for companies that consistently buy back their own shares.
• Study the dividend record of a company over the years and also how its earnings have fared in past recessions.
• Look for companies with little or no institutional ownership.
• All else being equal, favor companies in which management has a significant personal investment over companies run by people that benefit only from their salaries.
• Insider buying is a positive sign, especially when several individuals are buying at once.
• Devote at least an hour a week to investment research. Adding up your dividends and figuring out your gains and losses doesn’t count.
• Be patient. Watched stock never boils.
• Buying stocks based on stated book value alone is dangerous and illusory. It’s real value that counts.
• When in doubt, tune in later.
• Invest at least as much time and effort in choosing a new stock as you would in choosing a new refrigerator.

Part III: The Long-term View

There’s a long-standing debate between two factions of investment advisors, with the Gerald Loeb faction declaring, “Put all your eggs in one basket,” and the Andrew Tobias faction retorting, “Don’t put all your eggs in one basket. It may have a hole in it.”

In my view it’s best to own as many stocks as there are situations in which: (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research. Maybe that’s a single stock, or maybe it’s a dozen stocks.

That said, it isn’t safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios I’d be comfortable owning between three and ten stocks.

Some people automatically sell the “winners”—stocks that go up—and hold on to their “losers”—stocks that go down—which is about as sensible as pulling out the flowers and watering the weeds. Others automatically sell their losers and hold on to their winners, which doesn’t work out much better. Both strategies fail because they’re tied to the current movement of the stock price as an indicator of the company’s fundamental value.

If you can’t convince yourself “When I’m down 25 percent, I’m a buyer” and banish forever the fatal thought “When I’m down 25 percent, I’m a seller,” then you’ll never make a decent profit in stocks.

WHEN TO SELL Even the most thoughtful and steadfast investor is susceptible to the influence of skeptics who yell “Sell” before it’s time to sell. I ought to know. I’ve been talked out of a few tenbaggers myself.

WHEN TO SELL A SLOW GROWER I can’t really help you with this one, because I don’t own many slow growers in the first place.

Here are some other signs:

• The company has lost market share for two consecutive years and is hiring another advertising agency.
• No new products are being developed, spending on research and development is curtailed, and the company appears to be resting on its laurels.
• Two recent acquisitions of unrelated businesses look like diworseifications, and the company announces it is looking for further acquisitions “at the leading edge of technology.”• The company has paid so much for its acquisitions that the balance sheet has deteriorated from no debt and millions in cash to no cash and millions in debt. There are no surplus funds to buy back stock, even if the price falls sharply.
• Even at a lower stock price the dividend yield will not be high enough to attract much interest from investors.

WHEN TO SELL A CYCLICAL The best time to sell is toward the end of the cycle, but who knows when that is? Who even knows what cycles they’re talking about? Sometimes the knowledgeable vanguard begins to sell cyclicals a year before there’s a single sign of a company’s decline. The stock price starts to fall for apparently no earthly reason. To play this game successfully you have to understand the strange rules. That’s what makes cyclicals so tricky. In the defense business, which behaves like a cyclical, the price of General Dynamics once fell 50 percent on higher earnings. Farsighted cycle-watchers were selling in advance to avoid the rush. Other than at the end of the cycle, the best time to sell a cyclical is when something has actually started to go wrong. Costs have started to rise.

One obvious sell signal is that inventories are building up and the company can’t get rid of them, which means lower prices and lower profits down the road.

Falling commodity prices is another harbinger.

Final demand for the product is slowing down.

The company has tried to cut costs but still can’t compete with foreign producers.

WHEN TO SELL A FAST GROWER Here, the trick is not to lose the potential tenbagger. On the other hand, if the company falls apart and the earnings shrink, then so will the p/e multiple that investors have bid up on the stock. This is a very expensive double whammy for the loyal shareholders.

I’m constantly amazed at popular explanations of why stocks behave the way they do, which are volunteered by amateurs and professionals alike. We’ve made great advances in eliminating ignorance and superstition in medicine and in weather reports, we laugh at our ancestors for blaming bad harvests on corn gods, and we wonder, “How could a smart man like Pythagoras think that evil spirits hide in rumpled bedsheets?” However, we’re perfectly willing to believe that who wins the Super Bowl might have something to do with stock prices.

The Twelve Silliest (and Most Dangerous) Things People Say About Stock Prices

IF IT’S GONE DOWN THIS MUCH ALREADY, IT CAN’T GO MUCH LOWER

YOU CAN ALWAYS TELL WHEN A STOCK’S HIT BOTTOM

IF IT’S GONE THIS HIGH ALREADY, HOW CAN IT POSSIBLY GO HIGHER?

IT’S ONLY $3 A SHARE: WHAT CAN I LOSE?

EVENTUALLY THEY ALWAYS COME BACK

IT’S ALWAYS DARKEST BEFORE THE DAWN

WHEN IT REBOUNDS TO $10, I’LL SELL

WHAT ME WORRY? CONSERVATIVE STOCKS DON’T FLUCTUATE MUCH

IT’S TAKING TOO LONG FOR ANYTHINGTO EVER HAPPEN

LOOK AT ALL THE MONEY I’VE LOST: I DIDN’T BUY IT!

I MISSED THAT ONE, I’LL CATCH THE NEXT ONE

THE STOCK’S GONE UP, SO I MUST BE RIGHT, OR . . . THE STOCK’S GONE DOWN SO I MUST BE WRONG

…you can’t actually spend the proceeds you get from shorting a stock until you’ve paid the shares back and closed out the transaction.

The scary part about shorting stock is that even if you’re convinced that the company’s in lousy shape, other investors might not realize it and might even send the stock price higher.

Among all the folk tales of successful short sellers are the horror stories of shorters who watched helplessly as their favorite lousy stocks soared higher and higher, against all reason and logic, forcing them into the poorhouse. One such unfortunate was Robert Wilson, a smart man and a good investor, who a decade or so ago shorted Resorts International. He was right, eventually—most shorters are right, eventually—didn’t John Maynard Keynes say in the long run “we all are dead”? In the meantime, however, the stock advanced from 70 cents to $70, a modest 100-bagger, leaving Mr. Wilson with a modest $20 or $30 million loss.

This demonstrates that the market, like individual stocks, can move in the opposite direction of the fundamentals over the short term,

I hear every day that major companies are going out of business. Certainly some of them are. But what about the thousands of smaller companies that are coming into business and providing millions of new jobs? As I make my usual rounds of various headquarters, I’m amazed to discover that many companies are still going strong. Some are actually earning money. If we’ve lost all sense of enterprise and will to work, then who are those people who seem to be stuck in rush hour?

I hear every day that AIDS will do us in, the drought will do us in, inflation will do us in, recession will do us in, the budget deficit will do us in, the trade deficit will do us in, and the weak dollar will do us in. Whoops. Make that the strong dollar will do us in. They tell me real estate prices are going to collapse. Last month people started worrying about that. This month they’re worrying about the ozone layer. If you believe the old investment adage that the stock market climbs a “wall of worry,” take note that the worry wall is fairly good-sized now and growing every day.

If you take anything with you at all from this last section, I hope you’ll remember the following:

• Sometime in the next month, year, or three years, the market will decline sharply.
• Market declines are great opportunities to buy stocks in companies you like. Corrections—Wall Street’s definition of going down a lot—push outstanding companies to bargain prices.
• Trying to predict the direction of the market over one year, or even two years, is impossible.
• It takes years, not months, to produce big results.
• Different categories of stocks have different risks and rewards.
• Stock prices often move in opposite directions from the fundamentals but long term, the direction and sustainability of profits will prevail.
• Just because a company is doing poorly doesn’t mean it can’t do worse.
• Just because the price goes up doesn’t mean you’re right.
• Just because the price goes down doesn’t mean you’re wrong.
• Buying a company with mediocre prospects just because the stock is cheap is a losing technique.
• Selling an outstanding fast grower because its stock seems slightly overpriced is a losing technique.
• Companies don’t grow for no reason, nor do fast growers stay that way forever.
• You don’t lose anything by not owning a successful stock, even if it’s a tenbagger.
• A stock does not know that you own it.
• Don’t become so attached to a winner that complacency sets in and you stop monitoring the story.
• You won’t improve results by pulling out the flowers and watering the weeds.
• There is always something to worry about.
• You don’t have to “kiss all the girls.”

Analyst List

John Adams, Adams, Harkness & Hill

Mike Armellino, Goldman, Sachs & Co.

Steve Berman

Allan Bortel

Jon Burke

Norm Caris, Gruntal & Co.

Tom Clephane, Morgan Stanley & Co.

Art Davis Don DeScenza (deceased), Nomura Securities

David Eisenberg, Sanford Bernstein

Jerry Epperson

Joe Frazzano

Dick Fredericks

Jonathan Gelles

Jane Gilday, McKinley

Allsopp Maggie

Gilliam Tom

Hanley Herb Hardt, Monness, Crespi, Hardt & Co., Inc.

Brian Harra, Brean Murray, Foster Securities

Ira Hirsch, The Fourteen Research Corp.

Ed Hyman

Sam Isaly

Lee Isgur

Robert Johnson

Joe Jolson

Paul Keleher

John Kellenyi

Dan Lee

Bob Maloney, Wood Gundy Corp.

Peter Marcus

Jay Meltzer, Goldman Sachs & Co.

Tom Petrie

Larry Rader

Tom Richter, Robinson Humphrey

Bill Ritger, Dillon Reed & Co.

Elliot Schlang

Elliot Schneider, Gruntal & Co.

Rick Schneider

Don Sinsabaugh, Swergold, Chefitz & Sinsabaugh

Stein Soelberg, Baird, Patrick & Co.

Oakes Spalding

Stewart Spector

Joseph Stechler, Stechler & Co.

Jack Sullivan (deceased), Van Kasper & Co.

David Walsh Skip Wells, Adams, Harkness & Hill

Fund Manager List

James Roger Bacon, Putnam Management

George Boltres, Tiedman, Karlin, Boltres

Tom Cashman, Massachusetts Financial Services

Ken Cassidy, Cassidy Investments

Tony Cope

Richard Corneliuson

Gerald Curtis, Webster Management

Peter deRoetth, Account Management

Tom Duncan, Frontier Capital Management

Charles Flather, Middlegreen Associates

Richard Frucci, Putnam Management

Mario Gabelli, Gabelli & Company

Bob Gintel, Gintel & Company

Dick Goldstein, Richard Goldstein

Investments Jon Gruber, Gruber Capital Management

Paul Haagensen, Putnam Management

Bill Harris (retired), Massachusetts Financial Services

Ken Heebner, Capital Growth Management

Philip Hempleman, Ardsley Partners

Ed Huebner (deceased), Hellman, Jordan Management

Richard Jodka H.

Alden Johnson, Jr. (deceased), Massachusetts Financial Services

Donald Keller, Rollert & Sullivan

David Knight, Knight, Bain, Seath & Holbrook

Kathy Magrath, Valuequest

Terry Magrath, Valuequest

Ed Mathias, The Carlyle Group

Joe McNay, Essex Investment Management

Bill Miller, Legg Mason

Neal Miller, Fidelity

David Mills

Ernest Monrad, Northeast Investors

John Neff (retired), Wellington Management

Michael Price, MFP Investors, LLC

Jimmy Rogers

Binkley Shorts, Wellington Management

Rick Spillane, Eaton Vance (now Fidelity)

Richard Strong, Strong Corneliuson

Eyk Van Otterloo, Grantham, Mayo, Van Otterloo

Ernst H. von Metzch, Wellington Management

Wally Wadman, Constitution Research & Management Inc.

Matt Weatherbie, M.A. Weatherbie & Co., Inc.

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This was one of the best books I have ever read on investing.  The author Gautam Baid is not someone I had heard of before, but he is a good writer and researcher who knows how to synthesize the ideas of others into a coherent narrative.  I would highly recommend this entire book to anyone interested in the topic of investing, but I am not going to dive too deeply into the actual content in the body of this review. Instead, I included below a long list of annotated passages, tables, and one of the largest and most precious collections of investment quotes that I have come across in any book.

Gautam doesn’t share much about his professional career in the book, but he provided more color in this interview from January 2020:  “I am the youngest of the four siblings in my family and my parents, my two elder sisters and my elder brother reside in Kolkata, India. Prior to my relocation to the US in 2015, I served for seven years at the Mumbai, London and Hong Kong offices of Citigroup and Deutsche Bank as Senior Analyst in their healthcare investment banking teams.”  …  “I was so keen for a career shift that I relocated to the US (one of my relatives who is an American citizen sponsored my green card) without any job in hand!”  …  “I ran out of whatever little money I had brought with me from India and to take care of my living expenses in US, I did not want to sell even a single share from my portfolio of Indian stocks as I did not want to interrupt the process of compounding. So, I took up a minimum wage job as a front desk clerk at a hotel in San Francisco where I used to work during the graveyard shift.” One fine night during November 2016 while working at the hotel, I randomly clicked on the “quick-apply” button on a job application on LinkedIn during the course of my routine online job search. I unexpectedly received an interview call for the job and that too for a senior role in an investment firm even though I had zero formal work experience in the stock market!. … I was offered the role of Portfolio Manager and it was like a dream come true for me. Today, even after achieving financial freedom, I continue to work in my job because I just love the work that I get to do and the icing on the cake is that I get paid for getting to learn and improve every day.”

Gautam mentions in the interview that he was offered a Portfolio Manager job, yet this note that ran in the Utah Business Journal claims he joined Salt Lake City-based Summit Global Investors as a Senior Analyst.  As Summit’s website indicates, Gautam is a part of a 5-man team who co-manage US and Global equity portfolios by combining fundamental analysis with a quantitative Multi-Factor Model (MFM).  Founded in 2010, the firm manages about $1.3B across three strategies (US Large Cap, US Small Cap, and Global) – all of which have underperformed their benchmarks over the last 5 years.  Either way, Summit (SGI) is mentioned only once in the book (in a brief disclaimer), to say that Gautam’s views are his own and not associated with his employer’s.  His twitter account, which has over 70k followers, is also explicitly disassociated with Summit, who’s CEO (David Harden) can be seen here making a bad market-timing call ahead of the election in this CNBC clip from October 29, 2020.

Judging by his boyish looks and clear brilliance, one might be excused for thinking Gautam is a prodigy, but that’s far from the case. “Throughout my childhood years, I was a weak student,” he explains early in the book. “I barely finished tenth grade. My scores were so abysmally low that it was a struggle for me to gain admission to a decent high school. It was only my subsequent awakening, driven by a major personal setback, that made me finally realize the virtues of hard work and determined effort, and that was the catalyst for my academic revival and professional career growth.”  Instead of focusing on setbacks (which he apparently had several in his life), Gautam’s book offers precious insights and advice from the greats, on Becoming a Learning Machine (Section I), Building stronger Character (Section II), Common Stock Investing (Section III) and Portfolio Management (Section IV).  I enjoyed the whole book and will certainly read it again, but I also think that it could have easily been split in two 200-page books.

Chapter 22 was my favorite, because it did a great job of explaining why stocks go up or down over time, and it synthesized very well why quality is the holy grail of long-term investing – a concept that is near to our hearts at Victori.  “The time to evaluate quality is before the price action starts and not after it,” Gautam reminds us.  “Making the correct qualitative judgment about a business, including the long-term sustainability of its success attributes, is more important than the entry valuation over a long-term holding period. Within reason, you can survive overpaying for a growing high-quality franchise. If you have to go wrong, go wrong on valuation but not on quality.”

In summary, this was a gem of a book that came from an unlikely and largely unknown author.  While it can get a little heavy at times for those who are not enthusiasts, it’s lessons and insights go far beyond investing, and just the quotes alone are worth far more than the book.  In addition to serving as a manual on value investing, Gautam’s book and life story inspire a passion for learning and the pursuit of happiness.  As Munger would say and Buffett actually wrote, this book “deserves success.”

Best regards,

Adriano

Highlighted Passages:

Chapter 1: Introduction: The Best Investment You Can Make Is an Investment in Yourself

An hour’s time spent acquiring in-depth knowledge about an important principle pays off in the long run.

This is why good books are the most undervalued asset class: the right ideas can be worth millions, if not billions, of dollars over time.

Minimize your commute time to work and outsource all of the noncore time-consuming menial tasks to free up valuable time for self-development.

Section 1 – Achieving Worldly Wisdom

Chapter 2: Becoming a Learning Machine

When someone asked Jim Rogers what was the best advice he ever got, he said it was the advice he received from an old man in an airplane: read everything.

There is no better teacher than history in determining the future…. “There are answers worth billions of dollars in a $30 history book.” —Bill Gross

The rich invest in time, the poor invest in money. —Warren Buffett

For starters, I hardly watch television. I don’t even have a cable television connection. I get all my desired content on Netflix, YouTube, and Amazon Prime. I watch only those select few movies, documentaries, and shows that truly pique my interest. I ensure that I don’t spend a lot of time commuting to my workplace. I live in an area where I can walk to the grocery store, finish my purchases, and return home in less than twenty minutes. I have fully automated the monthly payments online for my phone, electricity, Internet, utilities, and meal plan bills.

You need to find writers who are more knowledgeable on a particular subject than you are. This is how you become more intelligent. Reach out to and associate with people better than you and you cannot help but improve.

Rarely do we stop to ask ourselves questions about what we consume: Is this important? Is this going to stand the test of time for even a year?

“The true scarce commodity of the near future will be human attention.” —Satya Nadella

In an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it. —Herbert Simon

The key lesson is that, in the pursuit of wisdom, we must read much more of what has endured over time (such as history or biographies) than what is ephemeral (such as daily news, social media trends, and the like). I agree with Andrew Ross, who says, “The smallest bookstore still contains more ideas of worth than have been presented in the entire history of television.”

Always respect the old. Apply the “Lindy effect” to reading and learning. According to Nassim Taleb, “The Lindy effect is a concept that the future life expectancy of some nonperishable things like a technology or an idea is proportional to their current age, so that every additional period of survival implies a longer remaining life expectancy.”  So, a book that has stood the test of time and survived fifty or one hundred or five hundred years and is still widely read because it contains timeless wisdom is expected to survive another fifty or one hundred or five hundred years for that very reason—that is, its wisdom is timeless.

The man who doesn’t read good books has no advantage over the man who cannot read them. —Mark Twain

Also, share your latest book purchases with like-minded friends. It’s a lot of fun to co-read and exchange insights.

Adler and Van Doren identify four levels of reading: elementary, inspectional, analytical, and syntopical. Before we can improve reading skills, we need to understand the differences among these reading levels. They are discussed as levels because you must master one level before you can move to a higher level. They are cumulative, and each level builds on the preceding one. Here is how Adler and Van Doren describe these four levels:

1. Elementary reading. This is the most basic level of reading as taught in our elementary schools. It is when we move from illiteracy to literacy.
2. Inspectional reading. This is another name for “scanning” or “superficial reading.” It means giving a piece of writing a quick yet meaningful advance review to evaluate the merits of a deeper reading experience. Whereas the question that is asked at the first level (elementary reading) is “What does the sentence say?” the question typically asked at this level is “What is the book about?”
3. Analytical reading. Analytical reading is a thorough reading. This is the stage at which you make the book your own by conversing with the author and asking many organized questions. Asking a book questions as you read makes you a better reader. But you must do more. You must attempt to answer the questions you are asking. While you could do this in your mind, Adler and Van Doren argue that it’s much easier to do this with a pencil in your hand. “The pencil,” they argue, “becomes the sign of your alertness while you read.” Adler and Van Doren share the many ways to mark a book. They recommend that we underline or circle the main points; draw vertical lines at the margin to emphasize a passage already underlined or too long to be underlined; place a star, asterisk, or other symbol at the margin for emphasis; place numbers in the margin to indicate a sequence of points made in developing an argument; place page numbers of other pages in the margin to remind ourselves where else in the book the author makes the same points; circle keywords or phrases; and write our questions (and perhaps answers) in the margin (or at the top or bottom of the pages). This is how we remember the best ideas out of the books we read, long after we have read them—by making a book our own through asking questions and seeking answers within it. As Cicero said, “Nothing so much assists learning as writing down what we wish to remember.”
4. Syntopical reading. Thus far, we have been learning about how to read a book. The highest level of reading, syntopical reading, allows you to synthesize knowledge from a comparative reading of several books about the same subject. This is where the real virtue of reading is actualized. I usually read multiple nonfiction books in tandem. I pick the one that interests me the most at the time and read at least one full chapter. If it keeps my interest, I keep going for another chapter.

Something you perceived to be of low value in an old book transforms into something of significant value, unlocked by another book in the future.

Reading multiple books simultaneously, quitting those that are not engaging, and constantly picking up new ones is the antifragile approach to self-education.

The Matthew effect, in this context, refers to a person who has more expertise and thus has a larger knowledge base. This larger knowledge base allows that person to acquire greater expertise at a faster rate. So, the amount of useful insight that Buffett can draw from the same reading material would be quite high compared with most any other person, and again, Buffett would end up becoming smarter at a faster rate.

When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it. —Jeff Bezos

When Jeff Bezos started Amazon.com, in 1995, he clearly identified the first principles that would guide his business philosophy—that is, long-term thinking and a relentless focus on the customer rather than on the competition. This led Amazon to focus on things that don’t change, such as customers’ preference.

“David was always there in the marble. I just took away everything that was not David.” – Michelangelo … This is the art of “reductionism.” Less is more. When we remove the things that aren’t truly representative of reality, we get closer to the ultimate truth.  … Nassim Taleb calls this “subtractive epistemology.” He argues that the greatest contribution to knowledge consists of removing what we think is wrong. We know a lot more about what is wrong than what is right. What does not work (i.e., negative knowledge) is more robust than positive knowledge. … Thus, disconfirmation is more rigorous than confirmation.

To apply first principles thinking to the field of value investing, consider several fundamental truths. Understand and practice the following if you want to become a good investor:

1. Look at stocks as part ownership of a business.
2. Look at Mr. Market—volatile stock price fluctuations—as your friend rather than your enemy. View risk as the possibility of permanent loss of purchasing power, and uncertainty as the unpredictability regarding the degree of variability in the possible range of outcomes.
3. Remember the three most important words in investing: “margin of safety.”
4. Evaluate any news item or event only in terms of its impact on (a) future interest rates and (b) the intrinsic value of the business, which is the discounted value of the cash that can be taken out during its remaining life, adjusted for the uncertainty around receiving those cash flows.
5. Think in terms of opportunity costs when evaluating new ideas and keep a very high hurdle rate for incoming investments. Be unreasonable. When you look at a business and get a strong desire from within saying, “I wish I owned this business,” that is the kind of business in which you should be investing. A great investment idea doesn’t need hours to analyze. More often than not, it is love at first sight.
6. Think probabilistically rather than deterministically, because the future is never certain and it is really a set of branching probability streams. At the same time, avoid the risk of ruin, when making decisions, by focusing on consequences rather than just on raw probabilities in isolation. Some risks are just not worth taking, whatever the potential upside may be.
7. Never underestimate the power of incentives in any given situation.
8. When making decisions, involve both the left side of your brain (logic, analysis, and math) and the right side (intuition, creativity, and emotions).
9. Engage in visual thinking, which helps us to better understand complex information, organize our thoughts, and improve our ability to think and communicate.
10. Invert, always invert. You can avoid a lot of pain by visualizing your life after you have lost a lot of money trading or speculating using derivatives or leverage. If the visuals unnerve you, don’t do anything that could get you remotely close to reaching such a situation.
11. Vicariously learn from others throughout life. Embrace everlasting humility to succeed in this endeavor.
12. Embrace the power of long-term compounding. All the great things in life come from compound interest.

Knowledge is overrated. Wisdom is underrated. Intellect is overrated. Temperament is underrated. Outcome is overrated. Process is underrated.

Growth is overrated. Longevity is underrated.

Chapter 3: Obtaining Worldly Wisdom Through a Latticework of Mental Models

Price-to-earnings ratio is overrated. Duration of competitive advantage period is underrated.

A foundational principle that aligns with the world and is applicable across the geologic time scale of human, organic, and inorganic history is compounding. Compounding is one of the most powerful forces in the world. In fact, it is the only power law in the universe that exists with a variable in its exponent.

The notion of a critical mass—that comes out of physics—is a very powerful model.

“Life is just one damn relatedness after another.”

In short, thinking for yourself. You simply cannot do that in bursts of 20 seconds at a time, constantly interrupted by Facebook messages or Twitter tweets, or fiddling with your iPod, or watching something on YouTube. I find for myself that my first thought is never my best thought. My first thought is always someone else’s; it’s always what I’ve already heard about the subject, always the conventional wisdom. It’s only by concentrating, sticking to the question, being patient, letting all the parts of my mind come into play, that I arrive at an original idea. By giving my brain a chance to make associations, draw connections, take me by surprise…You do your best thinking by slowing down and concentrating.

Look at this generation, with all of its electronic devices and multitasking. I will confidently predict less success than Warren, who just focused on reading. If you want wisdom, you’ll get it sitting on your ass. That’s the way it comes. —Charlie Munger

Understand deeply. When you learn anything, go for depth and make it rock solid. Any concept that you are trying to master is a combination of simple core ideas. Identify the core ideas and learn them deeply. This deeply ingrained knowledge base can serve as a meaningful springboard for more advanced learning and action in your field. Be brutally honest with yourself. If you do not understand something, revisit the core concepts again and again. Remember that merely memorizing stuff is not deep learning.

“I’ve missed more than nine thousand shots in my career. I’ve lost almost three hundred games. Twenty-six times, I’ve been trusted to take the game-winning shot and missed. I’ve failed over and over and over again in my life. And that is why I succeed.” – Michael Jordan

“many of life’s failures are people who did not realize how close they were to success when they gave up.” – Thomas Edison

Munger’s speeches and essays are filled with the thoughts of the great thinkers from many different domains. Munger reserves a lot of time in his schedule for reading and has read hundreds of biographies. He explains why he does so: “I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”

Chapter 4: Harnessing the Power of Passion and Focus Through Deliberate Practice

It’s the desire to learn that’s scarce. —Naval Ravikant

Take up one idea. Make that one idea your life—think of it, dream of it, live on that idea. Let the brain, muscles, nerves, every part of your body, be full of that idea, and just leave every other idea alone. This is the way to success. —Swami Vivekananda

Source: Thomas Oppong, “Ikigai: The Japanese Secret to a Long and Happy Life Might Just Help You Live a More Fulfilling Life,” Medium, January 10, 2018, https://medium.com/thrive-global/ikigai-the-japanese-secret-to-a-long-and-happy-life-might-just-help-you-live-a-more-fulfilling-9871d01992b7.

“Your goal in life is to find out the people who need you the most, to find out the business that needs you the most, to find the project and the art that needs you the most. There is something out there just for you.” —Naval Ravikant

Self-realization is closely linked to the concept of self-actualization, best known in the field of psychology in the context of Abraham Maslow’s hierarchy of needs. Self-actualized people are those who are fulfilled and are doing all that they are capable of. Maslow described the good life as one directed toward self-actualization, the higher need. Self-actualization occurs when you maximize your potential by doing your best.

“I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times.” —Bruce Lee

Focus on those investments for which the microeconomics are going to dominate the outcome. This approach will allow you to call upon your accumulated experience in analyzing companies and industries and to utilize the same to your advantage.

Today, an investor’s edge is less about knowing more than others about a specific stock and more about the mind-set, discipline, and willingness to take a long-term view about the intrinsic value of a business.

One of the best hacks in the investment field is learning to be happy doing nothing.

Investing isn’t just a process of wealth creation; it is a source of great happiness and sheer intellectual delight for the truly passionate investor. It is great to be passionate in life, but it is wise to be so only for things that are under our control, or else we risk being dejected because of unfavorable outcomes.

The only way to gain an edge is through long and hard work. Do what you love to do, so you just naturally do it or think about it all the time, even if you are relaxing…. Over time, you can accumulate a huge advantage if it comes naturally to you like this [emphasis added]. —Li Lu

Life is long if you know how to use it. —Seneca

We have two lives, and the second begins when we realize we have only one. —Confucius

“Our life is a matter of choices. Choose what makes you happy and your life will never go wrong. Some people die at age twenty-five but aren’t buried until they are seventy-five. Some people aren’t born until they are age twenty-five. Strive to be the latter. One day your life will flash before your eyes. Make sure it’s worth watching.” —Gerard Way

In his book The Little Book of Talent, Daniel Coyle wrote: From a distance, top performers seem to live charmed, cushy lives. When you look closer, however, you’ll find that they spend vast portions of their life intensively practicing their craft. Their mind-set is not entitled or arrogant; it’s 100-percent blue collar: They get up in the morning and go to work every day, whether they feel like it or not. As the artist Chuck Close says, “Inspiration is for amateurs.”

Section II—Building Strong Character

Chapter  5: The Importance of Choosing the Right Role Models, Teachers, and Associates in Life

It is a wonderful feeling to care for our parents. We have many ways to do this. Showing appreciation for little acts. Spending time together. Making small gestures of love and affection. This is all most parents want from us. It is what gives them great happiness. … My noble mother taught me the virtues of honesty, kindness, and empathy. My dear father constantly motivated me to push my limits and to improve. He has been a great friend, philosopher, and guide and has given me the greatest gift anyone could give: he believed in me. … Throughout my childhood years, I was a weak student. I barely finished tenth grade. My scores were so abysmally low that it was a struggle for me to gain admission to a decent high school. It was only my subsequent awakening, driven by a major personal setback, that made me finally realize the virtues of hard work and determined effort, and that was the catalyst for my academic revival and professional career growth. And this is why I instantly related to legendary investor Arnold Van Den Berg’s life, when I read his inspirational words: “I always had this image of myself that I wasn’t very smart, and the way I did in school proved that I wasn’t. But: Once I realized that if you dedicate yourself and you commit yourself, you can learn anything. I will admit this: whatever I learn takes me three times as long as anybody else. But if I spend three times as much time as anybody else, then I’m equal. I can learn it, just give me more time, more books.”

(if you want to know someone’s priorities in life, observe what they do between Friday evening and Monday morning),

Chapter 6: Humility Is the Gateway to Attaining Wisdom

True expert knowledge in life and investing does not exist, only varying degrees of ignorance.

I was born not knowing and have had only a little time to change that here and there. —Richard Feynman

Frank Wells was president of the Walt Disney Company from 1984 until his death in 1994. After Wells died, his son found a little piece of paper in his wallet that read “Humility is the essence of life.” Later, it was discovered that Frank Wells had carried that note with him for thirty years.

“Doubt is not a pleasant condition, but certainty is absurd.” —Voltaire

Morgan Housel offers a helpful suggestion to help us better empathize: “Start with the assumption that everyone is innocently out of touch and you’ll be more likely to explore what’s going on through multiple points of view, instead of cramming what’s going on into the framework of your own experiences. It’s hard to do. It’s uncomfortable when you do. But it’s the only way to get closer to figuring out why people behave like they do.” …  Housel writes: “It goes like this. The more successful you are at something, the more convinced you become that you’re doing it right. The more convinced you are that you’re doing it right, the less open you are to change. The less open you are to change, the more likely you are to tripping in a world that changes all the time. There are a million ways to get rich. But there’s only one way to stay rich: Humility, often to the point of paranoia. The irony is that few things squash humility like getting rich in the first place. It’s why the composition of Dow Jones companies changes so much over time, and why the Forbes list of billionaires has 60 percent turnover per decade…. Humility doesn’t mean taking fewer risks. Sequoia takes as big of risks today as it did 30 years ago. But it’s taken risks in new industries, with new approaches, and new partners, cognizant that what worked yesterday isn’t what will work tomorrow.”

CERTAINTY. An imaginary state of clarity and predictability in economic and geopolitical affairs that all investors say is indispensable—even though it doesn’t exist, never has, and never will. The most fundamental attribute of financial markets is uncertainty. UNCERTAINTY. The most fundamental fact about human life and economic activity. In the real world, uncertainty is ubiquitous; on Wall Street, it is nonexistent.

The question of doubt and uncertainty is what is necessary to begin; for if you already know the answer there is no need to gather any evidence about it. I have approximate answers and possible beliefs and different degrees of certainty about different things, but I’m not absolutely sure of anything and there are many things I don’t know anything about. The first source of difficulty is that it is imperative in science to doubt; it is absolutely necessary, for progress in science, to have uncertainty as a fundamental part of your inner nature. To make progress in understanding, we must remain modest and allow that we do not know. Nothing is certain or proved beyond all doubt. You investigate for curiosity, because it is unknown, not because you know the answer. And as you develop more information in the sciences, it is not that you are finding out the truth, but that you are finding out that this or that is more or less likely.

One should not blindly chase “buzzing stocks” or get swayed by exciting “stories,”“narratives,” or “futuristic” concepts, because these kinds of businesses usually have unproven track records or they lack profitability and cash flow.

Inspired by the German mathematician Carl Gustav Jacob Jacobi, Munger explains, Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead—through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.

“If we have a business about which we’re extremely confident as to the business results, we’d prefer that its stock have high volatility. We’ll make more money in a business where we know what the end game will be if it bounces around a lot.”

“I learned early in my career that if you read the annual reports, you’ve done more than 90 percent of the people on Wall Street. If you read the notes to the annual report, you’ve done more than 95 percent of the people on Wall Street.” —Jim Rogers

“I’ve always said that if you look at ten companies you’ll find one that’s interesting. If you look at 20, you’ll find, two; if you look at 100, you’ll find ten. The person that turns over the most rocks wins the game…. It’s about keeping an open mind and doing a lot of work. The more industries you look at, the more companies you look at, the more opportunity you have of finding something that’s mispriced.” —Peter Lynch

Chapter 7: The Virtues of Philanthropy and Good Karma

Thanks to my senior’s timely warning, I was able to exit the stock a few days earlier, at a handsome profit. When I called my senior to thank him and ask why he had helped me by sharing such sensitive information, these were his words: “Because you always used to share helpful company and industry data with me from time to time, even when I never asked you for it. You helped me then; I helped you now.”

Chapter 8: Simplicity Is the Ultimate Sophistication

In an interview with Business Wire in November 2011, Buffett said, “If you understand chapters 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of The General Theory (John Maynard Keynes, 1936), you don’t need to read anything else and you can turn off your TV.

Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count [emphasis added]. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables. —Warren Buffett

“The goal of investment is to find situations where it is safe not to diversify.” – Munger

“We have a passion for keeping things simple. If something is too hard, we move on to something else. What could be more simple than that?” – Munger

Every investor should diligently study the white papers titled “What Does a Price-Earnings Multiple Mean?” and “The P/E Ratio: A User’s Manual” by Michael Mauboussin and Epoch Investment Partners, respectively.

“Let’s be honest. We don’t know for sure what makes us successful. We can’t pinpoint exactly what makes us happy. But we know with certainty what destroys success or happiness. This realization, as simple as it is, is fundamental: Negative knowledge (what not to do) is much more potent than positive knowledge (what to do).” —Rolf Dobelli

To make good investing decisions, you need to actively look for reasons not to buy the stock in question. Simplifying helps us make better decisions by breaking down complex problems into component parts. For example, I ask four inverted questions whenever I am looking at a stock. These questions break the mind-set of trying to find supportive bullish reasons and force me to actively seek out disconfirming evidence. 1. How can I lose money? versus How can I make money? If you focus on preventing the downside, the upside takes care of itself. 2. What is this stock not worth? versus What is this stock going to be worth? If you can identify the floor price or a cheap price for a stock, it’s far easier to make profitable decisions. 3. What can go wrong? versus What growth drivers are there? Rather than focusing just on the growth catalysts, think probabilistically, in terms of a range of possible outcomes, and contemplate the possible risks, especially those that have never occurred. 4. What is the growth rate being implied by the market in the current valuation of the stock? versus What is my future growth rate assumption? A reverse discounted cash flow fleshes out the current assumptions of the market for the stock. We can then compare the market’s assumptions with our own and make a decision accordingly.

From traveling with less personal luggage, eating less junk food and sugar, and using fewer apps on my mobile phone to having fewer stocks in my portfolio, I have embraced minimalism as a way of living. I already can see the immense benefits of clarity, focus, and efficiency that this has brought to my life. To me, minimalism is about living with less stress. The fact that it saves money is just an added benefit.

“There is no path to peace. Peace is the path.” —Mahatma Gandhi

Chapter 9. Achieving Financial Independence

“A journey of a thousand miles begins with a single step.” – Lao Tzu

The only definition of success is to be able to spend your life in your own way.

The Way to Wealth, published in 1758, is a summary of Benjamin Franklin’s advice from Poor Richard’s Almanack, published from 1733 to 1758. It’s a compilation of proverbs woven into a systematic ethical code advocating industry and frugality as a “way to wealth,” thereby securing personal virtue. Franklin’s advice is just as relevant today as it was more than 260 years ago. He advocated work ethic, industry, and enterprise in one’s daily affairs: “But dost thou love life, then do not squander time, for that’s the stuff life is made of.”

It doesn’t matter what you do during the day, because you earn enough money while you are sleeping.

Great wealth often inflicts a curse on its owners. It’s called the “hedonic treadmill,” and its function is to continually move the goalpost of your financial dreams, completely extinguishing the joy you thought you would get from having more money, once you attain it. People are constantly running on the hedonic treadmill; as they make more money, their expectations and desires rise in tandem, which results in no permanent gain in happiness.

This revelation was termed the Easterlin paradox. Once one’s basic needs have been met, incremental financial gain contributes nothing to happiness. This is because, in our minds, wealth is always relative, not absolute.

A research study posed the following question: Which new employee would be happier, the person making $36,000 in a firm where the starting salary is $40,000 or the one making $34,000 where the average is $30,000? Almost 80 percent said $34,000 would make them happier.

Chapter 10: Living Life According to the Inner Scorecard

According to Warren Buffett, there are two kinds of people in life: those who care what people think of them, and those who care how good they really are.

I think the concept of fiduciary duty is innate: people either have it or they don’t.

“For Bernie Madoff, living a lie had once been a full-time job, which carried with it a constant, nagging anxiety. ‘It was a nightmare for me,’ he told investigators, using the word over and over, as if he were the real victim. ‘I wish they caught me six years ago, eight years ago,’ he said in a little-noticed interview with them.”

Shane Parrish writes, “The little mental trick is to remember that success, money, fame, and beauty, all the things we pursue, are merely the numerator! If the denominator—shame, regret, unhappiness, loneliness—is too large, our ‘Life Satisfaction Score’ ends up being tiny, worthless. Even if we have all that good stuff!…It’s so simple. This is why you see people that ‘should be happy’ who are not. Big denominators destroy self-worth.”

Chapter 11: The Key to Success in Life Is Delayed Gratification

“I didn’t get to where I am by going after mediocre opportunities.” – Munger

Most managers are not willing to suffer upfront pain. So they focus on short-term results, which contributes to underinvestment in brand building, R&D, and other long-term growth initiatives, which in turn eventually leads to long-term pain. They cut current costs to prop up current earnings, rather than spend more now to gain much more later. Consequently, they hurt their chances of long-term success.

“You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.” —Seth Klarman

Anshul Khare once aptly remarked, “In the initial years…compounding tests your patience and in later years, your bewilderment.”

Similarly, investors in Adobe (which, as of October 2019, has delivered a CAGR of ~24% since its IPO in August 1986) had to undergo a period of thirteen years (2000–2013) during which they made nil return on its stock. Investing is hard. Very hard.

Investors tend to become complacent and stop questioning their existing holdings when their stock prices are going up. They resume analyzing in detail only when the prices start falling. Don’t analyze your holdings only when they fall. Just because the stock price of an existing holding is going up doesn’t necessarily mean that nothing negative is happening in its business.

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”

In short, since 1950, there has never been any 20-year period when investors did not make at least 6 percent per year in the stock market. Although past performance is no guarantee of future returns, history shows that the longer the time frame, the greater are the odds of earning a satisfactory return.

It is human nature to seek instant gratification, and the market is dominated by individuals who simply do not want to wait for much larger rewards several years down the line. As a result, many investors end up engaging in “hyperbolic discounting,” heavily discounting the distant but large cash flows of high-quality businesses by applying high equity risk premiums, and they end up with much lower estimates of intrinsic business value than otherwise would have been the case. Consequently, even though those businesses may be fairly valued in the short term, they end up becoming grossly undervalued on a long-term basis. Professor Sanjay Bakshi illustrated this anomaly in his seminal October 2013 white paper on how quality businesses frequently end up getting mispriced by the market. (Any stock that has compounded at 15 percent to 20 percent for decades was, by definition, undervalued by the market for long periods of time.)

One Small Step Can Change Your Life: The Kaizen Way by Robert Maurer is one of my favorite books. It talks about the power of compounding small daily positive actions. This small book talks about the big idea of kaizen, which is Japanese for “taking small steps for continual improvement.” … The smaller steps get us to the desired goal because they can be incorporated more easily into our daily life. Small steps make delaying gratification easier and sustainable. So, whether it is quitting a bad habit or forming a good one, the idea is to start small, very small, and then to build on it over time. As the saying goes, “If we are facing in the right direction, all we have to do is keep on walking.”

Section III—Common Stock Investing

Chapter 12: Building Earning Power Through a Business Ownership Mind-Set

As an investor, your money is working for you 24/7. You are becoming wealthier with each passing second, alongside the increasing intrinsic value of your businesses.

As companies grow larger and more profitable, their stockholders share in the increased profits and dividends. Invest for the long term. Live fully today. Every day, millions of hardworking people around the world are doing great things at so many companies. As investors, we are thankful.

Chapter 14: The Significant Role of Checklists in Decision-Making

Charlie Munger has often been credited with popularizing the use of checklists in investing. In Poor Charlie’s Almanack, Peter Kaufman summarized Munger’s investing principles (risk, independence, preparation, intellectual humility, analytic rigor, allocation, patience, decisiveness, change, and focus) in a checklist form. This is a must-read for all investors.

Learn about the company and its competitors (both listed and unlisted) from company websites, filings, and information on the Internet. Read the past ten years’ worth of annual reports, proxies, notes and schedules to the financial statements, and management discussion and analysis (check for changes in tone and industry outlook) and observe the recent trends in insider shareholding.

[Cognitive dissonance] causes us to remain consistent with prior commitments and ideas, even in the face of disconfirming evidence. This includes confirmation bias—that is, looking for evidence that confirms our beliefs and ignoring or distorting disconfirming evidence to reduce the stress from cognitive dissonance.  … If you find yourself in a hole, stop digging. …  We are programmed to be lazy and are naturally inclined to follow the path of least resistance, that is, doing what is easy rather than doing what is required.

People will do many things to feel loved. They will do all things to be envied.

A good person can make a bad argument. A bad person can make a good argument. Judge the argument, not the person. Practice intellectual integrity.

Mental confusion from say-something syndrome. We often feel a need to say something when we have nothing to say. As the saying goes, “Better to remain silent and be thought a fool than to speak and remove all doubt.”

“You need a different checklist and different mental models for different companies. I can never make it easy by saying, ‘Here are three things.’ You have to derive it yourself to ingrain it in your head for the rest of your life.” – Munger

“Doing something according to pre-established rules, filters and checklists often makes more sense than doing something out of pure emotion. But we can’t have too many rules, filters or items without thinking. We must always understand what we’re trying to accomplish.”

Chapter 15: Journaling Is a Powerful Tool for Self-Reflection

When we remember something, we are simply pulling up a number of false details. Maybe we are even adding new errors with each act of recall. The presence of this feedback loop in memory reconsolidation compounds the problem over time. We tend to remember the things we want to remember and forget the things we would rather forget. As a result, a significant part of our memories is self-distorted fiction.

A decision journal helps you collect accurate and honest feedback on what you were thinking when you made decisions. This feedback helps you realize when you were just plain lucky. Sometimes things work out well for very different reasons than we initially envisaged. … This feedback loop is incredibly important, because the mind won’t provide it on its own. We don’t know as much as we think we know. We are fooled into thinking that we understand something when we do not, and we have no means to correct ourselves. Our minds revise history to preserve our view of ourselves. The story that we tell ourselves conjures up a linear cause-and-effect relationship between a decision we made and the actual outcome. The best cure for this cognitive malfunction is a decision journal.

In investing, conducting a premortem lets us take appropriate corrective action in a timely manner in the future. Before you buy a stock, visualize that a year has passed from the date of your purchase and that you have lost money on your investment, even in a steady market. Now, write down on a piece of paper what went wrong in the future. This “prospective hindsight” technique forces you to open up your mind, to think in terms of a broad range of outcomes, to consider the outside view, and to focus your attention on those potential sources of downside risk that did not intuitively come to your mind the first time you thought about buying a stock. Visualizing a range of scenarios for variables outside of one’s control also helps investors make better decisions for individual position sizing and portfolio construction.

Writing, apart from being a communication tool, is a thinking tool, too. It is almost impossible to write one thing and simultaneously think something else. When you force your hand to write something, it channels your thoughts in the same direction. Journaling turns out to be not just a tool for thinking but also a highly effective medium for focusing our thoughts. … Journaling has therapeutic benefits, too. Writing aids self-reflection, which is a great way to ease any unhappiness in our lives. Writing also improves our memory, because we remember more when we write down our thoughts and learnings.

Chapter 16: Never Underestimate the Power of Incentives

This just goes to show how the interplay of multiple behavioral biases results in extreme irrational outcomes. It is why Charlie Munger recommends, “Anti-gaming features constitute a huge and necessary part of system design. Also needed in the system design is an admonition: dread.” Incentives are not only financial but also include prestige, freedom, time, titles, power, and admiration. All of these are powerful incentives. And, according to Munger, few forces are more powerful than incentives: “Any time you create large differences in commissions where the guy gets X% for selling A, which is some mundane security, and 10 times X for selling B, which is something toxic, you know what’s going to happen.”

Because incentive-caused bias operates automatically, at a subconscious level, you may be fooled into believing that what is good for you is also good for the client.

Chapter 17: Always Think About the Math, but Avoid Physics Envy

“Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.” —Peter Lynch

“You don’t need a weighing scale to know that a four-hundred-pound man is fat.”

Personally, I have never opened a spreadsheet even once when making an investment decision. The most advanced technology I have ever used is a pocket calculator for basic math like addition, subtraction, multiplication, and division.

“Price is what you pay. Value is what you get.” – Buffett

The smarter you are, the better you are at constructing a narrative that supports your personal beliefs, rationalizing and framing the data to fit your argument or point of view. You may be smart, but not necessarily intelligent, because intelligence is the ability to arrive at accurate cause-and-effect descriptions of reality.

Suppose we want to know under what scenario we could earn a 15 percent annual return from this stock. What assumptions would be required to hold true to achieve this—and, more important, are they reasonable? A present market value of $1 billion and an annual return of 15 percent leads to $4 billion in market value in year 10. An exit multiple of 15× suggests owner earnings of $270 million in year 10. This implies an average annual growth rate of 21 percent in owner earnings (on the initial starting point of $40 million). A hypothetical profit margin of 15 percent suggests sales of $1.8 billion in year 10. This implies a 21 percent annual growth rate in sales for ten years. Now we can work with the various assumptions regarding required sales volume growth, trends in sales realization per unit, market share, and so on, and we can assess whether these are reasonable, given the past trends and track record of volume growth, pricing power, profit margins, market size, market share, and competitive advantage.  …  We cannot apply this model to fast-moving technology businesses, but we can apply it to moated businesses that meet basic human needs and aspirations in a relatively unsaturated market with a long runway for growth. These businesses usually experience a slower rate of change in their business models.

“We never sit down, run the numbers out and discount them back to net present value…. The decision should be obvious.”

Chapter 18: Intelligent Investing Is All About Understanding Intrinsic Value

In the past, Warren Buffett has described intrinsic value as private owner value, the price that an informed buyer would pay for the entire business and its future stream of cash.

“There is nothing more dangerous than an idea if it’s the only one you have.” – anonymous

The longer the competitive advantage period (CAP), the more likely a business is worth a lot more than what the market thinks. “Durability” of the moat is the key factor.

Ten dollars of earnings from a capital-light business like Moody’s, with its low reinvestment requirements, is obviously worth a lot more than the same earnings figure from a capital-intensive business like General Dynamics, so investors should capitalize each of them differently. Investors have to look at each business’s earning power, along with the future prospects of the business, to decide how much they are willing to pay to acquire that business’s future cash flows.

The traditional “value investor” mentality of buying cheap securities, waiting for them to bounce back to “intrinsic value,” selling and moving onto the next opportunity, is flawed. In today’s world of instant information and fast-paced innovation, cheap securities increasingly appear to be value traps; often they are companies ailing from technological disruption and long-term decline. This rapid recycling of capital also creates an enormous drag on our after-tax returns. In addition, by focusing on these opportunities, we incur enormous opportunity costs by not focusing instead on the tremendous opportunities created by the exceptional innovation S-curves we are currently witnessing. —Marcelo Lima, Managing Partner at Heller House.

I have learned to respect the market’s wisdom. Everything trades at the level it does for a reason. High quality tends to trade at expensive valuation and junk or poor quality is frequently available at cheap (or the harmful “optically cheaper on a relative basis”) valuation. It took me many years to learn this big market lesson: expensive is expensive for a reason and cheap is cheap for a reason.

“Remember that a man who will steal for you, will steal from you.”

Chapter 19. The Three Most Important Words in Investing

Time and again, the market teaches us that a big difference exists between a great company and a great stock.

A stable investor who earns 20 percent for two consecutive years comes out ahead of a flamboyant newcomer who earns 100 percent in a bull market year and loses 30 percent or more in the following year. (Most of the inexperienced investors realize this harsh math the painful way when junk stocks finally start crashing after a bull market, and only then do they begin to appreciate the significant importance of investing in quality.)

There always seems to be a strong divide within the investing community between “deep value” (statistically cheap securities) and “growth at a reasonable price” (high-quality compounders). It is true that many investors do well by buying great businesses at fair prices and holding them for long periods of time, whereas other investors prefer to buy cheap stocks of average or mediocre quality and sell them when they appreciate to fair value, repeating the process over time as they cycle through multiple new opportunities. The styles are different, but not as different as most people describe them to be. The tactics used are different, but the objective is exactly the same—that is, trying to buy something for less than what it’s really worth, or trying to locate the low-risk fifty-cent dollars. Both strategies are just different versions of Graham’s margin-of-safety principle.

“If you plan to hold a share for the long term, the rate of return on capital it generates and can reinvest at is far more important than the rating you buy or sell at.” —Terry Smith

Because the higher-quality compounder is worth a lot more over a long-term holding period than the lower-quality business, the former offers a larger margin of safety.

One way to reduce unforced errors in investing is to carefully choose the businesses that we decide to own. Investors are better off with a few solid long-term choices than flitting from one speculation to another, always chasing the latest hot stock in the market. (Better to have a few good, long-term friends rather than changing your friends every week for short-term advantage.) The gap between price and value ultimately will determine our returns, but picking the right business is possibly the most important step in reducing errors. Improving pattern recognition skills increases the probability of successfully identifying the right businesses to invest in. … companies with increasing intrinsic value over time are the clear winners.

The Graham and Dodd investor believes in mean reversion—that is, bad things will happen to good businesses and good things will happen to bad businesses. Buffett–Munger–Fisher investors invest in businesses with fundamental momentum, that is, a high probability of sustaining excess returns over long periods of time. These two ideologies often clash (mean reversion versus fundamental momentum) in the value investing community. For most businesses, mean reversion applies, but for some exceptional ones, it starts applying after a prolonged period of time, and until then, fundamental momentum applies.

Although Benjamin Graham is widely renowned as a deep value investor, the profits from his single growth stock investment, GEICO, were more than all his other career investments combined. In 1948, Graham’s investment partnership (Graham-Newman) purchased 50 percent of GEICO for $712,000. By 1972, this was worth $400 million. Graham had scored a Peter Lynchian five-hundred-bagger. He later wrote, “Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.”

Corporate profitability is sticky. Wonderful companies tend to remain wonderful, and poor companies tend to remain stuck in the mud. Our empirical evidence suggests that sustainable corporate turnarounds are difficult to execute…. Companies in defensive industries exhibit more stickiness in corporate profitability than firms in cyclical industries. However the persistence in performance remains highly significant and thus the reputation of the business tends to remain intact regardless of industry…. Firms with excellent profitability tend to outperform those with the worst return on capital. The outperformance improves if high-quality firms are purchased at a fair price.  …  This has been proven empirically not just in this study but in many others. Financial economist Robert Novy-Marx looked at New York Stock Exchange firms between 1963 and 2010 and at international firms between 1990 and 2009. He found the same persistence of high performance, not just in business fundamentals but also in stock market returns: “More profitable companies today tend to be more profitable companies tomorrow. Although it gets reflected in their future stock prices, the market systematically underestimates this today, making their shares a relative bargain—diamonds in the rough.”

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.” – Buffett

High quality always beats a bargain over time. Although there are certainly exceptions, in the long run, bargains never outperform solid investments. This simple yet profound principle can be applied to virtually every area of life. Crash diets, predatory pricing, dishonesty, and shortcuts can work well for a while, but they are never sustainable.

Chapter 20: Investing in Commodity and Cyclical Stocks Is All About the Capital Cycle

“The market is better at predicting the news than the news is at predicting the market.” – Gerald Loeb

A stock hitting a new high has no overhead supply to contend with and has much more of an open running field. Everybody has a profit; everybody is happy. In contrast, a stock near its fifty-two-week low has a great deal of overhead supply to work through and lacks upside momentum, because it is vulnerable to fresh bouts of selling by the old investors at every higher level.

Even if you do not end up investing in any of the breakout stocks, the positive takeaway from this exercise would be the fact that your mental database will have expanded by studying the annual reports, presentations, and conference call audio recordings and transcripts of the various companies in the industry. (Conference calls are a vital component of any serious investor’s research activity list.) For truly passionate investors, researching new companies is just delightful and never gets old. The importance of insatiable intellectual curiosity, along with a deep passion for continuous learning, cannot be overstated in the investing profession. In investing, all knowledge is cumulative, and the insights we acquire by putting in the effort today often help us in a serendipitous way at some time in the future. Work hard today to let good luck find you tomorrow.

I immediately read Sam Zell’s book Am I Being Too Subtle? which drilled the core fundamental concepts of demand and supply into my mind. I also reread Edward Chancellor’s book Capital Returns as well as the excellent chapter on commodity investing in Parag Parikh’s book Value Investing and Behavioral Finance. The right book at the right time will speak to you in a way that the right book at the wrong time just won’t. I had previously read Chancellor’s and Parikh’s books in 2016. I did not appreciate them at the time. I read them again in 2017, and they changed my life.

Peter Lynch calls the “bladder theory” of corporate finance: “The more cash that builds up in the treasury, the greater the pressure to piss it away.”

Chapter 21: Within Special Situations, Carefully Study Spinoffs

“In the broader sense, a special situation is one in which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance. In the narrow sense, you do not have a real ‘special situation’ unless the particular development is already under way [emphasis added].”

A global study conducted by consulting firm The Edge and accounting firm Deloitte looked at 385 global spinoffs from January 2000 to June 2014 involving parent companies with a market cap of $250 million or more. To qualify, transactions needed to be pure spinoffs, with shareholders of parent companies receiving shares of newly listed companies. The study found that the worldwide asset class of spinoffs generated more than ten times the average gains of the MSCI World Index during their first twelve months independent of the parent.

Investors often receive a blanket piece of advice like “Never add to a losing position” or “Do not ever average on the downside” or “Avoid catching a falling knife.” I simply recommend this: always think it over. A profitable opportunity often arises when a promising but small-size company demerged from a large-size parent is listed and has residual institutional holding. During its initial weeks and months of trading, you often observe forced selling by institutions that cannot hold the new stock in their portfolios because of certain rigid institutional mandates, such as being allowed to invest only in certain sectors or restrictions on market cap, and you end up with sizeable paper losses on your existing holding of the demerged company’s shares.

Greenblatt quotes a Penn State study that found spinoffs outperform the market by 10 percent per year. If you assume that the market will return 10 percent, then, theoretically, you can make 20 percent per year by just blindly buying spinoffs.  … Say what you will about the risks of investing in such companies, the rewards of sound reasoning and good research are vastly multiplied when applied in these leveraged circumstances. Tremendous leverage would magnify our returns if spinoff turned out, for some reason, to be more attractive than its initial appearances indicated [emphasis added].

Section IV – Portfolio Management

Chapter 22: The Holy Grail of Long-Term Investing

“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.” — Warren Buffett

A core test of success for a business is whether every dollar it invests generates a market value of more than that amount for the shareholders. Warren Buffett calls this the one-dollar test, and he explains it in his 1984 letter, “Unrestricted earnings should be retained only when there is a reasonable prospect—backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future—that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”  … For an increase in earnings to be evaluated properly, it always should be compared with the incremental capital investment required to produce it.

When Buffett talks about a dollar of retained capital creating a dollar of market value (he prefers to apply this test on a five-year rolling basis), he is talking about a dollar of intrinsic value. His implication is that the stock market will be a fairly accurate judge of intrinsic value over time. (A simple way to do a quick one-dollar test is to compare the change in beginning and ending market value of a company over a period of time to the change in its beginning and ending retained earnings values.) Basically, Buffett is saying that the market, over time, will reward those companies that create high returns on the dollars they keep (by giving them a higher valuation multiple) and will punish those companies whose retained dollars fail to earn their keep (by giving them a lower valuation multiple).

According to Charlie Munger, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”  [AA Note:  Terry Smith repeats this quote several times in his 2020 book, which is a compilation of his letters and articles over the past decade since starting Fundsmith.]

The math behind Munger’s assertion is easy to follow. An 18 percent return on invested capital (ROIC) over a multidecade period will dominate a 6 percent ROIC in terms of shareholder returns. Simple. It’s simple but not easy. One of the biggest challenges in investing is determining the competitive advantage of a business and, more important, the durability and longevity of that advantage. Competitive advantage is defined as a company’s ability to generate “excess returns,” that is, ROIC less cost of capital. A sustainable competitive advantage is defined as a company’s ability to generate excess returns over an extended period of time, which requires barriers to entry to prevent competitors from entering the market and eroding the excess returns. This, in turn, enables excess returns on invested capital for long periods of time (also known as the competitive advantage period, CAP). Growing firms with excess returns and longer CAPs are more valuable in terms of net present value. The value of a company’s CAP is the sum of the estimated cash flows solely generated by these excess returns, discounted for the time value of money and the uncertainty of receiving those cash flows.

In a 1999 interview with Fortune, Buffett highlighted “moats” as the main pillar of his investing strategy: “The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” In his 2007 letter, Buffett wrote what is considered by many to be the seminal piece on competitive advantage and value creation in which he discussed great, good, and gruesome businesses. 

Great businesses are those with an ever-increasing stream of earnings with virtually no major capital requirements. They produce extraordinarily high returns on incremental invested capital. The truly great businesses are literally drowning in cash all the time. They tend to earn infinitely high return on capital as they require little tangible capital to grow and are driven by intangible assets such as a strong brand name with “share of mind,” intellectual property, or proprietary technology. Great businesses typically are characterized by negative working capital, low fixed asset intensity, and real pricing power.

Negative working capital means that customers are paying the company cash up front for goods or services that will be delivered at a later date. This is a powerful catalyst for a growing company, as the customers are essentially financing the company’s growth through prepayments. Best of all, the interest rate on this financing is zero percent, which is tough to beat. Negative working capital is common in subscription-based business models in which customers pay up front for recurring service or access. Because revenue is recognized when the service is performed, which is after the cash comes in, these businesses typically have operating cash flow that exceeds net income.

In the franchisor business model, the franchisor collects a royalty from franchisees in exchange for the use of the brand name, business plan, and other proprietary assets. The overall system grows as franchisees supply the capital to build new locations, enabling the franchisor to increase revenue and earnings without deploying additional capital. This business model is great if it can be scaled up, because it is capital light and throws off lots of free cash flow by simply leveraging the brand-name equity of the franchisor. This is why Buffett says, “The best business is a royalty on the growth of others, requiring little capital itself.”  Firms that outsource their core manufacturing activities while focusing on design, marketing, and branding efforts also have low fixed asset intensity.

If the business provides a product or service that is differentiated, has high switching costs, or is critical to customers (while constituting a minuscule percentage of overall cost), it may be able to consistently raise prices at levels exceeding inflation. This method is the simplest way to grow earnings without additional capital, because the flow-through margins on price increases are usually quite high. Companies such as Bloomberg and See’s Candies have long histories of raising prices at or above inflationary rates, and Buffett considers this to be one of the most important variables when analyzing a business: “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.”

Great businesses are rare, scarce, and thus valuable. They are usually given rich valuation multiples by the market when longevity of growth is predictable with a high degree of certainty. Indeed, longevity of growth is becoming increasingly scarce in today’s world, which is characterized by rapid pace of change. The average time a company spent in the S&P 500 in the 1960s was about sixty years. Today, the average is barely ten years. Fewer than 12 percent of the Fortune 500 companies in 1955 were still on the list sixty-two years later in 2017, and 88 percent of the companies in 1955 had either gone bankrupt or had merged with (or were acquired by) another firm. If they still exist, they have fallen from the top Fortune 500 companies (as ranked by total revenues). This is Joseph Schumpeter’s “creative destruction” at its very best.

The market places a heavy weight on certainty. Stocks with the promise of years of predictable earnings growth tend to go into a long period of overvaluation, until such time that they are no longer able to grow earnings in a steady manner. Predictability of long-term growth matters more to the market than the absolute rate of near-term growth, so a stock that promises to grow earnings at 50 percent for the next couple of years, with no clarity thereafter, is given a lower valuation multiple by the market than a stock that has slower but highly predictable growth for a much longer period. Consistent growth increases valuation; consistent disruption decreases valuation. The longevity of growth is always given a greater weight by the market than the absolute rate of growth, so you often will notice stocks with 12 percent to 15 percent predictable earnings growth for the next ten to fifteen years getting current year price-to-earnings (P/E) multiples of 40× to 50×. This phenomenon perplexes most new investors, but with experience, they come to appreciate the finer nuances of the market and respect its wisdom. The expensive, high-quality secular growth stocks tend to remain at elevated valuations for extended periods of time because investors in such stocks generally are willing to sit out periods of high valuation until earnings catch up. Markets provide disproportionate rewards to companies that can promise years of sustainable earnings growth.

The principle of scarcity premium applies to the number of high-growth stocks available in an individual sector as well as in the overall market. A business with a perceived sustainable growth rate of 30 percent to 35 percent often ends up getting a 40× to 50× P/E (or an even higher valuation that generally keeps expanding throughout the entire duration of the bull run, as long as the high growth expectations are intact) if only a few companies in the market are able to achieve such high growth rates. In contrast, a business growing at 20 percent may not get more than 15× to 20× P/E if many 20 percent growers are available. (This is why looking at the P/E-to-growth ratio, also known as PEG ratio, in isolation can result in suboptimal return outcomes.)

When growth becomes scarce, the market breadth narrows, and demand–supply dynamics take over. During bearish phases, investors want certainty of growth (whereas during bullish phases, they are ready to take a leap of faith). During such periods of uncertainty, the market’s focus becomes extremely narrow, and valuations of the select few high-quality growth stocks in the market keep expanding until their growth rate remains at above-average levels relative to the majority of the stocks in the market. (Most investors remain in denial during this phase, as these expensive stocks keep becoming more expensive.) When growth finally starts decelerating, the valuation derating begins. The actual threat to a bull market stock is not excessive valuation but a sharp correction in its growth expectations by the investor community, because valuations remain expensive and then become excessive until such time as the company delivers above-average rates of growth. Markets love uninterrupted rates of high growth and accord rich valuations to companies that can convince the market that they have the ability to consistently deliver above-average rates of growth over longer periods of time.

Investors with a bias against high P/E stocks miss some of the greatest stock market winners of all time. Over ten years or more, a high P/E company that’s growing earnings per share at a much faster rate eventually will outperform a lower P/E company growing at a slower rate. This will be true even if some valuation derating occurs in the interim period for the former. If it comes to a choice between a 15 percent grower at 15× P/E and a 30 percent grower at 30× P/E, investors always should choose the latter, particularly when longevity of growth is highly probable.

As investors, we constantly try to identify “emerging moats” so that we benefit not only from the initial high growth years of the company but also from the subsequent valuation rerating as well. An example would be a lower-margin and working-capital-intensive business-to-business (B2B) company transitioning into a higher-margin business-to-consumer (B2C) company with superior terms of trade. Even if we miss the initial high growth phase but can identify these emerging moat businesses during their intermediate stages, a lot of wealth is created over time.

Good businesses are those that require a significant reinvestment of earnings to grow and produce reasonable returns on incremental invested capital. Many businesses fall in this put-up-to-earn-more category.

Gruesome businesses are those that earn below their cost of capital and still strive for high growth, even though that growth requires significant sums of additional capital and destroys value. These businesses usually are highly capital intensive and are subject to rapid technological obsolescence. They never make any real economic profits because they are subject to the “Red Queen effect”—that is, they keep investing more and more capital just to keep pace with competition and to remain at the same starting position, or they stop investing in new technology and are obliterated. (Debt, intense competition, and high capital intensity together make for a deadly concoction.) Buffett describes them best: “The worst business of all is the one that grows a lot, where you’re forced to grow just to stay in the game at all and where you’re reinvesting the capital at a very low rate of return. And sometimes people are in those businesses without knowing it.”

Consequently, the managements of these businesses often mindlessly mimic their competitors after falling prey to what Buffett calls the “institutional imperative.” They are not aware that they are constantly trying to run up a down escalator whose pace has accelerated to the point at which upward progress has halted. They are blindsided by the rapid growth rate at an industry level and fail to heed Benjamin Graham’s warning: “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.”

Buffett learned this valuable insight from his teacher very well. In his 1999 interview with Fortune, he said, “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 next time an analyst or so-called market expert touts the rapid growth rate of any industry as a justification for investing in the stocks within that industry, watch out. When all else is equal, a higher ROIC is always good. The same can’t be said for growth. Investing is all about individual stocks and their economic characteristics.

If you want to participate in the high growth rate of an industry that is characterized by poor profitability, do so indirectly through an ancillary industry that has better economics and lower competition (the best-case scenario would be if it’s a monopoly business and the sole supplier to all the players in the primary industry). For example, the organized luggage industry in India (characterized by moderate competition) could be used as a proxy to profit from the high traffic growth of airlines (characterized by hypercompetition).

Buffett sums up the discussion in his 2007 letter with a great analogy: “To sum up, think of three types of ‘savings accounts.’ The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”

“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.” —Charlie Munger

Recall Buffett’s definition of the best business to own. I love the business Munger talks about, which cuts me a check every year from its owner earnings. Ideally, however, I am looking for a business that will forgo sending me a check because it has attractive internal reinvestment opportunities. In other words, I prefer a business that not only produces high returns on invested capital but also consistently reinvests a large portion of its earnings at similarly high returns. This is the holy grail of long-term value investing. At this point, a business has achieved true internal compounding power, which is the product of two factors: return on incremental invested capital and the reinvestment rate. This compounding power leads to huge value creation over time.

This phenomenon was discovered almost a century ago by Edgar Lawrence Smith and was subsequently brought to the attention of the mainstream investment community by John Maynard Keynes, who, in May 1925, reviewed Smith’s book Common Stocks as Long Term Investments. Keynes stated, “[This is] perhaps Mr. Smith’s most important point…and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to their shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus, there is an element of compound interest operating in favor of a sound industrial investment.”

The two big ideas are reinvested profit and compound interest. Typically, “compounding machines” enjoy a niche positioning or some durable competitive advantage that allows them to achieve high returns on capital for a long time. The key to investing in these reinvestment moats lies in the conviction that the runway ahead for growth is long and that the competitive advantages that produce those high returns will sustain or strengthen over time. When I look at high-ROIC businesses, I am really looking for return on incremental invested capital (ROIC), that is, the return a business can generate on its incremental investments over time. The growth of a company’s intrinsic value depends on the returns it can earn on its incremental invested capital. Whether growth is good or bad is contingent on ROIIC. For companies that have a large spread between ROIIC and cost of capital, high growth is good and adds a lot of value. All things being equal, for such companies, faster growth translates directly into a higher P/E multiple. The value of high-ROIIC companies is extremely sensitive to changes in perceived rates of growth.

Investors tend to confuse incremental ROIC with ROCE (return on capital employed) or ROIC. ROIIC less cost of capital drives value creation. Even though legacy moat businesses with established franchises and low or no growth opportunities may have high return on invested capital, if you purchase their stock today and own it for ten years, it is unlikely that you will achieve exceptional returns. In this case, the company’s high ROIC reflects returns on prior invested capital rather than on incremental invested capital. In other words, a 20 percent reported ROIC today is not worth as much to an investor if no more 20 percent ROIC opportunities are available to reinvest the profits. Mature legacy moat businesses with good dividend yields may preserve one’s capital, but they are not great at compounding wealth.

I prefer businesses that grow intrinsic value over time. This type of growth provides us with a margin of safety not just in the valuation but also in the gap between price and intrinsic value, which widens over time as the business value continues to grow. If two businesses (Company A and Company B) have the same current ROIC of 20 percent, but Company A can invest twice as much as Company B at that 20 percent rate of return, then Company A will create much more value over time for its owners than Company B. Both of these companies will show up as businesses that produce 20 percent ROIC, but one is clearly superior to the other. Company A can reinvest a higher portion of its earnings, and thus it will create a lot more intrinsic value over time. The longer you own Company A, the wider the gap grows between Company A’s and Company B’s investment result.

I cannot emphasize this critical fact enough: although valuation is more important over shorter time periods, quality along with growth is much more important over long time periods (seven to ten years and longer). The longer you hold a stock, the more the quality of that company matters. Your long-term returns will almost always approximate the company’s internal compounding results over time. It is far more important to invest in the right business than it is to worry about whether to pay 10× or 20× or even 30× for current-year earnings. Many mediocre businesses are available at less than 10× earnings that lead to mediocre results over time for long-term owners. The intrinsic value of quality business increases over time, thus increasing the margin of safety in the event of a stagnant stock price. This is a pleasant situation because it creates antifragility for an investor. In contrast, if a business is shrinking its intrinsic value, time is your enemy. You must sell it as soon as you can, because the longer you hold it, the less it is worth.

“Time is the friend of the wonderful company, the enemy of the mediocre.” — Warren Buffett

“The bitterness of poor quality remains long after the sweetness of low price is forgotten.” — Benjamin Franklin

“The best stocks will always seem overpriced to a majority of investors.” — Gerald Loeb

An astonishing anomaly is that these superlative reinvestment moat opportunities often hide in plain sight. Most investors shun them at first glance, citing expensive current valuations, and end up overlooking the long-term power of internal compounding. The math behind choosing the right business is compelling.

Let’s consider two investments and observe which yields better results over a ten-year horizon (table 22.1). The first business, Reinvestment Corporation, has the ability to deploy all of its retained earnings at a high rate because of its strong reinvestment moat. Of course, the market acknowledges this likelihood, and the entry price is fairly high, at 20× earnings, leading most deep value investors to scoff. Conversely, Undervalued Corporation is a typical Graham cigar butt—that is, a steady business with a good dividend yield selling for only 10× earnings. Assume that, over time, both companies will be valued in line with the market, at 15×. [Note:  Reinvestment Corp IRR of 21.5% compares to 13.6% for Undervalued Corp.  The value of the more expensive stock 10 years out is multiples higher.]

TABLE 22.1 Comparison of investment results

“This is the most nuanced and misunderstood aspect of investing: a fair price may be a lot more than you would think if profitable reinvestment really can take place.” — Tom Gayner

“What is most important…is that stocks are not bought in companies where the dividend pay-out is so emphasized that it restricts realizable growth.” — Phil Fisher

Investing is part art, part science, but over the long term, investing in businesses that earn high returns on incremental invested capital significantly improves the probability of achieving above-average returns. Finding a great business that does all of the heavy lifting for you while you passively let value compound is about as good as it gets. These businesses give long-term investors the joys of averaging upward on improved prospects and superior execution, which is akin to giving a bonus to your best-performing employees for exceeding expectations. After all, the promoters of our investee companies are working around the clock to create wealth for us.

You might ask: How does one determine whether the attractive returns of the past will continue in the future? In his 1987 letter, Buffett shared his insights on businesses that are built to last: “The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don’t need to borrow. Second, except for one company that is “high-tech” and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane. Most sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.”  

In terms of percentages, the high-quality compounder category likely will have fewer errors—that is, fewer permanent capital losses—than the “statistically cheap” securities category. This doesn’t mean one will do better than the other, as a higher winning percentage doesn’t necessarily mean higher returns. But if you want to reduce “unforced errors,” or losing investments, it is more beneficial to focus on high-quality businesses. As an investor, life feels so pleasant when you are invested in high-quality compounders. Buffett advises: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock…. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” – Buffett

A few years back, I randomly came across a sample table of stock returns while browsing the Internet (table 22.2). This was the moment of awakening that made me finally realize the true power of Buffett’s insight. It sparked an illumination, an enlightenment, an oceanic feeling. Something akin to the one that sent Archimedes jumping out of the tub shouting, “Eureka!”

TABLE 22.2 Comparison of stock returns, 2008 and 2013

Consider that $20,000 invested in the great businesses (Hawkins, ITC, Titan, and HDFC Bank) appreciated almost five times, to $100,000, in five years, while the same money in the gruesome businesses (Reliance Communications, Reliance Capital, DLF, HDIL, and GMR Infra) experienced brutal destruction and would have been worth only $3,000. … This led me to one of the biggest findings in my investing journey: great businesses created a lot of wealth even when measured from the top of the previous bull market to close to the end of the subsequent bear market. To achieve big wealth creation, an investor had only to hold on to them in a disciplined manner during the turbulent times in the stock market and stay the course. Liquidity and sentiment drive the market index in the short term, whereas individual company earnings drive stock prices in the long term. Great businesses create enormous wealth over long holding periods across market cycles, even in the midst of negative macro headlines about high inflation, rising interest rates, geopolitical tensions, weak macroeconomic data points, and political uncertainty. Gruesome businesses eventually destroy wealth, irrespective of whether the news is positive or negative.

Sample this. The Dow Jones Industrial Average was 874.12 on December 31, 1964, and 875.00 on December 31, 1981. Nearly zero change in seventeen long years. Yet Buffett compounded his capital at more than 20 percent compound annual growth rate during this period. Investing is about identifying great businesses with high-quality earnings growth and capital allocation and firmly holding on to them as long as they exhibit these characteristics. The stock markets do not really matter over the long run when you invest in such businesses and, most important, stay the course.

Tying It Together: ROIC with Competitive Advantage and Capital Allocation

Critically evaluating the durability of competitive advantage and how capital allocation affects shareholder value can create a variant perception when selecting equities for long holding periods. —Pat Dorsey

Combining the key insights from this chapter, we arrive at investing nirvana: long-term ownership of competitively advantaged businesses with significant reinvestment potential, managed by excellent capital allocators and shareholder-friendly management teams.

Competitive Advantage 

Capitalism is brutal. Excess returns attract competition. Only a few rare businesses enjoy excess returns for many years by creating structural competitive advantages or economic moats. … An extended period of excess returns increases business value. Competitive advantages stem from various sources, including intangible assets, such as brands, patents, and licenses; switching costs; network effects; or low-cost advantages.

Intangible Assets

Some companies (such as Apple) simply offer a product or service that is far superior to their competitors’ products, and other companies offer a product or service of quality similar to their competitors’ products but simply are better at telling a story about that product (such as Tiffany & Co.). Businesses that primarily depend on marketing a story are much more vulnerable to shifting consumer behavior. (The most devastating substitutes cost less and have at least one feature that is superior.) Branding has historically served a few key purposes: to guarantee minimum assured product quality and to allow people to express their identity in a social context. Brands prospered in an environment of information scarcity, in which an asymmetrical relationship developed between customers and companies. Signs are clear, however, that this trend is coming to an end. Brands must be authentic, because very few veils remain between a business and the public. Everything is on the record all the time in today’s information age. In a highly connected and well-informed world, value to the customer is the most important thing to consider when analyzing a company.

Another intangible asset is patents. Patents confer legal monopolies (in the case of innovator companies), and a basket of patents is preferable to an overdependence on a single patent. Some regional or national monopolies have a product that customers have difficulty avoiding, something like a toll road. (Buffett often has talked about his love for toll roads in a figurative manner, such as newspapers in one-newspaper towns.) Likewise, licenses and regulatory approvals confer legal oligopoly status through regulatory fiat (as is the case with ratings agencies).

Switching Costs

Switching costs come in many forms and may be explicit (in the form of money and time) or psychological (resulting from deep-rooted loss aversion or status quo bias). These costs tend to be associated with critical products (such as Oracle’s SAP software) that are so tightly integrated with the customer’s business processes that it would be too disruptive and costly to switch vendors, or with products that have high benefit-to-cost ratios (such as Moody’s).

Network Effects

The network effect advantage comes from providing a product or service that increases in value as the number of users expands, as with Airbnb, Visa, Uber, or the National Stock Exchange of India. This functions as a strong moat as long as pricing power is not abused and the user experience does not degrade. Creating a two-sided network such as an auction or marketplace business requires both buyers and sellers, and each group is going to show up only if they believe the other side will be present as well. Once this network is established, it becomes stronger as more participants from either side engage. As more buyers show up, more sellers are attracted, which in turn attracts more buyers. Once this powerful positive feedback loop is in place, it becomes nearly impossible to convince either the buyer or the seller to leave and join a new platform. This kind of business actually becomes stronger as it grows and displays accelerating fundamental momentum. Look at Airbnb’s strong two-sided network as an example of a business model that greatly benefits from positive feedback loops (figure 22.1). FIGURE 22.1 The strong network effect enjoyed by Airbnb. Source: “Airbnb TWOS: Network Effects,” SlideShare, March 7, 2016, https://www.slideshare.net/a16z/network-effects-59206938/34-AirbnbT_W_O_S_I.

Low-Cost Advantages

Low-cost advantages stem from various sources, including process, scale, niche, and interrelatedness.

Process. Advantage accrues when a company creates a cheaper way to deliver a product, which cannot be replicated easily, as with Inditex, GEICO, or Southwest Airlines. [Fundsmith?]

Scale Advantage accrues when a company spreads fixed costs over a large base, as do Costco and Nebraska Furniture Mart. Relative size in a market matters more than absolute size in isolation.

Niche Advantage accrues when a company dominates an industry with high minimum efficient scale relative to total addressable market, as with Wabtec Corporation or Spirax-Sarco Engineering.

Interrelatedness of new initiatives with existing lines of business. Companies gain an advantage when their product lines or business segments are interrelated and reinforce each other (as with Hester Biosciences). Saurabh Madaan of Markel Corporation refers to this as the “octopus model.” Phil Fisher has talked about this source of competitive advantage in the past: “The investor usually obtains the best results in companies whose engineering or research is to a considerable extent devoted to products having some business relationship to those already within the scope of company activities.”

Low-cost producers can sell their product or service at a lower margin than competitors and still operate profitably, because of the large volume of customers. A good example of a low-cost producer is GEICO, the direct seller of automobile insurance to Americans. GEICO has the lowest operating costs in its industry, primarily because it sells directly to its customers instead of hiring insurance agents. Buffett has often talked about GEICO’s cost advantage over its competitors as a strong moat: “Others may copy our model, but they will be unable to replicate our economics.” The more customers that buy from a low-cost producer, the more its cost advantage moat widens over time, creating a “flywheel” that accelerates as the business grows.

Culture as a Moat

We have discussed the traditional sources of competitive advantages, but a much-underappreciated source of a sustainable and difficult-to-replicate competitive advantage is culture. Culture is best epitomized by such companies as Berkshire Hathaway, Amazon, Costco, Kiewit Corporation, Constellation Software, and Markel Corporation, to name a few.

To illustrate the critical significance of an organization’s culture, consider this: from 1957 to 1969, Buffett did not mention the word “culture” even once in his letters; from 1970 to 2017, he has mentioned the word more than thirty times. Businesses with a strong culture focus on delivering a great customer value proposition and communicating about the same more effectively than their competitors do. To create strong value propositions, firms should ask customers what they want to achieve and how they measure success and failure. (Instead, too many firms still ask customers what they want. Customers are not experts on the solution.)

As investors, we look for those companies that are fanatically obsessed with the well-being of their customers and that empathize with them more than their competitors do. Culture matters to long-term investors because it empowers the company’s employees to do their day-to-day tasks slightly better than the company’s competitors do theirs. Over time, these little advantages compound into much larger advantages, which can persist far longer than conventional wisdom expects.

When investing in businesses that are widening the moat, with the passage of time, these businesses invariably turn out to be much cheaper than what would have resulted from our initial valuation work.

High absolute market share (think General Motors) is not a moat. Great technology products (think GoPro), absent customer lock-in, is not a moat, as commoditization and disruption are inevitable. Hot products (like Crocs) can generate high returns for a short period of time, but sustainable excess returns make a moat. When assessing the moat of any business, simply ask yourself how quickly a smart competitor with unlimited financial resources could replicate it. If your competitors know your success secret and still can’t copy it, you have a strong moat.

“One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it.” —Warren Buffett

Capital Allocation

Capital allocation is the bridge between intrinsic business value and shareholder value. If a company has high-return investment opportunities internally, it should reinvest heavily. Maturing companies, however, often continue to invest despite declining or low returns on capital. (Aging is tough for companies as well as for people.) These companies should instead return capital via dividends or share buybacks. Dividends are important not only for the obvious reason of the use of idle cash but also because they act as a discipline—for a company to pay a dividend, the profits have to be real. Remember, dividends are not necessarily good if they are funded poorly (sometimes management takes on debt just because shareholders expect dividends) or if they are paid out in lieu of investing in high-net-present-value projects and represent a large opportunity cost.

The time to evaluate quality is before the price action starts and not after it.

Making the correct qualitative judgment about a business, including the long-term sustainability of its success attributes, is more important than the entry valuation over a long-term holding period. Within reason, you can survive overpaying for a growing high-quality franchise. If you have to go wrong, go wrong on valuation but not on quality.

It seems fitting to end this chapter with Buffett’s views on the topic of quantitative versus qualitative investing: “Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess — I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a high-probability insight. This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.”

Chapter 23:  The Market is Efficient Most, but Not All, of the Time

The stock market is a giant distraction to the business of investing. —John Bogle

Napoleon’s definition of a military genius: “The man who can do the average thing when all those around him are going crazy.” Your lifetime achievement as an investor will be determined primarily by how you conduct yourself during the occasional periods of extreme market behavior.

This advice is what Buffett was referring to when he shared the secret to becoming rich in the stock market: “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”

Peter Lynch calls these companies “stalwarts.” They are the big companies without a lot of high growth potential. Occasionally, however, you can buy them at a discount and sell them after a 30 percent to 50 percent rise, which largely comes from the valuation multiple reverting back to the mean, as opposed to the business value increasing. Always remember: stock prices randomly fluctuate every day, sometimes wildly on either side, but business value changes very slowly. Therein lies the big opportunity. Focusing on what is moving is part of our evolutionary instincts. This explains why market participants focus more on stock prices, which keep bobbing around, than on business values, which change quite slowly.

The major thing we look at is liquidity, meaning as a combination of an economic overview. Contrary to what a lot of the financial press has stated, looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going [emphasis added].

Investors usually step up their efforts during a bear market, because of the tense environment, and they tend to become complacent during a bull market. Instead, dream big, manage risk, and intensify your efforts during a bull market to achieve financial independence early in life. When you are lucky to experience a bull market, ensure that it makes a big difference to your life. Make the most of a bull market to earn. Make the most of a bear market to learn.

Andy Grove’s words, “Bad companies are destroyed by crisis, good companies survive them, great companies are improved by them.”

“The real key to making money in stocks is not to get scared out of them.” -Peter Lynch

Buffett’s advice: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” He continues, “During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy.”

Just because a company’s future is highly uncertain or unknown at present, this does not mean an investment in it is risky. In fact, some of the best investment opportunities are highly uncertain but have minimal risk of permanent capital loss.

When I read James Surowiecki’s book The Wisdom of Crowds, I finally learned to recognize the significance and deeper meaning of trading volumes. When in doubt about a stock after a sudden sharp move on either side, look at the volumes. The collective wisdom of the market will guide you in the right direction most of the time.

Chapter 24: The Dynamic Art of Portfolio Management and Individual Position Sizing

“The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results.” —Charlie Munger

“The appeal of a concentrated portfolio is that it is the only chance an investor has to beat the averages by a noteworthy margin.” —Frank Martin

“The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obviously good idea. But ninety-eight percent of the investment world doesn’t think this way.” —Charlie Munger

“Phil Fisher believed in concentrating in about ten good investments and was happy with a limited number. That is very much in our playbook. And he believed in knowing a lot about the things he did invest in. And that’s in our playbook, too. And the reason why it’s in our playbook is that to some extent we learned it from him.” —Charlie Munger

“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” —John Maynard Keynes

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – George Soros

“I size individual allocations in my portfolio according to my evaluation of potential risk, with the largest holdings having the lowest likelihood of permanent capital loss coupled with above-average return potential. I initiate new positions with a minimum weighting of 5 percent and subsequently average upward if the management executes above my expectations. Individual position sizing is important not only for its impact on overall portfolio performance but also for mental peace of mind. I sell down to my “sleeping point” if an individual position becomes a discomfortingly large percentage of my portfolio value. Always have bigger weights in businesses with high longevity, solid growth prospects, and disciplined capital allocators. As Mae West said: Too much of a good thing can be wonderful.”

Every bust in one area of the market establishes the foundations for a boom in another. Every company’s rising cost is another company’s rising revenue; every company’s declining revenue is another company’s declining cost. The best part is that the stock market usually does an excellent job of recognizing the beneficiaries in each situation by sending their stocks to the fifty-two-week-high list. Money has a metaphysical-like attraction to places of its best possible use. This is one of the powerful correcting forces of capitalism. Take advantage of it.

As Humphrey Neill said, “Don’t confuse brains with a bull market.”

Chapter 25: To Finish First You Must First Finish

“You just have to be prepared to be wrong and understand that your ego had better not depend on being proven right. Being wrong is part of the process. Survival is the only road to riches.” – Peter Bernstein

How much you are able to retain after the recovery from a bear market is far more important than how much paper profit you make during a bull market. And quality of business matters the most in retaining long-term wealth.

Market turbulence tends to cluster. This is no surprise to an experienced trader…. They also know that is in those wildest moments—the rare but recurring crisis of the financial world—where the biggest fortunes of Wall Street are made and lost. …Periods of big price changes groups together, interspersed by intervals of more sedate variation—the tell-tale marks of long memory and persistence. It shows scaling. …Large price changes tend to be followed by more large price changes, positive or negative. Small changes tend to be followed by more small changes. Volatility clusters [emphasis added].

We all contemplate and understand the things that happen within three standard deviations, but everything important in financial history takes place outside those three standard deviations.

Failure often comes from a failure to imagine failure.

Investors should study what happened to RS Software India, which used to get about 85 percent of its revenues from Visa. [AA NOTE:  It went from 20 to 420 then back to 20].

Source:  Bloomberg

“More money has been lost reaching for yield than at the point of a gun.” – Raymond DeVoe Jr.

Businesses with staying power have stable product characteristics, a strong competitive advantage, a fragmented customer and supplier base, prudent capital allocation, a growth mind-set with a razor-sharp focus on long-term profitability and sustainability, a corporate culture of intelligent and measured risk taking, a cash-rich promoter family or parent company that can infuse capital during periods of high stress, a highly liquid balance sheet, and both the willingness and the capacity to suffer by investing for the long term at the expense of short-term earnings. These companies thus have higher longevity, higher duration of cash flows, and thus higher intrinsic value.

From an investor’s point of view, staying power comes from a strong passion for the investing discipline; a constant learning mind-set; a long remaining investing life span; low or no personal debt; frugality; discipline; a sound understanding of human behavior, market history, and cognitive biases; a patient, long-term mind-set; and a supportive family whose importance is appreciated in a big way during the periodic rough times in the market. It seems fitting to end this chapter with Buffett’s profound words on avoiding the risk of ruin: “It takes twenty years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

Chapter 26: Read More History and Fewer Forecasts

“Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you have invested.” —Peter Lynch

Jason Zweig explains the constant human urge to predict, in his book Your Money and Your Brain: “Just as nature abhors a vacuum, people hate randomness. The human compulsion to make predictions about the unpredictable originates in the dopamine centers of the reflexive brain. I call this human tendency ‘the prediction addiction’ [emphasis added].”2

“Progress happens too slowly to notice; setbacks happen too quickly to ignore.” —Morgan Housel

“Whatever methods you use to pick stocks, your success will depend on your ability to ignore the worries of the world long enough to allow your stocks to succeed. No matter how intelligent you are, it isn’t the head but the stomach that will determine your fate.” —Peter Lynch

With rare exceptions, most of the miracles of humankind are long-term, constructed events. Progress comes bit by bit.

“More money has been lost trying to anticipate and protect from corrections than actually in them.” —Peter Lynch

Emotions cannot be back-tested

The market moves first. The accompanying sense-making narrative follows later. Always.

As the saying goes, “No force on earth can stop an idea whose time has come.” And India’s time has arrived. It took India nearly sixty years to reach its first trillion dollars in GDP but only seven years to reach its second trillion. The next consecutive trillions are expected to be reached in faster succession. Even if market cap to GDP remains around parity in the long run, one can envision the kind of wealth creation that lies in store for investors in great Indian businesses. Trillions of dollars. This, in turn, will have a positive multiplier effect on the prosperity of the nation.

“In times like these, it helps to recall that there have always been times like these.” – Paul Harvey

French polymath Gustave Le Bon wrote one of the most influential works on social psychology, The Crowd, as a rant on French politics, but his observations also describe how stock market manias take place. The book, widely considered to be the definitive work on mass psychology, despite its 1895 publishing date, explains how a crowd goes from controlled logic to uncontrolled emotion, resulting in conscious personalities vanishing into a collective mind.

Bear markets bring the fundamental truths of investing to the fore.

“There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they’d all be millionaires by now…. But as far as I know, most of them are still gainfully employed, which ought to tell us something.”

Chapter 27: Updating Our Beliefs in Light of New Evidence

“If you do not change direction, you may end up where you are heading.” —Lao Tzu

“Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate. Something interesting is happening.” —Tom Goodwin

“The big picture is that software is eating the world—that is, many of the products and services developed over the past 150 years are transforming into, or being disrupted by software…. The implications are enormous; software is infinitely replicable and, through the internet, can be delivered at zero marginal cost. When a major input to business—distribution cost—goes to zero, entire industries get disrupted. When one can build a business model from the ground up with entirely new assumptions, one can attack incumbents in a way that is very difficult to defend.” —Marcelo Lima

In psychology, this is referred to as cognitive flexibility. Psychologists consider this flexibility to be one of the key mental skills required to succeed along with other skills, such as creativity, critical thinking, and problem solving.

…there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.

Munger’s warning usually comes true: “When you mix raisins with turds, you’ve still got turds.”

What matters far more to the superforecasters than Bayes’ theorem is Bayes’ core insight of gradually getting closer to the truth by constantly updating in proportion to the weight of the evidence.

“When information is cheap, attention becomes expensive.” – James Gleick

Bayesian thinking helps us overcome our biases and personal prejudices. Many investors in the Indian markets have a prejudice against Hyderabad-based companies, microcap stocks, turnaround situations, conglomerates, highly leveraged companies, commodity stocks, and holding companies. That prejudice (baseline information) is reflected in the cheaper valuations. “At the same time, however,” writes Bakshi, “you should recognize the possibility that this particular business which you are evaluating could be different from the statistical class to which it belongs.” (For instance, I usually begin studying select leveraged distress situations after the borrowers have entered into a formal debt-restructuring arrangement.)

In his book Winning on Wall Street, Martin Zweig talks about how bearish he was during a sell-off in February and March 1980: “I was sitting there looking at conditions and being as bearish as I could be—but the market had reversed. Things began to change as the Fed reduced interest rates and eased credit controls. Even though I had preconceived ideas that we were heading toward some type of calamity, I responded to changing conditions.” He concludes, “The problem with most people who play the market is that they are not flexible…. To succeed in the market you must have discipline, flexibility, and patience.”

The art of timely selling is gradually developed through real-life experience in the markets and increasing familiarity with the finer nuances of various industries and their evolving valuation dynamics over time.

One big lesson I have learned over the years is to be reluctant to sell a great business that is trading at expensive valuations, especially when cash is the alternative. A better approach is to wait to sell until a far superior opportunity comes along, or until the stock has become absurdly overvalued.

“How can anyone say with even moderate precision just what is overpriced for an outstanding company with an unusually rapid growth rate? Suppose that instead of selling at twenty-five times earnings, as usually happens, the stock is now at thirty-five times earnings. Perhaps there are new products in the immediate future, the real economic importance of which the financial community has not yet grasped. Perhaps there are not any such products. If the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 percent overpriced? That which really matters is not to disturb a position that is going to be worth a great deal more later. …If the job has been correctly done when a common stock is purchased, the time to sell it is—almost never.” – Phil Fisher

The best time to invest is when you have money. This is because history suggests it is not timing which matters, but time.” – John Templeton

“My dad never worried about quarterly comparisons. He slept well.” – Walther Schloss’ son Edwin.

“There’s no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or worse, to buy more of it when the fundamentals are deteriorating.”

I am happy to have learned Confucius’s teaching well: “A man who has committed a mistake and doesn’t correct it is committing another mistake.”

Chapter 28: Life is a Series of Opportunity Costs

It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it. —W. Somerset Maugham

An effective way to counter this bias is to mentally liquidate your portfolio before the start of every trading day and ask yourself a simple question: “Given all the current and updated information I now have about this business, would I buy it at the current price?” If you conclude that you would not buy the shares today but find that you cannot push the sell button, be aware that this is because of endowment bias and not because of a logical hold thesis. Sell. … In most cases, you will find that your smallest-weight holdings will be the ones that get sold, because you had less conviction in them to start with (as indicated by their low weights).

When we are truly disciplined and highly demanding in the required hurdle rate for incoming ideas, then the best stock to buy at any given time is usually among the ones we already own in our portfolio. Don’t diversify just for the sake of it. Avoid adding anything to your life, your investment portfolio, or your business unless it makes them better.

Chapter  29: Pattern Recognition

“People Calculate Too Much and Think Too Little”

Investors who primarily rely on screening tools to generate ideas end up missing such opportunities.

Receiving voluntary praise from a competitor is always a positive sign for a firm. But these softer aspects cannot be captured by quants, Excel spreadsheets, or screeners.

…if the leading stocks of a sector are falling sharply even after reporting strong earnings or are going up even after bad earnings, the market is trying to tell you something important.

Many business-to-business companies (though not all) face much slower changes in customer preferences, making financial modeling easier.

In his second quarter 2018 letter to Heller House fund clients, Marcelo Lima wrote: “Cheap” is a poor proxy for value: the new business models…—SaaS [software as a service] in particular—are not well suited to traditional GAAP [generally accepted accounting principles] accounting. Here’s why: if distribution costs are zero, the optimal strategy is to gain as many customers for your software product, as quickly as possible. In digital businesses, there are increasing advantages to scale, and many of these companies operate in winner-take-all or winner-take-most markets. The name of the game is thus to build, grow, then monetize. Frequently, this means spending a lot of money in sales and marketing, which depresses reported earnings. Thus, SaaS companies spend to acquire customers upfront, and recognize revenue from those customers over many years. This mismatch burdens the income statement. Some of the most successful—and highest performing stocks—in the SaaS world have spent many years growing despite producing no meaningful accounting profits. They are very profitable in terms of unit economics, and once they stop reinvesting every dollar generated into further growth. The traditional method of screening for low P/E stocks doesn’t work in this scenario. For these SaaS companies, study the incremental unit economics—that is, how much it costs to acquire each customer and how much value they deliver over a span of time—and then analyze what the business margins and cash flows look like at a steady state once the investment phase slows down. Then discount those cash flows back to the present.

Second, some types of unknowable situations have been associated with highly profitable outcomes, and we can think about these situations systematically. People overwhelmingly prefer to take on (measurable and quantifiable) risk in situations in which they know specific odds rather than an alternative risk scenario in which the odds are completely ambiguous. They tend to choose a known probability of winning over an unknown probability of winning, even if the known probability is low and the unknown probability could be a guarantee of winning. (This paradox in decision theory in which people’s choices violate the postulates of subjective expected utility is known as the Ellsberg paradox.) Fear of the unknown is one of the most potent kinds of fear, and the natural reaction is to get as far away as possible from what is feared. Unknown unknowns make most of us withdraw from the game. These, however, are also the circumstances in which extraordinary returns are possible.

“One of the lessons your management has learned—and, unfortunately, sometimes re-learned—is the importance of being in businesses where tailwinds prevail rather than headwinds.” —Warren Buffett

Based on my personal investing experiences over the years, I have found that it is better to buy a good company in a great sector than a great company in a bad sector.

There’s no course in business school called ‘Getting on the Right Train,’ but it’s really important. You can be an average passenger but if you get on the right train it will carry you a long way.”… In other words, invest in companies with tailwinds, not headwinds.

Chapter 30: Acknowledging the Role of Luck, Chance, Serendipity, and Randomness

“The first step toward improving your luck is to acknowledge that it exists.”

“Whenever I meet anyone at the peak of success who insists luck isn’t a huge factor, I make a mental note to check back on him* five years later. Five years later, none of these people have still been at the peak.” – Jason Zweig Twitter, March 9, 2018, https://twitter.com/jasonzweigwsj/status/972131380460163074.

Just as I had no personal conviction or good understanding of my choices when buying these stocks, I did not have any better insight when selling them. Yes, this is true. This was my pitiful state as an investor at the time, even after being present in the markets since 2007. I had initiated my self-education on value investing in 2013, and the power of compounding knowledge had not yet kicked in.

The best way to approach learning is with childlike curiosity. All of us came into this world with abundant curiosity. As children, we were inherently curious and constantly engaging in joyful discoveries. Exploration preceded explanation. As we grew up, however, a fear of looking stupid dampened this curiosity. Snap out of it. Adopt the motto “ABC: Always Be Curious.” (As Charlie Munger often says, if we want to become smarter, the question we need to keep asking is “Why, why, why?”)

Albert Einstein once wrote to a friend, “I have no special talents. I am only passionately curious.”

Don’t think about why you question, simply don’t stop questioning. Don’t worry about what you can’t answer, and don’t try to explain what you can’t know. Curiosity is its own reason. Aren’t you in awe when you contemplate the mysteries of eternity, of life, of the marvelous structure behind reality? And this is the miracle of the human mind—to use its constructions, concepts, and formulas as tools to explain what man sees, feels and touches. Try to comprehend a little more each day. Have holy curiosity. —Albert Einstein

In fact, luck is the sole reason that I am alive today and able to share my story. I have survived three potentially fatal accidents in my personal life—once, I fell down the stairs of my building during my childhood years and underwent a surgery; once, I toppled over while riding an all-terrain vehicle in Thailand and miraculously incurred only minor bruises; and, on a third occasion, I was badly injured in a bike accident during my MBA college days in Ahmedabad, India. As a survivor, I remain ever grateful for the smallest of things in my life. Every new day is God’s gift to me. I am truly blessed.

The lucky approach is to say to yourself, “Okay I’m going to get into this risky situation—this roulette game, this mutual fund investment. But I am not operating under the delusion that planning will make it turn out my way. I see luck looming large in it, so I will be careful not to let myself grow too confident and relaxed. I will expect rapid change. I won’t make large, irrevocable commitments. I’ll stay poised to bail out the minute I see a change I don’t like.”… To be lucky in this game you must discard bad hands when you get them. … Much more often what starts to go wrong stays wrong—or goes wronger. In a souring situation, with no compelling reason to think things will get better, you are always right to cut your loss and go. You are right even when, in retrospect, you turn out to have been wrong.

“Obvious responses to opportunities and circumstances, rather than studied decisions, have put me on the particular roads I have followed.” —Herbert Simon

If you want to feel rich, just count all the gifts you have that money can’t buy.

Economists, market advisers, political oracles, and clairvoyants all know the basic rule by heart: If you can’t forecast right, forecast often…. Not all oracles have been able to organize the annual forecast-revising dance of the economists, but all are followers of the basic rule. They all forecast often and hope nobody scrutinizes the results too carefully….

Stock market investing is an activity in which luck plays a significant role. Consider the typical process that many retail investors follow. They look at a fund manager’s most recent few years of performance and invest their money in his or her mutual fund if it has been a recent outperformer. And then their chosen fund starts underperforming the benchmark for the next few years. Frustrated, these investors pull out the money and find another fund manager based on the same criteria—the manager with the most recent few years’ outperformance. A similar episode is repeated. The investors are completely baffled as to why their chosen fund’s performance deteriorates immediately after they put their money into it. Mean reversion, my friend.

“Most fund buyers look at past performance first, then at the manager’s reputation, then at the riskiness of the fund, and finally (if ever) at the fund’s expenses. The intelligent investor looks at those same things—but in the opposite order.” —Jason Zweig

This is the big lesson for all investors. Focus on the “karma”—the process and action—and not on the outcome. Numerous research studies have identified a common trait among successful professionals in fields of probabilistic activity: they all emphasize process over outcome.

“Whatever the future holds, we will stick to our process. We are not guaranteed of getting what we want all the time—far from it—but we believe it is the best foundation for getting what we want over time. —Chuck Akre

Chapter 31: The Education of a Value Investor

During 2016, I bought a stock solely on the basis of the rationale of a peer who I admired and looked up to for his investing skills. A few weeks later, the stock fell sharply, post weak quarterly earnings, and I exited my position at a 14 percent loss because I lacked the personal conviction to hold. To rub salt into the wounds, the stock then doubled in less than ten months. Ouch.

We live in a world in process, and it changes continuously, every single minute. Nothing stays the same. Thomas Russo likes to give the analogy of a seven-hundred-year-old temple in Japan. The temple is made of wood, and none of the wood is seven hundred years old, as the pieces have been replaced numerous times over the years. But we still talk about the temple as if it is seven hundred years old. In the stock markets, we see the effect of change in similar ways. Consider the S&P 500, one of the most frequently cited market indexes. On average, over the past fifty years, more than twenty companies are swapped out each year. Yet investors cite and treat the S&P 500 as if it were a monolithic, unchanging object. It clearly isn’t. The constituents of the S&P 500 of 2020 are completely different from the S&P 500 of 2000, even though our language infers otherwise when we say things like, “The S&P 500 is trading at a premium/discount to its ten-year average.”

“For the great majority of transactions, being stubborn about a tiny fractional difference in the price can prove extremely costly.” —Philip Fisher

If the story has gone wrong, simply book your losses and move on to a better opportunity. Continuity of compounding is the key to success in this long-term game. After buying a stock, forget what you paid, or this knowledge will forever affect your judgment.

Another faulty anchor is the past price of a stock—that is, the point at which an investor originally contemplated buying it but failed to pull the trigger, after which point the stock has appreciated significantly. Missing out on an early opportunity creates regret. That regret often is unwarranted because, for a truly outstanding business, multiple opportunities to buy the stock exist. By definition, a hundred-bagger is a ten-bagger twice over. Even if someone bought it after it became 10×, it still went up another 10×. This shows the importance of actively keeping up with a company’s story even after you have exited it. Think of investments not as disconnected events but as continuing sagas that need to be reevaluated periodically for new twists and turns in the plot. Unless a company goes bankrupt, the story is never over.

This applies to selling as well. Selling a big winner from our portfolio is never easy, because we tend to get emotionally attached to it over the years. After all, it has been responsible for our wealth creation. But a stock does not know that we own it. Just as we cling to outdated beliefs, we hang on to these stocks because we remain fixated on meaningless anchors like our lower original cost price. But the investor of today does not benefit from yesterday’s growth.

Ernest Hemingway’s words: “There is nothing noble in being superior to your fellow man; true nobility is being superior to your former self.”

As Munger says, “You don’t have to pee on an electric fence to learn not to do it.”

When we have a negative opinion about the person delivering the message, we close our minds to what they are saying and miss a lot of learning opportunities because of it. Likewise, when we have a positive opinion of the messenger, we tend to accept the message without much vetting. Both are bad. —Annie Duke

In investing, always consciously separate the stock from the personality of the individual at the helm of the company. Concentrate on the merits and economics of the underlying business. Look at the facts and assess the situation objectively.

Conversely, I once displayed disliking bias by delaying my decision to buy the stock in a great business just because I did not like the rude verbal tone of its promoter on television. This was completely irrational behavior. The business had good economics and the promoter had a clean corporate governance track record. A highly capable CEO may be arrogant, loud, flamboyant, and smoke cigars, whereas another CEO might be humble, introverted, and a self-disciplined individual of high moral character. We tend to be biased toward people who display qualities we admire or who are similar to us, but the people we like are not necessarily the people who have the capabilities to execute and deliver results.

“The degree of one’s emotion varies inversely with one’s knowledge of the facts—the less you know, the hotter you get.” —Bertrand Russell

(If something is too much in the news, it is already discounted in the price.)

Chapter 32: Conclusion

You only get one mind and one body. And it’s got to last a lifetime. Now, it’s very easy to let them ride for many years. But if you don’t take care of that mind and that body, they’ll be a wreck forty years later…. It’s what you do right now, today, that determines how your mind and body will operate ten, twenty, and thirty years from now.

Money without health is pointless.

“Take care of your body. It’s the only place you have to live.” —Jim Rohn

Your mind is like an empty glass; it’ll hold anything you put into it. You put in sensational news, negative headlines, talk-show rants, and you’re pouring dirty water into your glass. If you’ve got dark, dismal, worrisome water in your glass, everything you create in your mind will be filtered through that muddy mess, because that’s what you’ll be thinking about. Be conscious of your information diet.

I can’t emphasize this enough: learn to meditate. When you train your mind to focus on something as simple as the breath, it also gives you the discipline to focus on much bigger things and to tell the difference between what’s really important and everything else.

The difference between interest and commitment is the will to not give up. When you truly commit to something, you have no alternative but success. Getting interested will get you started, but commitment gets you to the finish line.

It’s not getting to the wall that counts; it’s what you do after you get there.

“Nothing in the world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent.” —Calvin Coolidge

In his blog, Joshua Kennon wrote about Munger’s excruciatingly painful experiences with multiple adversities during his lifetime: In 1953, Charlie was 29 years old when he and his wife divorced. He had been married since he was 21. Charlie lost everything in the divorce, his wife keeping the family home in South Pasadena. Munger moved into “dreadful” conditions at the University Club and drove a terrible yellow Pontiac…. Shortly after the divorce, Charlie learned that his son, Teddy, had leukemia. In those days, there was no health insurance, you just paid everything out of pocket and the death rate was near 100 percent since there was nothing doctors could do. Rick Guerin, Charlie’s friend, said Munger would go into the hospital, hold his young son, and then walk the streets of Pasadena crying. One year after the diagnosis, in 1955, Teddy Munger died. Charlie was 31 years old, divorced, broke, and burying his 9-year-old son. Later in life, he faced a horrific operation that left him blind in one eye with pain so terrible that he eventually had his eye removed. It’s a fair bet that your present troubles pale in comparison. Whatever it is, get over it. Start over. He did it. You can, too.  …  You never know how strong you are until being strong is the only choice you have.

In his memoir Man’s Search for Meaning, Viktor Frankl wrote about this intrinsic virtue in all of us: “Everything can be taken from a man but one thing: the last of the human freedoms—to choose one’s attitude in any given set of circumstances, to choose one’s own way.” … Montaigne, the great French philosopher, adopted these seventeen words as the motto of his life: “A man is not hurt so much by what happens, as by his opinion of what happens.”

Our view of the world can be completely transformed when we embrace the belief that people are inherently good. … When you change the way you look at things, the things you look at change.

It’s not dying you should worry about; it’s chronic disease. What you can expect from not making the right health decisions isn’t an early death—in fact, that’s the least of your worries. Instead, you should be concerned about years, possibly decades, of suffering from chronic disease in your old age. As the pendulum has swung away from deaths caused by acute illness, it has gravitated toward chronic illness. Today, a great number of working professionals die from heart problems, strokes, diabetes, and lung disease. Our cars, Internet connections, and lives have become faster, but our physical activities have become slower.

As James Clear aptly puts it, “The costs of your good habits are in the present. The costs of your bad habits are in the future.”

young will catch up with you when you get old. As James Clear aptly puts it, “The costs of your good habits are in the present. The costs of your bad habits are in the future.”

The World Health Organization makes it clear that chronic disease is primarily caused by common, modifiable risk factors, with the big three being unhealthy diet, physical inactivity, and tobacco use.

That’s why it’s critical to break out of the vicious cycle of being unfit. Poor health triggers negative feelings, thoughts, and emotions, which hinder your performance and prevent you from reaching your potential. If you don’t approach your limits (which is a prerequisite for deliberate practice), you won’t improve. With enough dedication and discipline, what was once your stretch goal will become your warm-up routine. Those who have undergone major healthy changes realize how the state of their body correlates with the clarity of their mind and the stability of their emotions. These, in turn, influence the quality of social interactions.

High performance often hides behind boring solutions and underused basic insights. The fundamentals aren’t cool or sexy. They just work. One of the best health habits is to exercise for one hour three to four times every week and to avoid prolonged sedentary periods. The second habit is to get eight hours of sleep every night. The third is to drink more water and consume less sugar and junk food. All three are obvious, but they are often overlooked. They have a more meaningful and immediate impact on the quality of your mental and physical health than 99 percent of all productivity tips. Systems are better than goals because once you reach a goal (e.g., to lose twenty pounds), you tend to stop doing the very thing that made achieving that goal possible, and you revert back to your old ways.

A person who puts in continuous effort for ten years may achieve more in one week than someone who, having started six months ago, will achieve in an entire year.

Do less than you’re capable of, but do it consistently. That is the key to compounding. You have to build a program that you can do for decades, not weeks or months. It’s far easier and requires a lot less energy to take off once and maintain a regular speed (even if it is slower than everyone else) all along the way. Start with the easiest things so you gain momentum and confidence to tackle the more difficult things later. Pursue small, incremental victories. A small, concrete win creates momentum and affirms our faith in our further success. Confidence is like a muscle. The more you use it, the stronger it gets.

The post The Joys of Compounding: The Passionate Pursuit of Lifelong Learning appeared first on VII Capital Management.

This was an excellent book that profiled the legendary investor Robert Wilson, who famously turned a small inheritance of $15,000 into $800 million before giving it all away.  I suspect the reason he is not better known these days is that like Jesse Livermore (of similar legend), he committed suicide.  But unlike Livermore, who reportedly suffered from depression and died broke, Robert Wilson lived a happy, productive, and rewarding life, even though he ultimately chose to end his life shortly after a second debilitating stroke that left him disabled.  In his suicide note, he argued there was no reason for shame for he had lived a wonderful life and was making his decision rationally.  He even left instructions on the note for meetings that would need to be canceled from that day.  As McPhee puts it, it was like “just another trade.”

Again like Livermore, Wilson was a one man show who traded actively (both long and short), and deployed a high degree of financial leverage.  Interestingly, because he made his fame in the 1970s bear market, Wilson was known as a short seller by his contemporaries.  I did some Google searches and was able to find several good articles and this classic interview from 1985 where Wilson follows Warren Buffett and John Templeton in the Adam Smith TV show.  What had elevated Wilson to such prominence, aside from his net worth, was his inclusion in John Train’s classic 1980 book, The Money Masters , where he was famously quoted as saying that “one of the dumbest things you can do with money is spend it.”  It is notable that by that interview in 1985, Wilson was only a year away from calling it quits, after which he handed his fortune over to dozens of outside managers to focus entirely on philanthropy.

“Like the story of any great artist,” McPhee writes, “the story of Robert Wilson’s career will never get to the essence of what is ultimately an inexplicable gift. Wilson was a mythically talented stock-picker, who could routinely look at a list of twenty stocks and select the only two that were worth buying; and he had a nose for corporate death like no one else,” an acquaintance once said of his short-selling ability.  McPhee knew Wilson personally, but only from after he had retired from investing.  Most of the information he shares in his book comes from articles and interviews, as well as from Wilson’s required SEC filings.  Wilson frequently spoke with the media, who would probe him for long and short ideas, much like occurs with celebrity investors today.  Using a handful of investment examples, McPhee was able to reconstruct the narratives that justified some of Wilson’s best known positions.  While the examples themselves could not reveal all details of Wilson’s thinking, they were effective in illustrating the sort of investments that Wilson made.  Fedex, Lockheed, and American Express were notable examples on the long side, and bogus theme stocks like Memory Metals, National Video, and Pizza Time Theater were profiled on the short side.  He was also good at detecting when an entire industry was in trouble, such as oil in 1981.

If he were active today, Wilson would likely be long high-beta tech stocks.  He liked growth, but as the book’s examples reveal, what he really liked was change.  He was attracted to “the explosive stock, the wild and crazy stock. The stock that was held by the fearful, or the greedy, or both, and thus had the potential for a big price move.” He once told reporters,  “I’m not interested in buying it if it can’t go down 30%,” but he also told John Train in 1979 that he would be “scared silly if my long positions were only ten of my stocks.” At the time, Wilson owned seventy long positions. John Train even commented that “this was the most useful thing he had ever heard Wilson say.” Given his preference for surprise and controversy, Wilson sought to play the big secular growth themes through “step-sister” names.  One of his dictums was that in a gold rush, one should look for the lesser knowns, who must work harder to survive. So he chose Compaq over Microsoft, K-Mart over Walmart, and Denny’s over McDonalds.  When he explained his preference for fast growth in the 1985 interview, Adam Smith asked:  “But, rapidly growing companies, those companies are prizes – they are scanned for by computer screens, emerging growth mutual funds look for them – isn’t this quality already reflected in the price of each of those stocks?” To which Wilson answered:  “The only way one makes money in the market is when the market’s perception of a stock changes – so basically, I am looking for stocks where perhaps earnings have not started to improve yet, or if they have started to improve they are going to accelerate.  To buy stocks simply because earnings have been going up 30% per year for the last three years – and to just do that on a rote basis, is a good way to lose money fast because as earnings growth slows down, the stocks tend to go down.”

His experiences on the short side were also precious, especially the short squeeze with Resorts International, an Atlantic City gaming play.  The sheer size of the loss he was forced to take by his brokers ($24 million at the time), caused a media frenzy because like David Einhorn with Tesla these days, Wilson was vocally short a stock that became a rocket ship.  Reportedly he began shorting it at $9/shr and covered above at $180/shr.  Incredibly, even though that one loss amounted to 50% of his net worth, Wilson was up 25% that same year (1978), and 70% in 1979 and 60% in 1980.  When asked about Resorts International in the in the 1985 interview, Wilson pontificates: “I had God-like success on the short side in the 1970s. I shorted about a thousand stocks, and maybe five went up,” but “hubris is a very human thing that happens to all of us, and it particularly happens on Wall Street.  We tend, in this business to be terribly right for a while, or terribly wrong, and no matter how wrong and how often we have been wrong in the past, when we have a period when we are right it’s so wonderful and we think we’re so good,” before the interviewer asks, what happened?  “Well, I lost a lot of money.”  

Perhaps the most valuable insight I got from Robert Wilson was his view of competitive threats.  “Wilson stated many times that the single biggest mistake he made as an investor, the mistake that cost him the most money in his career, was worrying about business competition too early. Don’t sell out of perfectly good long positions for no good reason. The arrival of competitors often can mean something good: like, an expanding marketplace.”  To say that Wilson was ahead of his time is not even fair, because he did very well in spite of his time, which included an extended bear market – but his advice about downplaying competitive fears in expanding markets, has proven timeless.  Another prized insight was his mentality towards shorting, and the fact that he admitted (in the 1985 interview) that “from the beginning to the end of it, throwing in the Resorts, I may have broken even on my shorts.”  This may seem like a disappointing statement coming from a man who was considered to be the best short seller of his time – but as he quickly adds, “it permitted me to make a lot more money on the long side.”  Indeed, Wilson always ran net long, and sometimes it was well above 100%.  “When I was bearish,” he once told a reporter of TheStreet.com, “I was maybe 25% net long, and when I was bullish, I might be 125% net long.”

So all told, this was an inspiring and informative book about an impressive, if not obscure, investor who showed the world that it was possible for someone to systematically beat the market and create tremendous wealth with shrewd stock-picking, meaningful leverage, and nerves of steel. When asked in 1985 if he had an end object in mind for his investment career, Wilson answered: “Yes, to make a billion dollars.”  He didn’t quite make it, but came remarkably close.

Best regards,

Adriano

Highlighted Passages:

Foreword

Like the story of any great artist, the story of Robert Wilson’s career will never get to the essence of what is ultimately an inexplicable gift. Wilson was a mythically talented stock-picker, who could routinely look at a list of twenty stocks and select the only two that were worth buying; he had “a nose for corporate death like no one else,” an awed associate once said of his short-selling ability. Similarly, I have heard it said that Louis Armstrong had no idea how truly great he was; author Kurt Vonnegut said once that his books “just poured out of him”; hockey immortal Wayne Gretzky has said that in competition on the ice, “time just moved slowly for me.”

Chapter 1:  Capital

People do not kill the investment markets. The investment markets kill them.

Wilson ran this not inconsiderable sum—perhaps $150,000 today—to the fabulous amount of $230 million, by 1986. Then, with assistance he himself sought out, he nearly quadrupled his net worth to $800 million by the year 2000. The sum of $800 million is more than 50,000 times Wilson’s original stake of $15,000—from 1958. It is a capital appreciation, after taxes no less, of more than five million percent—5,000,000%. Robert Wilson did it—by himself, without partners—in about forty years.

We do know that it deeply affected Wilson as a very young man that his family occupied a “lower upper-class” socioeconomic position in Detroit, Michigan, in the years surrounding World War II.

It was the hedging, the protection of short positions vs. long positions, held at the same time, that had been missing from his investing.

Robert Wilson graduated from Amherst College in Massachusetts in 1946, and got a graduate degree the next year, in economics, from the University of Michigan, at Ann Arbor. Then he went to Michigan Law School, but left after two years without a degree.

Chapter 2:  The Tiger in the Tank Is Fear

What Wilson came up with was the idea of the explosive stock, the wild and crazy stock. The stock that was held by the fearful, or the greedy, or both, and thus had the potential for a big price move. The individual stock that had publicity and public attention, and was drenched in human emotion. Stock-market investing is an entirely human process, after all. Hedged fully, Robert Wilson didn’t care if a stock went up or down, so long as it moved. Driven by fear, or greed, or, ideally, both. Otherwise, what is the point?

What, Wilson might have asked at the time, is the point of a T. Rowe Price conventional growth-stock investment, or some predictable dividend payer like General Electric or IBM or Procter & Gamble? Or some predictable stock of any kind? Those stocks aren’t going to take their shareholders anywhere fast, and they don’t. What Robert Wilson determined was that he was going to center his investing on the scary business-equity share, the stock that scared the hell out of people—even him—because it was impossible to know what was going to happen next. But something—a move up or down in price—was going to happen. That was for sure. And probably a dramatic one, a violent one. Robert Wilson founded his investing on the stock that scared you in the nighttime, and made you fearful to take a look at its price the next morning.

Chapter 3:  Portfolio Genius: Heavy Diversification, Full Hedging

Robert Wilson once told financial reporter John Train that he would be “scared silly if my long position were only ten of my stocks.” (This was in 1979.) At the time, Wilson owned seventy long positions. John Train continued on in his article that this was the most useful thing he had ever heard Wilson say.

Wilson had great regard for business innovation. Innovation was a natural, automatic competitive advantage, and could cause a big advance in stock price as the particular business captured revenues and profits other companies were not capturing.  … Wilson was also on the lookout for surprises. Key developments in a business that were not appreciated or understood by the investment community, at least not right away, and could cause real changes in the company’s fortunes, and position, and stock price.

Down was the other direction, the second direction, in which stocks could and often did move, after all. It was potential price movement, and that meant money changing hands. Money changing hands from someone else, to Robert Wilson (most of the time, as it turned out).

“I had God-like success on the short side in the 1970s. I shorted about a thousand stocks, and maybe five went up.”

At the low point, the stock market in 1962 was down an average of 40%, and Wilson’s portfolio at the same time was down something close to 30%. He had begun 1962 with a net worth and portfolio value of $300,000. He was taken down about 30% at the low, to $210,000, but then recovered with the market, and ended 1962 at $300,000—exactly unchanged. Wilson was not upset, he was delighted, as he looked things over. He was a hedger, an aggressive hedger, and he was right to be one. Nobody and nothing could bust him. It brings a bit of a chill to hear what he told his wife Marilyn at this point: “Now I know that I can get rich. Now it is just a matter of getting rich.”

He was very sensitive to its [the market’s] themes, its moods, its changing moods, its dreams and its fears. This was the very complex animal that fed Wilson, and as anyone who looks at Wilson’s very famous and public career can tell, he developed every sensitivity he could, to extract as much treasure from the market as possible. Wilson said something quite marvelous at one point, long ago: “I know absolutely everything. But I am willing to change my mind.” Unlike millions of hardheaded, insistent investors out there, insisting on this idea or that, and treading water or losing money, Wilson worked very hard to understand the complexities of the U.S. stock market, was always determined to be aligned with it properly, and was as flexible as a willow, and could change his mind in a minute.

A stock sold short can only return 100% to the seller: a sale of a stock at $100, that subsequently goes to $0, and out of existence, yields the short-seller a profit of $100. The stock that is purchased at $100, on the other hand, has no limit on potential profits, and may ascend to $1,000 and $2,000 and beyond. In other words, there is a floor on price movement down, but no ceiling on price movement up. Ultimately, in his career, Robert Wilson made far more money owning stocks than selling them short. Short-selling was insurance and portfolio hedging first, and a profit-center second. It was a way to let those lucrative long positions keep growing, without getting margin calls from a bad market. Even in the 1970s, Wilson at any given time always had more money in stocks he owned than in stocks he had sold short. But—it is important to try to harvest all fruit.

All of Robert Wilson’s money came from the U.S. stock market. Yes, there are many other stock markets around the world, but the home market was plenty big enough to play in, he had obviously decided very early in his career.

Chapter 4:  Leverage Artist, Extraordinaire

“T. Rowe Price is a big name, but how much money does he have? Not all that much!” – Wilson

“The only office title I am interested in around here is millionaire.” – Wilson

His average compound growth rate over his entire investing career, after taxes, was a very formidable 28%.

It produced the following, select set of results:

Year Net Worth
1958      $15,000
1960      $195,000
1962      $300,000
1966      $1 million
1968      $7.4 million
1971      $12.4 million
1972      $21 million
1977      $42 million
1980      $81 million
1982      $110 million
1983      $173 million
1984      $154 million
1985      $197 million
1986      $230 million

Wilson’s stock-picking was usually first-rate, on both the long and short sides of the market. That fact has long been established.

There is a great old saying about debt: it requires you to get up in the morning, and go to work. The reference is to debt service, the cost of debt, the interest on debt that always must be paid, month after month.

Wilson, throughout his career, wanted a very aggressive 80% leverage on his portfolio. In other words, for every $100 of equity, Wilson wanted (and in fact got) $400 in borrowed money to work with, as well. A final key point about investing with borrowed money is that you have to believe in your ability to beat the market, short-term and long-term. Clearly, Wilson had great professional self-confidence.

80% leverage, 80% debt, is far more than the Federal Reserve Board, which sets the margin rules for all U.S. investors, or the New York Stock Exchange, or any other U.S. stock exchange, has ever allowed. And here is where things get interesting. Robert Wilson was determined to get way past the normal 50% “initial margin” allowed on a stock investment, or the 30% “maintenance margin” that has been set by the New York Stock Exchange, and has long been an industry-wide convention. What did he do? He went overseas, to overseas bankers, to borrow money against his investment equity—first in Mexico, and then in Switzerland.

Robert Wilson, in characteristic fashion, said that he took “a full half-second” to come up with a response. He would go out on his own; he would leave A.G. Becker, so that he could continue to borrow margin money from overseas. His job was one thing; his capital and his method of operation were quite another, and far more important, and could not be messed with or disturbed.

In 1968, Wilson formed Wilson & Associates, in New York City. He started to manage money for a few family members, and for some wealthy friends in Boston. The new firm began work with $3.5 million in capital. Wilson continued to manage his own money, of course, but he kept it separate, in large part because he knew he could not operate as aggressively with other people’s money as he could and did with his own. As an example: overseas borrowing would not be part of the new firm’s activity.

There was a major stock-market top in December, 1968, and then things generally started to head south. Even for hedge funds. Wilson’s clients didn’t lose as much money as the general public around them did, but a lot of these people became discouraged. They were not professional investors, of course. While Wilson’s own net worth increased to $8.3 million in 1969, at the same time he watched his Wilson & Associates clients start to withdraw money from the firm.

At the deep, scary September low, Wilson & Associates’ performance was down 35% for the year. Most of Wilson’s clients left right at this low—they withdrew their funds at absolutely the worst moment. The firm’s capital, with withdrawals, and to a lesser extent because of losses, dropped to just $350,000 at one point. This was just ten percent of its starting value, from two years earlier. Then it recovered, on an annual-performance basis, to about break-even, by year-end 1970. In just three months! So did Robert Wilson and his own money. Wilson was not impressed with his clients’ behavior, or sense of market timing, and he determined to put no emphasis on work for clients in the future. It was not what he was about, and it was not where the money was. He remarked, “It’s too bad they left when they did. They were at the start of a 1,000% gain!” By the end of 1971, Wilson himself was worth $12.4 million. By the end of 1972, he was worth $21 million. Sayonara, everybody. There was, in fact, only one Robert Wilson.

A crucial point about Wilson’s investing is that he believed that risk was centered in a lack of hedging; a lack of protection from hedged investments; a portfolio where stocks were owned and not also sold short, in a big percentage of overall portfolio value. Wilson evidently did not see borrowing large sums and percentages of money, in a hedged portfolio, as a big risk, and evidently, he was correct. It is one of the truly profound insights into the investment business ever achieved, and ever demonstrated. It is an insight that cannot be proved theoretically; it has to be demonstrated, and proved beyond any statistical doubt. Wilson demonstrated it, over thirty years of steady investment work. If borrowing were as dangerous as many people think it is, it would have eliminated Wilson and his money and his career at some point between the late 1950s and the late 1980s. He was always heavily leveraged, and yet he always survived, and survived very well.

Chapter 5:  The Individual Stock Positions, Short and Long

“It’s been a quiet life. The market has provided the excitement.” – Wilson

Robert Wilson famously watched even the tiniest public offerings of stock (all of them a matter of public record), and throughout his career he read the business press voraciously.

“I have an icy resolve never to cover a short position.” – Wilson

What is traditionally very hard for amateur investors to understand is that it is never too late to buy into a winning stock and business, and never too late to sell, or sell short, a loser.

“What is a calculator, but a couple of semi-conductors in a metal box, with some buttons?” He started selling Bowmar Instrument short at a fairly high price, around $20 per share. He thought he had been patient with the big rally in the stock. But, no matter. The market didn’t see things Wilson’s way, and the stock price kept rising. First to $25, and then to $30. Wilson was down 50% on his overall position. Unlike almost every other short-seller in the investment business, this price rise inspired him to sell more. (“If I sell short and the stock doesn’t go against me at least 20%, I start to think I’ve done something wrong.”)  And still, Wilson hung on to his position. Bowmar stock hit $40 per share. $42. $44. Wilson was down more than 80% on his position, and his money, even though he had been selling short all the way up. …  [eventually] … Bowmar stock began a nose-dive. A good business had suddenly turned lousy, and looked like it was going to stay that way. Bowmar stock fell for two years, and went way below all of Robert Wilson’s original short-sale prices. In 1976, the company filed for bankruptcy. Wilson covered—bought in—his entire short position at an average price of $2 ½. He had made another small, seven-figure fortune in the market—by being right, and by hanging tough. His most famous comment about Bowmar at the time: “That was a rough one!” And there are two comments about the short side that Wilson made later, which are still well remembered on Wall Street: “To be a short-seller you have to be a masochist, and then try to make money later on.”

Lockheed had always been an innovative, creative, very high-earning supplier of complex weapons systems, and some fighter jets, to the U.S. military. In fact, the leader in the field. Corporate management sensed, and the point was obvious, that a civilian jet and a civilian program were not its business. Sales were half what had been hoped, and profits were less than nil. Actually, Lockheed lost plenty of money on the L-1011 project, and in 1981 they said they were getting rid of it. Robert Wilson entered this situation and took a long position near $27 per share. Lockheed Aircraft was worth owning—the number-one seller and earner, supplying the U.S. military. Even with the L-1011 project in place. Getting rid of this big project was like a perfectly good aircraft remembering to pull its flaps up, while in cruise flight. An obvious mid-course correction to be made, to an otherwise perfectly good aircraft (and business)—and then the future was going to be just roses. At the time, noting the impending closure of the L-1011 project, Robert Wilson said that “the stock, at scarcely over twice earnings, will soar.” Great students of the U.S. stock market, like James Finucane, out of Chicago and Colorado, have made the key observation that stocks will trade up and down, to very unreasonable levels, because of quarterly earnings reports. While earnings might swing wildly, due to temporary circumstances that are positive and negative, the great indicator of the health of a business—revenues and sales—is almost always a far more stable statistic. The fact that it is not well heeded presents great opportunity for investors. Lockheed Aircraft Corp., in 1981, had a phony earnings problem, because of the L-1011 airliner, and a very strong and stable, nay expanding business enterprise, overall. The company had the most interesting and most sophisticated weapons systems on offer anywhere, and sales to the military were strong and growing fast. Management cured its earnings problem quickly and easily by getting out of the civilian-airliner business permanently, and returning to its terrific core business. Lockheed stock went nuts, to the upside, more than tripling in price. Robert Wilson, of course, was on board, and had been for months.

What the top executives at Baldwin-United did was make a very large bet on interest rates, essentially—and one that the company did not need to make. Like the average trader in high-interest bonds—any member of the general public—Baldwin was incautious, and dumb as a rock, at the bottom of the bond market. … Wilson shorted Baldwin-United stock heavily around $3 per share, and ended up pocketing every dollar he was able to transact for. (“Always kick a dog when he’s down,” he would say about short-selling.) There was no turning back Baldwin-United. Its fate was sealed. It was one of those ideal short sales: bankruptcy and liquidation were certain. Just a matter of mathematics. Selling short at a low price, Wilson pocketed every dollar that he had been able to raise through his short sales. Eventually he purchased a significant number of common shares back “against the box,” to protect himself against capital-gains taxes. But apparently he didn’t press this matter as far as he could have. Wilson had a marvelous, oft-repeated saying: “Be a gentleman, and pay some taxes.”

Compaq Computer Corp. [L]:   The Brass Ring Robert Wilson missed Microsoft Corp., which went public in 1986, but since the late 1970s he had been focusing on the very grand minicomputer, and personal-computer, revolution. The movement of computer power away from government and corporations exclusively, and then, incredibly, on to individuals everywhere. There was a ton of money in this massive shifting of the ziggurat, this platinum investors’ vault, this grand new personal computer (“p.c.”) industry, and the right investment judgments held the keys to fortunes.  …  A great deal of its market appeal, apparently, was public hunger for an alternative, any good alternative, to the dominant IBM p.c. Compaq out-engineered and out-manufactured its competitors into the late 1980s, when other companies really did begin to catch up to Compaq’s production standards. Then, the commodification of the p.c. business truly began, and price wars became very frequent. But Compaq Computer had grown huge, hitting $1 billion in sales in 1987, five years after its founding, by diving into the p.c. gold rush early but correctly, with correct strategy, and plenty of intelligent advance planning. Compaq Computer went public in 1983, and Robert Wilson took a heavy long position in the stock (this is all the detail he would give the press). He always seemed able to spot an innovator early. And this innovator meant particularly large capital gains: Compaq was eventually purchased, twenty years after its founding, by the Hewlett-Packard Corporation, for $25 billion.

One of Wilson’s dictums is that in a gold rush, in a huge new market, look for the lesser knowns, who are innovative and clever and hard-working, because they have to be to survive. These lesser lights have far less stock-market exposure than the leader(s), and their necessary efforts and creativity can often lead them not just to survive, but to prosper greatly. And particularly in a rich business like computers.

Nolan Bushnell wanted to bring in the children, en masse, and make a fortune off their millions of fresh quarters dropped into vast numbers of freshly built video-game slots, as the kids ate pizza and watched Pizza-Time Theater’s cheap animatronics (moving, electronic characters, like a poor man’s Disney World). After a completely surprising, huge decline in the video-game business, beginning in 1983, Nolan Bushnell really started digging himself a hole. He didn’t consider strategic changes; he pressed on with his original business plan. He seemed to think that he, the video-game king, the original, could not fail at an expansion effort, in spite of major warnings from the market. He thought that he could single-handedly revive the video-game business by continuing to try to create more markets for it. After 1983, and the video-game “crash,” Bushnell’s high-cost version of his original, lean success, Atari Corp., was overwhelmed by costs and expenses, and soon filed for bankruptcy, in 1984. Initially, Bushnell certainly seemed to think that he could re-create the old, grand success of Atari Corp. in the 1970s—by putting his head in the sand and spending money on a losing game. In 1983, all Robert Wilson saw was Bushnell spending a fortune to stay afloat with Pizza Time Theater, now a bad business. Bushnell was spending hand over fist, self-deluded, getting swallowed in a whirlpool, throwing good money after bad. “[The business has turned lousy] and they aren’t earning any money, and I think it’s a disaster,” Wilson told Barron’s weekly newspaper. Wilson was heavily short Pizza Time Theater after the video-game “crash” of 1983, and he spent nothing to cover his short position in the stock. It went to zero.

Tandy Corporation [L]:  The Harder I Work, the Luckier I Get In the dark days of 1974 in America, into and through President Nixon’s resignation in August, and the super low in the stock market at the end of the year, Robert Wilson started buying the common stock of Tandy Corp. This company had long been a very clever mail-order retailer of craft and hobby merchandise, and leather goods, and it had started planting small retail stores across the U.S., as well. What Wilson particularly liked about Tandy Corp. was that it had owned Radio Shack, Inc. since 1963. This meant high-margin consumer electronics—audio and video devices and ham radios, etc.—pumped through a big and rapidly expanding distribution system. Tandy Corp. expanded into Europe and Australia as early as 1973, and in five years of blinding growth after 1969, it expanded its U.S. store count from 132 to 269.

In the “p.c.” gold rush, there was plenty of money to be made by everybody, and especially in the earliest years. Tandy Corp. was not only the dominant U. S. retailer for quite a while; it had the great foresight to start manufacturing the micro-computer machines as well, for its own account. Tandy Corp. was a very fine investment that did much better than Robert Wilson thought it would. But, he always tried to bet on people, and Tandy management was first-rate, and with fine judgment they jumped into the personal-computer business right at its birth. In fact, they were among the founders of this great new industry. Wilson went along for the ride, and it helped him reach a net worth of $26 million by the end of 1975.

Robert Wilson understood that innovation takes many forms. The classic form, the invention of a completely new product that catches everyone else by surprise, and makes a fortune, is only one form. In the case of American Airlines, in the early 1980s, Wilson noticed true innovation, as one competitor learned how to attack and defeat others. An innovative ability to win market share from other airlines, and take for itself a larger slice of the same old pie. American was big enough to cut its costs below those of its competitors, by using a “hub and spoke” system for delivering passengers to their destinations. (This ingenious system was pioneered by Federal Express Corp. years earlier—see section below.) A regional airline can only deliver a passenger point-to-point, but a large, national carrier like American can and did deliver passengers from one point to any other point in the country, by sending them through a central “hub.” In American Airlines’ case, that hub was Dallas, Texas. Chairman Crandall also developed the first frequent-flyer system in the industry, known as SABRE; and he used many different financial incentives and discounts on tickets, to cement customer loyalty. The airline business in the early 1980s was stagnant, but American Airlines under Robert Crandall was on the move, chewing up competitors and improbably making lots of new money. The airline was like a pickerel, in a pond full of vulnerable trout. It became what an airline almost never is: a great investment. Wilson loaded up on the stock. He always had his hand on the sell switch, because this was the airline business, but he was not rash about making a fast buck and getting out.

Federal Express Corp. [L]:  20/20 Vision Robert Wilson had been fond of the airline business since 1964, when with the arrival of the major innovation of the jet engine, he had made ten times his money in Northwest Airlines, for himself and his clients at A.G. Becker, in New York. But he did not usually have a lot of investments in the industry. There were really none to make. Industry innovations were few and far between, and the airline business was generally competitive and low-margin, and, therefore, lousy. At the beginning of the 1970s, the hard-charging, visionary, no-nonsense Fred Smith arrived on the scene. He was a former Marine Corps pilot, and he was convinced that high technology, particularly in the computer world, required fast delivery of high-value parts and equipment of all kinds. The only way to do this, Smith reasoned, was through air transport. And, some kind of new cargo airline.  …  Federal Express went public in 1973, and Robert Wilson took a large position. He could see what was nothing less than the amazing and very surprising reality of a new airline, enjoying huge barriers to entry by potential competitors. The other thing that Wilson appreciated about Federal Express was its ingenious use of a “hub-and-spoke” delivery system. In the nature of its business Federal Express had to be a national airline from day one, so it immediately established a single central city, a central city-hub, for itself. (Not at first, but eventually, this was Memphis, Tennessee.) There are enormous efficiencies and cost savings to be achieved by transporting people and cargo through a national system of “hub” cities—if the operation is big enough to accomplish it. (In other words, not point-to-point, like a regional carrier, but point to any other point in the entire system, through centralization.) From its very first day of operations, with twenty French Dassault Falcon jets, Federal Express Corp. was a national airline, and a national delivery system. Not just a regional one. It had to be. But this also allowed it to operate “hub-and-spoke” from the beginning—big enough to be very efficient and very cost-effective.

Wilson also said, however, that his big investment in Northwest Airlines, in 1964, which turned out to be a 1,000% winner, was as close to a group or “macro” long investment as any he ever made. It was a bit of an exception, in other words. The broad idea was the arrival of the jet engine, and jet-engine technology, as the new standard in civilian air transportation. It would make civilian-airline costs much lower, and revenues much higher, per “seat-mile,” in industry parlance. And particularly on long-haul routes, which were a Northwest Airlines specialty at the time and later. Northwest was the largest U.S. trans-Pacific air carrier after World War II, with a major hub in Tokyo, Japan. It started flying the three-engine Boeing 727 airliner late in 1964, and fresh revenues and profits just poured into the company. Basically, Northwest was doing an awful lot of high-profit long-haul business, of both people and freight, and the arrival of the jet engine then expanded good profit margins dramatically.

Chapter 6:  Just Another Trade

He stated that he had had a good life, a rewarding life, and that he had done everything he wanted to do. He also stated that he felt no shame in doing what he was about to do. As a final practical matter, he set down a short list of upcoming appointments, and noted that they would have to be cancelled. Shortly after the note was finished, the New York City police would find it. Wilson opened a back window of his apartment, one that looked out onto an inner courtyard. The courtyard was about 150 feet down, and it was empty. There was no one out there; no one down there. Wilson would never have considered a jump from the front side of his apartment, onto busy Central Park West. Absolutely nobody else was going to be harmed by what he was about to do. And there was no harm in him. Never. Wilson leapt out of the window. It was certainly a frightening few seconds, and without question it was a very brave thing to do. He was killed instantly. America’s greatest investor—ever—was gone.

Google Research:

Interview with Meet Roemer McPhee author of Killing the Market

• Wilson had no secrets, but he was a very private man. The business press in America was fascinated by Wilson very early, just as I have been later, and the press is the main source of information about Wilson’s unique investment career. My chief source on Wilson is that I knew him for about 25 years, in NYC, and met with him maybe a dozen times, mainly to talk about his work, and the stock market.
• Roemer: Wilson left very little information behind, directly. Journalist John Train’s extensive writing about Wilson was very helpful to me, as were the major American business publications that would not let Wilson go, for very good reason: in the investment game, he was number-one, and everybody knew it. Late in his life, Wilson also appeared in philanthropy publications.
• The number-one reason a person should read this book is to experience, in detail, human greatness. It is truly unbelievable, what all of us can achieve. Secondarily, the book will reinforce the need to work hard to achieve anything. Talent is great, but it must be worked, and shaped, and worked again, to produce real value of any kind.
• His genius is ultimately a mystery. Like Michelangelo.
• Wilson is just about the most productive individual, living or dead, I have ever encountered. A machine; a wonderful machine.

YouTube Interview with Roemer McPhee – December 12, 2016

• A lot of people traded in sympathy with him
• Why is now the time to write this book:  “I think he would be hedged out in the business. .. “ – oh no we lost him” [webcast cut short].

TheStreet.com Streetside Chat: Robert Wilson – April 16, 2000

• Wilson’s investment strategy was to go both long and short — long because he believed in the long-term future of America and short because he never wanted to be wiped out in a downturn.
• His fortune, approaching a billion dollars, is managed for him by a small posse of investment advisors — some short, some long; some U.S., some overseas; some value, some growth; some large-cap, some small-cap.
• For more on Wilson, see the chapter on him in John Train’s investing classic, Money Masters
• But if the market went down, 30%, 40% with the kind of growth stocks I owned, I could be rendered worthless, whether I was worth $100 or a million dollars. If you own 50% margin and the stock goes down 50%, you don’t have any money left, no matter how much you started with.
• I was always net long. When I was bearish, I was maybe 25% net long, and when I was bullish, I might be 125% net long.
• “There’s something intellectually much more intriguing about failure, which is knowable, rather than success, which is sort of unknowable.  The way people fail is understandable and predictable and almost inevitable, whereas the way people succeed may never have happened, and so an intellectual is drawn towards failure, I think.”
• Where were you getting most of your good ideas, stock ideas, for longs or shorts? “From other people. I networked. Even when I was at a brokerage firm and was not paying for ideas, I would exchange ideas.”
• The people in the research departments in those days didn’t make the multimillion dollars they do now. They tended to be the mundane people.  Not moneymakers. They tended to be intellectual types who followed companies painstakingly and knew their stuff. They weren’t dumb, they just didn’t have that aggressiveness, or that spark, to be moneymakers. And it was the institutional salesmen who plucked the pearls among the swine.
• The whole money management business is enormously profitable, but nobody’s rigging it … it sort of amazes me that there are so many people making so much money in a purely competitive market.
• I remember at one point, that Julian Robertson had just acquired some more space and had a lot of very lush offices, which weren’t filled yet. And I said, “Are you going to hire people and give them offices like that?” And he said, “Bob, if they come up with one idea a year, it’ll cover that office and what I pay them, and all other expenses and if it’s two or three ideas … ” and Julian never paid anybody much less than half a million. A nincompoop would make a half a million, and a really bright guy would make $3 million or $4 million. And that was back before the multimillion research.
• Oh, I knew Julian when I was richer than he was. I knew Julian from when he was still a registered rep at Kidder-Peabody — the ’60s — and … well, I don’t think there’s much secret about this, I think one reason Julian amassed so much money under management is he wanted to sell out. And the more money he had under management, the better the price he could sell it for. Julian is a very high-grade guy, so I’m sure he wouldn’t have sold it to just anybody. He would have sold it to somebody who could continue to do a good job for these people. And this I don’t know, but I think Julian wanted to retire, or at least slow down. Again, I think, and I think most potential buyers weren’t very interested without Julian’s aggressive role. And then he — I don’t know how old Julian is now — he’s 67 or something like that, and I’ve always said young men and middle-aged men can make good money in the market, but not many old men can, and I define old as getting over 60.
• Well, he went from $26 billion, down to what? Eight … oh, billion. I mean, the people who ran out on him, the withdrawals, aside from his losses — he could have handled the market losses — but the withdrawals were just breathtaking.
• I think the greatest success of my whole career was the jets, when airlines switched from propeller-driven planes to jet planes. There are very few cases where the airlines’ costs plummeted, the quality of their service skyrocketed, and if ever there was a win-win situation, that was it. People talk about the Internet “revolutionizing” the world. Well, jet travel revolutionized the world, too, and there was a huge amount of money to be made in that.
• I covered it when I got back. I was fundamentally wrong, you see, and once I realized I was fundamentally wrong. … Another thing: I thought competing casinos were closer to approval than they actually were. So Resorts had a monopoly for a couple of years.
• And I said to everybody at the time, I hope next time I make a boo-boo like this, I lose $200 million.  Because I’ll be so much richer. You can’t lose $200 million in an individual stock, unless you’re quite rich.  I should point out that for the year in which I had that $20 million loss, I was up 25%, in my overall account and that was a very strong year in the market. I should have been up 50%, or 60% or 70%. That was only one position, and I had a lot of longs that did very well. So it was a plus year. This is the point of hedging.
• What would be your general advice to an investor who, for some reason, has bet against a company and suddenly it’s going the wrong way — whether it’s a long that suddenly goes down a great deal, or a short that goes up a great deal? Well, I think you should look at the fundamentals. I always used to say, if I shorted a stock and it didn’t go 20% against me, I probably made a mistake.
• Yet generally speaking, did you make money on your shorts?  I would say from the beginning to the end of it, throwing in the Resorts, I may have broken even on my shorts. And it permitted me to make a lot more money on the long side.
• And what would be your advice then to investors in this kind of a market?  I would forget the shorting. I think it’s over. It’s over for one simple reason: If shorts start working, that is, stocks go down for any sustained period of time, a great many people who are not now shorting will start shorting. There is a limited supply of stocks to borrow to sell short. Those stocks that are good shorts tend to be very obvious. As I’ve often said, I can predict with confidence that you’ll die. I cannot predict that you’ll be born, and so failure is analytically obvious and so everybody piles into the same short.  When I was doing it, it was a rather unpopular procedure, and I was able to borrow, generally. People are able to borrow now, but I do believe if shorting really becomes profitable again, it’s going to become so crowded that most people won’t be able to borrow stock.
• Who do you think was the greatest stock investor that you have ever seen operating in the market when you were active?  Oh, well, Warren Buffett, obviously.  What is it about him that impressed you?  Well, his prescience, his ability to buy stocks and see them go up multiples over a period of years. In other words, whenever I bought a stock, I always dreamed that it would go up a 100-fold over 10 years, and he bought one after another that did that. So, he not only made the most money. There is a correlation, of course. But he did it with such great style and imagination. There’s nobody even comes close to him.
• There is a lot of pooh-poohing of Buffett.  Well, Buffett is old. Buffett, I think, is almost my age, and I think his days of being a brilliant investor are over. I think he’s too old, and in a way, is selling out. He can’t sell the stocks, but he bought general reinsurance. He started diluting his equity, and I think he realizes this, too. He’s not exactly a dumb guy, and I think he probably knows this, too.

Lessons from a Legendary Short Seller – CFA Institute – 22 December 2016

• “If it bleeds, it leads,” after all. But there’s a difference between generating clicks and generating alpha: We all know there are no short sellers in the Fortune 500.
• This sentiment is echoed by Chanos, who recently stated:  “A good short portfolio allows you to be more long. . . . And that’s the crux of what we do. It enables our investors — and ourselves — to be more long, whether it’s passive investments or stocks we select.”
• There is a twofold takeaway here:  The greatest short sellers barely break even. The primary goal of short selling should be to provide cash in a sell-off and let you “back up the truck” on your longs.
• Many managers prefer to wait until the short has already “cracked” and press it on the way down. As famed short seller Marc Cohodes commented:  “I never, ever, ever get involved in what I would call open-ended situations. . . . I have avoided pie-in-the-sky names. To use an analogy, I’m not interested in climbing into a tree and wrestling the jaguar out of the tree. I’m interested in someone shooting the jaguar out of the tree, and then I will go cut the thing apart once it hits the ground. Instead of open-ended situations, I like to short complete pieces of garbage with fraudulent management and horrifically bad balance sheets. I look for change, I look for ‘if this goes away tomorrow will anyone miss them’? What do they do well?”
• Why did you first go to Wall Street, what were you seeking to achieve and did you get what you wanted?  “I’m dealing with humanity, and don’t have to put up with any feedback.”  This speaks to how investing can be a lonely endeavor. Unlike someone in banking or sales and trading, which generally require exemplary social skills to succeed, a money manager like Wilson can generate out-sized returns for a decade all on his own — just a man versus the market.

Adam Smith Interview:  Warren Buffett, John Templeton & Robert Wilson Interview From 1985 – posted November 27, 2017

• John Templeton from the Caribbean:  “…of course we make hundreds of mistakes all the time.  Our average holding period is six years.  We are worldwide bargain hunters.” –
• Warren Buffett interview starts at 10.20min.  “This is not a business where you take polls.  It’s a business where you think.”
• Robert Wilson Starts at 17:10min:  “I would be bored to death to live in Omaha or the Bahamas.  The most important thing is to enjoy life. … Unlike these other distinguished gentlemen, I am not an original thinker.  I tend to rely on other people to feed me ideas. … I’m a derivative thinker. .. I like to be in things that have great potential for huge gains.  I’m not interested in buying it if it can’t go down 30%.  If the downside risk is limited then the outside potential is also limited.  I give a lot of money out in commissions and tend to sit at my desk waiting for people to call me.”
• Interviewer:  But, rapidly growing companies, those companies are prizes – they are scanned for by computer screens, emerging growth mutual funds look for them – isn’t this quality already reflected in the price of each of those stocks? Wilson:  “Maybe I can refine what I said.  The only way one makes money in the market is when the market’s perception of a stock changes – so basically, I am looking for stocks where perhaps earnings have not started to improve yet, or if they have started to improve they are going to accelerate.  To buy stocks simply because earnings have been going up 30% per year for the last three years – and to just do that on a rote basis, is a good way to lose money fast because as earnings growth slows down, the stocks tend to go down.”
• “Hubris is a very human thing that happens to all of us, and it particularly happen on Wall Street.  We tend, in this business to be terribly right for a while, or terribly wrong, and no matter how wrong and how often we have been wrong in the past, when we have a period when we are right its so wonderful and we think we’re so good.”  What happened? “Well, I lost a lot of money.”
• If a young person came to you straight out of college and said I want to be as rich and successful as you, how would I do it?  “Money, in the abstract, not what money will buy, has to be the most important thing in the world.  It is not the most important thing in the world for the vast majority of talented people.”
• 24:13 min: Do you have an end object in mind in your investment career?  “Yes, to make a billion dollars.”  Really?  “Yes.  I am not at all sure I am going to do it but I am going to try.”

Good-Bye Wall Street:  A Famed Investor Bows Out – New York Magazine, May 26, 1986

Short Seller Goes Long on the Future – HuffPost 07/01/2009

• Robert Wilson, a retired 82-year-old investment legend, never did get around to building an empire. But he managed to dazzle Wall Street with a remarkable achievement. Namely, he parlayed $15,000 that his parents gave him in the 1940s into an astonishing $800 million net worth.
• He retired in 1986 and placed most of his assets with a group of money managers. Unfortunately, they couldn’t match Wilson’s standard of performance, causing him the loss of a fair amount of money.
• Describing himself as “an old man now,” Wilson says “anyone who thinks they’re young at 82 is on their way to dementia.” Still though, he remains an active 82-year-old. A world traveler, a lover of the arts and a former chairman of the New York City Opera, Wilson exercises 45 minutes a day and he’s still running.
• His advice to the average investor: “I would avoid the stock market and put my money in short-term Treasuries and savings accounts and wait for interest rates to go up, which they’re already doing on the long end.”

Robert W. Wilson leaps to his death at 87; hedge-fund founder and philanthropist

• Died Dec. 23 in Manhattan. He was 87.
• Wilson suffered a stroke in June, Gary Castle, his accountant, said Tuesday in a telephone interview.
• In 1949, Mr. Wilson got his first job in New York, as a trainee at First Boston, which was later acquired by Zurich-based Credit Suisse. After serving in the Army during the Korean War, he returned to First Boston in 1953.
• In May 1978, he created a short position of 200,000 shares of Resorts International at an average price of $15 each, according to a 1979 account in Forbes. The company had just opened the first gambling casino in Atlantic City, and Mr. Wilson was betting the stock would fall. Instead, the shares rose to $20. The shares continued to rise and by September reached $190. By then, Mr. Wilson was buying back the stock at appreciated levels, costing him millions of dollars in losses.
• He was divorced from his wife, Marilyn, and had no children.

Robert W. Wilson, Frugal Philanthropist, Dies at 87 – NYT December 23, 2013

• “ ‘Well, now that you’ve given all this money to our schools, I should try to convert you,’ ” Mr. Wilson recalled the cardinal saying. “I said to him: ‘Well, Cardinal, if you do, I suppose I should try to convert you. The only problem is that if I succeed, you’ll lose your job.’ ”
• He was known for his frugal habits. Mr. Wilson rarely took a cab, managing to get where he needed by subway, until he had the stroke. When he had to take a cab, he was known to persuade one of his well-heeled San Remo neighbors to share the fare.
• “One of the dumbest things you can do with money,” Mr. Wilson said in a 1979 interview with Forbes magazine, “is spend it.”
• “The gist of it was that he had had a great life, and done all the things he wanted to,” Mr. Schneidman said, “and that the way he chose to die was nothing to be ashamed of and shouldn’t be kept secret.”
• The note concluded on a practical note, he added: “He wrote a list of appointments that would have to be canceled.”

Philanthropist carefully planned suicide jump; ‘not ashamed’ – NY Post – December 25, 2013

• Friends said Wilson didn’t even shy away from the subject at a party for his 87th birthday last month.
• “His health was failing, and he was ready to go,’’ said pal Stephen Viscusi.
• Wilson’s anonymous female pal suggested that he jumped into the courtyard of his building to make sure he didn’t land on anyone.
• In August 2011, looking out onto the park from the same terrace where he would later jump to his death, he told the Financial Times, “Who needs a summer place? I’ve got one.’’

Tycoon who jumped to his death after stroke leaves $2M to staffer – January 16, 2014

• The openly gay Wilson did not name his family– including his ex-wife, brother, niece and nephew– in the will but Viscusi said they were provided for in other ways.
• “He was an unusual guy,” said Viscusi, who threw an 87th birthday bash for his friend just a month before his suicide.
• Police had read Schneidman Wilson’s suicide note, which said that he “had a great life” and his decision to die was “nothing to be ashamed of,” according to an interview the accountant gave to The New York Times.

https://en.wikipedia.org/wiki/Robert_W._Wilson_(philanthropist)

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