Value investing

A Comparison of Measures of Investment Returns

2008-05-02T06:06:00.000-07:00

Growth Arithmetic

2008-04-17T14:30:00.000-07:00

http://arnoldkling.com/econ/arith.html
Growth Arithmetic
Here is some basic algebra/arithmetic that can be used for calculations involving growth. This could be growth of GDP, growth of money in a savings account, or growth in the population of gerbils. The algebra is the same.
There are four variables involved.
Y0 is the initial value of the variable. For example, we could start out with a population of 1000 gerbils in period 0.
t is the number of periods over which we are calculating growth. The periods could be days, months, or years. In the example, let us think in terms of years, so that if t=4 that means that we are observing growth in the gerbil population over 4 years.
Yt is the value of the variable at the end of the observation interval. If t=4, then Y is the size of the gerbil population after 4 years.
r is the average periodic rate of growth, expressed as a decimal. For example, if the gerbil population increases at an average rate of 24 percent per year, then r=.24
The fundamental equation for growth is given by
[1] Yt = Y0(1+r)t
For example, if we start with 1000 gerbils and the population grows at an average rate of 24 percent for 4 years, we have:Y4 = 1000(1+.24)4 = 2364 gerbils.
Calculating cumulative growth
Cumulative growth is the total growth from the beginning to the end of the observation interval, expressed in percent. That is,
Cumulative growth = [(Yt - Y0)/Y0]*100
I find it easier to work with the equivalent formula
Cumulative growth = (Yt/Y0 - 1)*100
Using the equivalent formula, we have in the gerbil example
Cumulative growth = (2364/1000 - 1)*100 = 136.4 percent.
Solving for r
Suppose that we know the value we started with and the value at the end of the observation interval, and we want to calculate the average growth rate, r. Solving equation [1] for r gives
r = (Yt/Y0)(1/t) - 1
For example, if we start with 1000 gerbils and after five years we have 1800 gerbils, then the average annual growth rate is
r = (1800/1000)(1/5) - 1 = .125, or 12.5 percent per year
Solving for t
Suppose we ask, how long will it take for the gerbil population to reach 4000, starting from a population of 1000 and growing at an average annual rate of 24 percent? This is a problem where we are given Y0, Yt, and r, and we need to solve for t.
To do this, we use something I'll bet you never thought you would use: logs! If you take the log of both sides of equation [1], to get
logYt = logY0 + t[log(1+r)]
Solving for t gives
t = (logYt - logY0)/log(1+r)
In our example where we want to know when the gerbil population will reach 4000, we have
t = (log[4000] - log[1000])/log[1+.24] = 6.44 years

quote

2008-03-07T05:13:00.001-08:00

Getting ahead in a difficult profession requires avid faith in yourself. That is why some people with mediocre talent, but with great inner drive, go so much further than people with vastly superior talent" - Sophia Loren (Italian actress

Charlie Munger's Lollapalooza Effect

2007-11-20T05:20:00.000-08:00

http://seekingalpha.com/article/54625-charlie-munger-s-lollapalooza-effect-and-this-credit-fiasco
CHARLIE MUNGER ON THE PSYCHOLOGY OF HUMAN MISJUDGMENT
Speech at Harvard Law School (date unknown)
For an article about this speech, see Munger on Human Misjudgments

Moderator: ...and they discovered extreme, obvious irrationality in many areas of the economy that they looked at. And they were a little bit troubled because nothing that they had learned in graduate school explained these patterns. Now I would hope that Mr. Munger spends a little bit more time around graduate schools today, because we've gotten now where he was 30 years ago, and we are trying to explain those patterns, and some of the people who are doing that will be speaking with you today.
So I think he thinks of his specialty as the Psychology of Human Misjudgment, and part of this human misjudgment, of course, comes from worrying about the types of fads and social pressures that Henry Kaufman talked to us about. I think it's significant that Berkshire Hathaway is not headquartered in New York, or even in Los Angeles or San Francisco, but rather in the heart of the country in Nebraska.
When he referred to this problem of human misjudgment, he identified two significant problems, and I'm sure that there are many more, but when he said, "By not relying on this, and not understanding this, it was costing me a lot of money," and I presume that some of you are here in the theory that maybe it's costing you even a somewhat lesser amount of money. And the second point that Mr. Munger made was it was reducing...not understanding human misjudgment was reducing my ability to help everything I loved. Well I hope he loves you, and I'm sure he'll help you. Thank you. [Applause]
Munger: Although I am very interested in the subject of human misjudgment -- and lord knows I've created a good bit of it -- I don't think I've created my full statistical share, and I think that one of the reasons was I tried to do something about this terrible ignorance I left the Harvard Law School with.
When I saw this patterned irrationality, which was so extreme, and I had no theory or anything to deal with it, but I could see that it was extreme, and I could see that it was patterned, I just started to create my own system of psychology, partly by casual reading, but largely from personal experience, and I used that pattern to help me get through life. Fairly late in life I stumbled into this book, Influence, by a psychologist named Bob Cialdini, who became a super-tenured hotshot on a 2,000-person faculty at a very young age. And he wrote this book, which has now sold 300-odd thousand copies, which is remarkable for somebody. Well, it's an academic book aimed at a popular audience that filled in a lot of holes in my crude system. In those holes it filled in, I thought I had a system that was a good-working tool, and I'd like to share that one with you.
And I came here because behavioral economics. How could economics not be behavioral? If it isn't behavioral, what the hell is it? And I think it's fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there's anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working on this fringe between economics and psychology are absolutely right to be there, and I think there's been plenty wrong over the years. Well let me romp through as much of this list as I have time to get through:
24 Standard Causes of Human Misjudgment
1. First: Under-recognition of the power of what psychologists call 'reinforcement' and economists call 'incentives.'
Well you can say, "Everybody knows that." Well I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.
One of my favorite cases about the power of incentives is the Federal Express case. The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can't be done fast. And Federal Express had one hell of a time getting the thing to work. And they tried moral suasion, they tried everything in the world, and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked.
Early in the history of Xerox, Joe Wilson, who was then in the government, had to go back to Xerox because he couldn't understand how their better, new machine was selling so poorly in relation to their older and inferior machine. Of course when he got there he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine.
And here at Harvard, in the shadow of B.F. Skinner -- there was a man who really was into reinforcement as a powerful thought, and, you know, Skinner's lost his reputation in a lot of places, but if you were to analyze the entire history of experimental science at Harvard, he'd be in the top handful. His experiments were very ingenious, the results were counter-intuitive, and they were important. It is not given to experimental science to do better. What gummed up Skinner's reputation is that he developed a case of what I always call man-with-a-hammer syndrome: to the man with a hammer, every problem tends to look pretty much like a nail. And Skinner had one of the more extreme cases in the history of Academia, and this syndrome doesn't exempt bright people. It's just a man with a hammer...and Skinner is an extreme example of that. And later, as I go down my list, let's go back and try and figure out why people, like Skinner, get man-with-a-hammer syndrome.
Incidentally, when I was at the Harvard Law School there was a professor, naturally at Yale, who was derisively discussed at Harvard, and they used to say, "Poor old Blanchard. He thinks declaratory judgments will cure cancer." And that's the way Skinner got. And not only that, he was literary, and he scorned opponents who had any different way of thinking or thought anything else was important. This is not a way to make a lasting reputation if the other people turn out to also be doing something important.
2. My second factor is simple psychological denial.
This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead. And, of course, if you turn on the television, you'll find the mothers of the most obvious criminals that man could ever diagnose, and they all think their sons are innocent. That's simple psychological denial. The reality is too painful to bear, so you just distort it until it's bearable. We all do that to some extent, and it's a common psychological misjudgment that causes terrible problems.
3. Third: incentive-cause bias, both in one's own mind and that of ones trusted advisor, where it creates what economists call 'agency costs.'
Here, my early experience was a doctor who sent bushel baskets full of normal gall bladders down to the pathology lab in the leading hospital in Lincoln, Nebraska. And with that quality control for which community hospitals are famous, about five years after he should've been removed from the staff, he was. And one of the old doctors who participated in the removal was also a family friend, and I asked him: I said, "Tell me, did he think, 'Here's a way for me to exercise my talents'" -- this guy was very skilled technically-- "'and make a high living by doing a few maimings and murders every year, along with some frauds?'" And he said, "Hell no, Charlie. He thought that the gall bladder was the source of all medical evil, and if you really love your patients, you couldn't get that organ out rapidly enough."
Now that's an extreme case, but in lesser strength, it's present in every profession and in every human being. And it causes perfectly terrible behavior. If you take sales presentations and brokers of commercial real estate and businesses... I'm 70 years old, I've never seen one I thought was even within hailing distance of objective truth. If you want to talk about the power of incentives and the power of rationalized, terrible behavior: after the Defense Department had had enough experience with cost-plus percentage of cost contracts, the reaction of our republic was to make it a crime for the federal government to write one, and not only a crime, but a felony.
And by the way, the government's right, but a lot of the way the world is run, including most law firms and a lot of other places, they've still got a cost-plus percentage of cost system. And human nature, with its version of what I call 'incentive-caused bias,' causes this terrible abuse. And many of the people who are doing it you would be glad to have married into your family compared to what you're otherwise going to get. [Laughter]
Now there are huge implications from the fact that the human mind is put together this way, and that is that people who create things like cash registers, which make most [dishonest] behavior hard, are some of the effective saints of our civilization. And the cash register was a great moral instrument when it was created. And Patterson knew that, by the way. He had a little store, and the people were stealing him blind and never made any money, and people sold him a couple of cash registers and it went to profit immediately. And, of course, he closed the store and went into the cash register business...
And so this is a huge, important thing. If you read the psychology texts, you will find that if they're 1,000 pages long, there's one sentence. Somehow incentive-caused bias has escaped the standard survey course in psychology.
4. Fourth, and this is a superpower in error-causing psychological tendency: bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won.
Well what I'm saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can't get in. The human mind has a big tendency of the same sort. And here again, it doesn't just catch ordinary mortals; it catches the deans of physics. According to Max Planck, the really innovative, important new physics was never really accepted by the old guard. Instead a new guard came along that was less brain-blocked by its previous conclusions. And if Max Planck's crowd had this consistency and commitment tendency that kept their old inclusions intact in spite of disconfirming evidence, you can imagine what the crowd that you and I are part of behaves like. And of course, if you make a public disclosure of your conclusion, you're pounding it into your own head. Many of these students that are screaming at us, you know, they aren't convincing us, but they're forming mental change for themselves, because what they're shouting out [is] what they're pounding in. And I think educational institutions that create a climate where too much of that goes on are...in a fundamental sense, they're irresponsible institutions. It's very important to not put your brain in chains too young by what you shout out.
And all these things like painful qualifying and initiation rituals pound in your commitments and your ideas. The Chinese brainwashing system, which was for war prisoners, was way better than anybody else's. They maneuvered people into making tiny little commitments and declarations, and then they'd slowly build. That worked way better than torture.
5. Fifth: bias from Pavlovian association, misconstruing past correlation as a reliable basis for decision-making.
I never took a course in psychology, or economics either for that matter, but I did learn about Pavlov in high school biology. And the way they taught it, you know, so the dog salivated when the bell rang. So what? Nobody made the least effort to tie that to the wide world. Well the truth of the matter is that Pavlovian association is an enormously powerful psychological force in the daily life of all of us. And, indeed, in economics we wouldn't have money without the role of so-called secondary reinforcement, which is a pure psychological phenomenon demonstrated in the laboratory. Practically...I'd say 3/4 of advertising works on pure Pavlov. Think how association, pure association, works. Take Coca-Cola company (we're the biggest share-holder). They want to be associated with every wonderful image: heroics in the Olympics, wonderful music, you name it. They don't want to be associated with presidents' funerals and so-forth. When have you seen a Coca-Cola ad...and the association really works.
And all these psychological tendencies work largely or entirely on a subconscious level, which makes them very insidious. Now you've got Persian messenger syndrome. The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should've seen Bill Paley in his last 20 years. [Paley was the former owner, chairman and CEO of CBS; click here to read his bio.] He didn't hear one damn thing he didn't want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn't want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.
And now the Persian messenger syndrome is alive and well. I saw, some years ago, Arco and Exxon arguing over a few hundred millions of ambiguity in their North Slope treaties before a superior court judge in Texas, with armies of lawyers and experts on each side. Now this is a Mad Hatter's tea party: two engineering-style companies can't resolve some ambiguity without spending tens of millions of dollars in some Texas superior court? In my opinion what happens is that nobody wants to bring the bad news to the executives up the line. But here's a few hundred million dollars you thought you had that you don't. And it's much safer to act like the Persian messenger who goes away to hide rather than bring home the news of the battle lost.
Talking about economics, you get a very interesting phenomenon that I've seen over and over again in a long life. You've got two products; suppose they're complex, technical products. Now you'd think, under the laws of economics, that if product A costs X, if product Y costs X minus something, it will sell better than if it sells at X plus something, but that's not so. In many cases when you raise the price of the alternative products, it'll get a larger market share than it would when you make it lower than your competitor's product. That's because the bell, a Pavlovian bell -- I mean ordinarily there's a correlation between price and value -- then you have an information inefficiency. And so when you raise the price, the sales go up relative to your competitor. That happens again and again and again. It's a pure Pavlovian phenomenon. You can say, "Well, the economists have figured this sort of thing out when they started talking about information inefficiencies," but that was fairly late in economics that they found such an obvious thing. And, of course, most of them don't ask what causes the information inefficiencies.
Well one of the things that causes it is pure old Pavlov and his dog. Now you've got bios from Skinnerian association: operant conditioning, you know, where you give the dog a reward and pound in the behavior that preceded the dog's getting the award. And, of course, Skinner was able to create superstitious pigeons by having the rewards come by accident with certain occurrences, and, of course, we all know people who are the human equivalents of superstitious pigeons. That's a very powerful phenomenon. And, of course, operant conditioning really works. I mean the people in the center who think that operant conditioning is important are very much right, it's just that Skinner overdid it a little.
Where you see in business just perfectly horrible results from psychologically-rooted tendencies is in accounting. If you take Westinghouse, which blew, what, two or three billion dollars pre-tax at least loaning developers to build hotels, and virtually 100% loans? Now you say any idiot knows that if there's one thing you don't like it's a developer, and another you don't like it's a hotel. And to make a 100% loan to a developer who's going to build a hotel... [Laughter] But this guy, he probably was an engineer or something, and he didn't take psychology any more than I did, and he got out there in the hands of these salesmen operating under their version of incentive-caused bias, where any damned way of getting Westinghouse to do it was considered normal business, and they just blew it.
That would never have been possible if the accounting system hadn't been such but for the initial phase of every transaction it showed wonderful financial results. So people who have loose accounting standards are just inviting perfectly horrible behavior in other people. And it's a sin, it's an absolute sin. If you carry bushel baskets full of money through the ghetto, and made it easy to steal, that would be a considerable human sin, because you'd be causing a lot of bad behavior, and the bad behavior would spread. Similarly an institution that gets sloppy accounting commits a real human sin, and it's also a dumb way to do business, as Westinghouse has so wonderfully proved.
Oddly enough nobody mentions, at least nobody I've seen, what happened with Joe Jett and Kidder Peabody. The truth of the matter is the accounting system was such that by punching a few buttons, the Joe Jetts of the world could show profits, and profits that showed up in things that resulted in rewards and esteem and every other thing... Well the Joe Jetts are always with us, and they're not really to blame, in my judgment at least. But that bastard who created that foolish accounting system who, so far as I know, has not been flayed alive, ought to be.
6. Sixth: bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.
Well here, again, Cialdini does a magnificent job at this, and you're all going to be given a copy of Cialdini's book. And if you have half as much sense as I think you do, you will immediately order copies for all of your children and several of your friends. You will never make a better investment.
It is so easy to be a patsy for what he calls the compliance practitioners of this life. At any rate, reciprocation tendency is a very, very powerful phenomenon, and Cialdini demonstrated this by running around a campus, and he asked people to take juvenile delinquents to the zoo. And it was a campus, and so one in six actually agreed to do it. And after he'd accumulated a statistical output he went around on the same campus and he asked other people, he said, "Gee, would you devote two afternoons a week to taking juvenile delinquents somewhere and suffering greatly yourself to help them," and there he got 100% of the people to say no. But after he'd made the first request, he backed up a little, and he said, "Would you at least take them to the zoo one afternoon?" He raised the compliance rate from a third to a half. He got three times the success by just going through the little ask-for-a-lot-and-back-off.
Now if the human mind, on a subconscious level, can be manipulated that way and you don't know it, I always use the phrase, "You're like a one-legged man in an ass-kicking contest." I mean you are really giving a lot of quarter to the external world that you can't afford to give. And on this so-called role theory, where you tend to act in the way that other people expect, and that's reciprocation if you think about the way society is organized.
A guy named Zimbardo had people at Stanford divide into two pieces: one were the guards and the other were the prisoners, and they started acting out roles as people expected. He had to stop the experiment after about five days. He was getting into human misery and breakdown and pathological behavior. I mean it was...it was awesome. However, Zimbardo is greatly misinterpreted. It's not just reciprocation tendency and role theory that caused that, it's consistency and commitment tendency. Each person, as he acted as a guard or a prisoner, the action itself was pounding in the idea. [For more on this famous experiment, click here.]
Wherever you turn, this consistency and commitment tendency is affecting you. In other words, what you think may change what you do, but perhaps even more important, what you do will change what you think. And you can say, "Everybody knows that." I want to tell you I didn't know it well enough early enough.
7. Seventh, now this is a lollapalooza, and Henry Kaufman wisely talked about this: bias from over-influence by social proof -- that is, the conclusions of others, particularly under conditions of natural uncertainty and stress.
And here, one of the cases the psychologists use is Kitty Genovese, where all these people -- I don't know, 50, 60, 70 of them -- just sort of sat and did nothing while she was slowly murdered. Now one of the explanations is that everybody looked at everybody else and nobody else was doing anything, and so there's automatic social proof that the right thing to do is nothing. That's not a good enough explanation for Kitty Genovese, in my judgment. That's only part of it. There are microeconomic ideas and gain/loss ratios and so forth that also come into play. I think time and time again, in reality, psychological notions and economic notions interplay, and the man who doesn't understand both is a damned fool.
Big-shot businessmen get into these waves of social proof. Do you remember some years ago when one oil company bought a fertilizer company, and every other major oil company practically ran out and bought a fertilizer company? And there was no more damned reason for all these oil companies to buy fertilizer companies, but they didn't know exactly what to do, and if Exxon was doing it, it was good enough for Mobil, and vice versa. I think they're all gone now, but it was a total disaster.
Now let's talk about efficient market theory, a wonderful economic doctrine that had a long vogue in spite of the experience of Berkshire Hathaway. In fact one of the economists who won -- he shared a Nobel Prize -- and as he looked at Berkshire Hathaway year after year, which people would throw in his face as saying maybe the market isn't quite as efficient as you think, he said, "Well, it's a two-sigma event." And then he said we were a three-sigma event. And then he said we were a four-sigma event. And he finally got up to six sigmas -- better to add a sigma than change a theory, just because the evidence comes in differently. [Laughter] And, of course, when this share of a Nobel Prize went into money management himself, he sank like a stone.
If you think about the doctrines I've talked about, namely, one, the power of reinforcement -- after all you do something and the market goes up and you get paid and rewarded and applauded and what have you, meaning a lot of reinforcement, if you make a bet on a market and the market goes with you. Also, there's social proof. I mean the prices on the market are the ultimate form of social proof, reflecting what other people think, and so the combination is very powerful. Why would you expect general market levels to always be totally efficient, say even in 1973-74 at the pit, or in 1972 or whatever it was when the Nifty 50 were in their heyday? If these psychological notions are correct, you would expect some waves of irrationality, which carry general levels, so they're inconsistent with reason.
8. Nine [he means eight]: what made these economists love the efficient market theory is the math was so elegant.
And after all, math was what they'd learned to do. To the man with a hammer, every problem tends to look pretty much like a nail. The alternative truth was a little messy, and they'd forgotten the great economists Keynes, whom I think said, "Better to be roughly right than precisely wrong."
9. Nine: bias from contrast-caused distortions of sensation, perception and cognition.
Here, the great experiment that Cialdini does in his class is he takes three buckets of water: one's hot, one's cold and one's room temperature, and he has the student stick his left hand in the hot water and his right hand in the cold water. Then he has them remove the hands and put them both in the room temperature bucket, and of course with both hands in the same bucket of water, one seems hot, the other seems cold because the sensation apparatus of man is over-influenced by contrast. It has no absolute scale; it's got a contrast scale in it. And it's a scale with quantum effects in it too. It takes a certain percentage change before it's noticed.
Maybe you've had a magician remove your watch -- I certainly have -- without your noticing it. It's the same thing. He's taking advantage of contrast-type troubles in your sensory apparatus. But here the great truth is that cognition mimics sensation, and the cognition manipulators mimic the watch-removing magician. In other words, people are manipulating you all day long on this contrast phenomenon.
Cialdini cites the case of the real estate broker. And you've got the rube that's been transferred into your town, and the first thing you do is you take the rube out to two of the most awful, overpriced houses you've ever seen, and then you take the rube to some moderately overpriced house, and then you stick him. And it works pretty well, which is why the real estate salesmen do it. And it's always going to work.
And the accidents of life can do this to you, and it can ruin your life. In my generation, when women lived at home until they got married, I saw some perfectly terrible marriages made by highly desirable women because they lived in terrible homes. And I've seen some terrible second marriages which were made because they were slight improvements over an even worse first marriage. You think you're immune from these things, and you laugh, and I want to tell you, you aren't.
My favorite analogy I can't vouch for the accuracy of. I have this worthless friend I like to play bridge with, and he's a total intellectual amateur that lives on inherited money, but he told me once something I really enjoyed hearing. He said, "Charlie," he say, "If you throw a frog into very hot water, the frog will jump out, but if you put the frog in room temperature water and just slowly heat the water up, the frog will die there." Now I don't know whether that's true about a frog, but it's sure as hell true about many of the businessmen I know [laughter], and there, again, it is the contrast phenomenon. But these are hot-shot, high-powered people. I mean these are not fools. If it comes to you in small pieces, you're likely to miss, so if you're going to be a person of good judgment, you have to do something about this warp in your head where it's so misled by mere contrast.
10. Bias from over-influence by authority.
Well here, the Milgrim experiment, as it's called -- I think there have been 1,600 psychological papers written about Milgrim. And he had a person posing as an authority figure trick ordinary people into giving what they had every reason to expect was heavy torture by electric shock to perfectly innocent fellow citizens. And he was trying to show why Hitler succeeded and a few other things, and so this really caught the fancy of the world. Partly it's so politically correct, and over-influence by authority...
You'll like this one: You get a pilot and a co-pilot. The pilot is the authority figure. They don't do this in airplanes, but they've done it in simulators. They have the pilot do something where the co-pilot, who's been trained in simulators a long time -- he knows he's not to allow the plane to crash -- they have the pilot to do something where an idiot co-pilot would know the plane was going to crash, but the pilot's doing it, and the co-pilot is sitting there, and the pilot is the authority figure. 25% of the time the plane crashes. I mean this is a very powerful psychological tendency. It's not quite as powerful as some people think, and I'll get to that later.
11. Eleven: bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed.
Here I took the Munger dog, a lovely, harmless dog. The only way to get that dog to bite you is to try and take something out of its mouth after it was already there. And you know, if you've tried to do takeaways in labor negotiations, you'll know that the human version of that dog is there in all of us. And I have a neighbor, a predecessor who had a little island around the house, and his next door neighbor put a little pine tree on it that was about three feet high, and it turned his 180 degree view of the harbor into 179 3/4. Well they had a blood feud like the Hatfields and McCoys, and it went on and on and on...
I mean people are really crazy about minor decrements down. And then, if you act on them, then you get into reciprocation tendency, because you don't just reciprocate affection, you reciprocate animosity, and the whole thing can escalate. And so huge insanities can come from just subconsciously over-weighing the importance of what you're losing or almost getting and not getting.
And the extreme business case here was New Coke. Coca-Cola has the most valuable trademark in the world. We're the major shareholder -- I think we understand that trademark. Coke has armies of brilliant engineers, lawyers, psychologists, advertising executives and so forth, and they had a trademark on a flavor, and they'd spent the better part of 100 years getting people to believe that trademark had all these intangible values too. And people associate it with a flavor. And so they were going to tell people not that it was improved, because you can't improve a flavor. A flavor is a matter of taste. I mean you may improve a detergent or something, but don't think you're going to make a major change in a flavor. So they got this huge deprival super-reaction syndrome.
Pepsi was within weeks of coming out with old Coke in a Pepsi bottle, which would've been the biggest fiasco in modern times. Perfect insanity. And by the way, both Goizuetta [Coke's CEO at the time] and Keough [an influential former president and director of the company] are just wonderful about it. I mean they just joke. Keough always says, "I must've been away on vacation." He participated in every single decision -- he's a wonderful guy. And by the way, Goizuetta is a wonderful, smart guy -- an engineer. Smart people make these terrible boners. How can you not understand deprival super-reaction syndrome? But people do not react symmetrically to loss and gain. Well maybe a great bridge player like Zeckhauser does, but that's a trained response. Ordinary people, subconsciously affected by their inborn tendencies...
12. Bias from envy/jealousy.
Well envy/jealousy made, what, two out of the ten commandments? Those of you who have raised siblings you know about envy, or tried to run a law firm or investment bank or even a faculty? I've heard Warren say a half a dozen times, "It's not greed that drives the world, but envy."
Here again, you go through the psychology survey courses, and you go to the index: envy/jealousy, 1,000-page book, it's blank. There's some blind spots in academia, but it's an enormously powerful thing, and it operates, to a considerable extent, on the subconscious level. Anybody who doesn't understand it is taking on defects he shouldn't have.
13. Bias from chemical dependency.
Well, we don't have to talk about that. We've all seen so much of it, but it's interesting how it'll always cause this moral breakdown if there's any need, and it always involves massive denial. See it just aggravates what we talked about earlier in the aviator case, the tendency to distort reality so that it's endurable.
14. Bias from mis-gambling compulsion.
Well here, Skinner made the only explanation you'll find in the standard psychology survey course. He, of course, created a variable reinforcement rate for his pigeons and his mice, and he found that that would pound in the behavior better than any other enforcement pattern. And he says, "Ah ha! I've explained why gambling is such a powerful, addictive force in this civilization." I think that is, to a very considerable extent, true, but being Skinner, he seemed to think that was the only explanation, but the truth of the matter is that the devisors of these modern machines and techniques know a lot of things that Skinner didn't know.
For instance, a lottery. You have a lottery where you get your number by lot, and then somebody draws a number by lot, it gets lousy play. You have a lottery where people get to pick their number, you get big play. Again, it's this consistency and commitment thing. People think if they have committed to it, it has to be good. The minute they've picked it themselves it gets an extra validity. After all, they thought it and they acted on it.
Then if you take the slot machines, you get bar, bar, walnut. And it happens again and again and again. You get all these near misses. Well that's deprival super-reaction syndrome, and boy do the people who create the machines understand human psychology. And for the high-IQ crowd they've got poker machines where you make choices. So you can play blackjack, so to speak, with the machine. It's wonderful what we've done with our computers to ruin the civilization.
But at any rate, mis-gambling compulsion is a very, very powerful and important thing. Look at what's happening to our country: every Indian has a reservation, every river town, and look at the people who are ruined by it with the aid of their stock brokers and others. And again, if you look in the standard textbook of psychology you'll find practically nothing on it except maybe one sentence talking about Skinner's rats. That is not an adequate coverage of the subject.
15. Bias from liking distortion, including the tendency to especially like oneself, one's own kind and one's own idea structures, and the tendency to be especially susceptible to being misled by someone liked. Disliking distortion, bias from that, the reciprocal of liking distortion and the tendency not to learn appropriately from someone disliked.
Well here, again, we've got hugely powerful tendencies, and if you look at the wars in part of the Harvard Law School, as we sit here, you can see that very brilliant people get into this almost pathological behavior. And these are very, very powerful, basic, subconscious psychological tendencies, or at least party subconscious.
Now let's get back to B.F. Skinner, man-with-a-hammer syndrome revisited. Why is man-with-a-hammer syndrome always present? Well if you stop to think about it, it's incentive-caused bias. His professional reputation is all tied up with what he knows. He likes himself and he likes his own ideas, and he's expressed them to other people -- consistency and commitment tendency. I mean you've got four or five of these elementary psychological tendencies combining to create this man-with-a-hammer syndrome. Once you realize that you can't really buy your thinking -- partly you can, but largely you can't in this world -- you have learned a lesson that's very useful in life. George Bernard Shaw had a character say in The Doctor's Dilemma, "In the last analysis, every profession is a conspiracy against the laity." But he didn't have it quite right, because it isn't so much a conspiracy as it is a subconscious, psychological tendency.
The guy tells you what is good for him. He doesn't recognize that he's doing anything wrong any more than that doctor did when he was pulling out all those normal gall bladders. And he believes his own idea structures will cure cancer, and he believes that the demons that he's the guardian against are the biggest demons and the most important ones, and in fact they may be very small demons compared to the demons that you face. So you're getting your advice in this world from your paid advisor with this huge load of ghastly bias. And woe to you.
There are only two ways to handle it: you can hire your advisor and then just apply a windage factor, like I used to do when I was a rifle shooter. I'd just adjust for so many miles an hour wind. Or you can learn the basic elements of your advisor's trade. You don't have to learn very much, by the way, because if you learn just a little then you can make him explain why he's right. And those two tendencies will take part of the warp out of the thinking you've tried to hire done. By and large it works terribly. I have never seen a management consultant's report in my long life that didn't end with the following paragraph: "What this situation really needs is more management consulting." Never once. I always turn to the last page. Of course Berkshire doesn't hire them, so I only do this on sort of a voyeuristic basis. Sometimes I'm at a non-profit where some idiot hires one. [Laughter]
16. Seventeen [he means 16]: bias from the non-mathematical nature of the human brain in its natural state as it deal with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to overweigh conveniently available information and other psychologically misrouted thinking tendencies on this list.
When the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes, the right way to think is the way Zeckhauser plays bridge. It's just that simple. And your brain doesn't naturally know how to think the way Zeckhauser knows how to play bridge. Now, you notice I put in that availability thing, and there I'm mimicking some very eminent psychologists [Daniel] Kahneman, Eikhout[?] (I hope I pronounced that right) and [Amos] Tversky, who raised the idea of availability to a whole heuristic of misjudgment. And they are very substantially right.
I mean ask the Coca-Cola Company, which has raised availability to a secular religion. If availability changes behavior, you will drink a helluva lot more Coke if it's always available. I mean availability does change behavior and cognition. Nonetheless, even though I recognize that and applaud Tversky and Kahneman, I don't like it for my personal system except as part of a greater sub-system, which is you've got to think the way Zeckhauser plays bridge. And it isn't just the lack of availability that distorts your judgment. All the things on this list distort judgment. And I want to train myself to kind of mentally run down the list instead of just jumping on availability. So that's why I state it the way I do.
In a sense these psychological tendencies make things unavailable, because if you quickly jump to one thing, and then because you jumped to it the consistency and commitment tendency makes you lock in, boom, that's error number one. Or if something is very vivid, which I'm going to come to next, that will really pound in. And the reason that the thing that really matters is now unavailable and what's extra-vivid wins is, I mean, the extra-vividness creates the unavailability. So I think it's much better to have a whole list of things that would cause you to be less like Zeckhauser than it is just to jump on one factor.
Here I think we should discuss John Gutfreund. This is a very interesting human example, which will be taught in every decent professional school for at least a full generation. Gutfreund has a trusted employee and it comes to light not through confession but by accident that the trusted employee has lied like hell to the government and manipulated the accounting system, and it was really equivalent to forgery. And the man immediately says, "I've never done it before, I'll never do it again. It was an isolated example." And of course it was obvious that he was trying to help the government as well as himself, because he thought the government had been dumb enough to pass a rule that he'd spoken against, and after all if the government's not going to pay attention to a bond trader at Salomon, what kind of a government can it be?
At any rate, this guy has been part of a little clique that has made, well, way over a billion dollars for Salomon in the very recent past, and it's a little handful of people. And so there are a lot of psychological forces at work, and then you know the guy's wife, and he's right in front of you, and there's human sympathy, and he's sort of asking for your help, which encourages reciprocation, and there's all these psychological tendencies are working, plus the fact he's part of a group that had made a lot of money for you. At any rate, Gutfreund does not cashier the man, and of course he had done it before and he did do it again. Well now you look as though you almost wanted him to do it again. Or God knows what you look like, but it isn't good. And that simple decision destroyed Jim Gutfreund, and it's so easy to do.
Now let's think it through like the bridge player, like Zeckhauser. You find an isolated example of a little old lady in the See's Candy Company, one of our subsidiaries, getting into the till. And what does she say? "I never did it before, I'll never do it again. This is going to ruin my life. Please help me." And you know her children and her friends, and she'd been around 30 years and standing behind the candy counter with swollen ankles. When you're an old lady it isn't that glorious a life. And you're rich and powerful and there she is: "I never did it before, I'll never do it again." Well how likely is it that she never did it before? If you're going to catch 10 embezzlements a year, what are the chances that any one of them -- applying what Tversky and Kahneman called baseline information -- will be somebody who only did it this once? And the people who have done it before and are going to do it again, what are they all going to say? Well in the history of the See's Candy Company they always say, "I never did it before, and I'm never going to do it again." And we cashier them. It would be evil not to, because terrible behavior spreads.
Remember...what was it? Serpico? I mean you let that stuff...you've got social proof, you've got incentive-caused bias, you've got a whole lot of psychological factors that will cause the evil behavior to spread, and pretty soon the whole damn...your place is rotten, the civilization is rotten. It's not the right way to behave. And I will admit that I have...when I knew the wife and children, I have paid severance pay when I fire somebody for taking a mistress on an extended foreign trip. It's not the adultery I mind, it's the embezzlement. But there, I wouldn't do it like Gutfreund did it, where they'd been cheating somebody else on my behalf. There I think you have to cashier. But if they're just stealing from you and you get rid of them, I don't think you need the last ounce of vengeance. In fact I don't think you need any vengeance. I don't think vengeance is much good.
17. Now we come to bias from over-influence by extra-vivid evidence.
Here's one that...I'm at least $30 million poorer as I sit here giving this little talk because I once bought 300 shares of a stock and the guy called me back and said, "I've got 1,500 more," and I said, "Will you hold it for 15 minutes while I think about it?" And the CEO of this company -- I have seen a lot of vivid peculiarities in a long life, but this guy set a world record; I'm talking about the CEO -- and I just mis-weighed it. The truth of the matter was the situation was foolproof. He was soon going to be dead, and I turned down the extra 1,500 shares, and it's now cost me $30 million. And that's life in the big city. And it wasn't something where stock was generally available. So it's very easy to mis-weigh the vivid evidence, and Gutfreund did that when he looked into the man's eyes and forgave a colleague.
18. Twenty-two [he means 18]: Mental confusion caused by information not arrayed in the mind and theory structures, creating sound generalizations developed in response to the question "Why?" Also, mis-influence from information that apparently but not really answers the question "Why?" Also, failure to obtain deserved influence caused by not properly explaining why.
Well we all know people who've flunked, and they try and memorize and they try and spout back and they just...it doesn't work. The brain doesn't work that way. You've got to array facts on the theory structures answering the question "Why?" If you don't do that, you just cannot handle the world.
And now we get to Feuerstein, who was the general counsel with Salomon when Gutfreund made his big error, and Feuerstein knew better. He told Gutfreund, "You have to report this as a matter of morality and prudent business judgment." He said, "It's probably not illegal, there's probably no legal duty to do it, but you have to do it as a matter of prudent conduct and proper dealing with your main customer." He said that to Gutfreund on at least two or three occasions. And he stopped. And, of course, the persuasion failed, and when Gutfreund went down, Feuerstein went with him. It ruined a considerable part of Feuerstein's life.
Well Feuerstein, [who] was a member of the Harvard Law Review, made an elementary psychological mistake. You want to persuade somebody, you really tell them why. And what did we learn in lesson one? Incentives really matter? Vivid evidence really works? He should've told Gutfreund, "You're likely to ruin your life and disgrace your family and lose your money." And is Mozer worth this? I know both men. That would've worked. So Feuerstein flunked elementary psychology, this very sophisticated, brilliant lawyer. But don't you do that. It's not very hard to do, you know, just to remember that "Why?" is very important.
19. Other normal limitations of sensation, memory, cognition and knowledge.
Well, I don't have time for that.
20. Stress-induced mental changes, small and large, temporary and permanent.
Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came and it just went right up and the dog's in a cage. And the dog had as much stress as you can imagine a dog ever having. And the water receded in time to save some of the dogs, and Pavlov noted that they'd had a total reversal of their conditioned personality. And being the great scientist he was, he spent the rest of his life giving nervous breakdowns to dogs, and he learned a helluva lot that I regard as very interesting.
I have never known any Freudian analyst who knew anything about the last work of Pavlov, and I've never met a lawyer who understood that what Pavlov found out with those dogs had anything to do with programming and de-programming and cults and so forth. I mean the amount of elementary psychological ignorance that is out there in high levels is very significant[?].
21. Then we've got other common mental illnesses and declines, temporary and permanent, including the tendency to lose ability through disuse.
22. And then I've got development and organizational confusion from say-something syndrome.
And here my favorite thing is the bee, a honeybee. And a honeybee goes out and finds the nectar and he comes back, he does a dance that communicates to the other bees where the nectar is, and they go out and get it. Well some scientist who is clever, like B.F. Skinner, decided to do an experiment. He put the nectar straight up. Way up. Well, in a natural setting, there is no nectar where they're all straight up, and the poor honeybee doesn't have a genetic program that is adequate to handle what he now has to communicate. And you'd think the honeybee would come back to the hive and slink into a corner, but he doesn't. He comes into the hive and does this incoherent dance, and all my life I've been dealing with the human equivalent of that honeybee. [Laughter] And it's a very important part of human organization so the noise and the reciprocation and so forth of all these people who have what I call say-something syndrome don't really affect the decisions.
Now the time has come to ask two or three questions. This is the most important question in this whole talk:
1. What happens when these standard psychological tendencies combine? What happens when the situation, or the artful manipulation of man, causes several of these tendencies to operate on a person toward the same end at the same time?
The clear answer is the combination greatly increases power to change behavior, compared to the power of merely one tendency acting alone. Examples are:
Tupperware parties. Tupperware's now made billions of dollars out of a few manipulative psychological tricks. It was so schlocky that directors of Justin Dart's company resigned when he crammed it down his board's throat. And he was totally right, by the way, judged by economic outcomes.
Mony[?] conversion methods: boy do they work. He just combines four or five of these things together.
The system of Alcoholics Anonymous: a 50% no-drinking rate outcome when everything else fails? It's a very clever system that uses four or five psychological systems at once toward, I might say, a very good end.
The Milgrim experiment. It's been widely interpreted as mere obedience, but the truth of the matter is that the experimenter who got the students to give the heavy shocks in Milgrim, he explained why. It was a false explanation. "We need this to look for scientific truth," and so on. That greatly changed the behavior of the people. And number two, he worked them up: tiny shock, a little larger, a little larger. So commitment and consistency tendency and the contrast principle were both working in favor of this behavior. So again, it's four different psychological tendencies. When you get these lollapalooza effects you will almost always find four or five of these things working together.
When I was young there was a whodunit hero who always said, "Cherche la femme." [In French, "Look for the woman."] What you should search for in life is the combination, because the combination is likely to do you in. Or, if you're the inventor of Tupperware parties, it's likely to make you enormously rich if you can stand shaving when you do it.
One of my favorite cases is the McDonald-Douglas airliner evacuation disaster. The government requires that airliners pass a bunch of tests, one of them is evacuation: get everybody out, I think it's 90 seconds or something like that. It's some short period of time. The government has rules, make it very realistic, so on and so on. You can't select nothing but 20-year-old athletes to evacuate your airline. So McDonald-Douglas schedules one of these things in a hangar, and they make the hangar dark and the concrete floor is 25 feet down, and they've got these little rubber chutes, and they've got all these old people, and they ring the bell and they all rush out, and in the morning, when the first test is done, they create, I don't know, 20 terrible injuries when people go off to hospitals, and of course they scheduled another one for the afternoon.
By the way they didn't read[?] the time schedule either, in addition to causing all the injuries. Well...so what do they do? They do it again in the afternoon. Now they create 20 more injuries and one case of a severed spinal column with permanent, unfixable paralysis. These are engineers, these are brilliant people, this is thought over through in a big bureaucracy. Again, it's a combination of [psychological tendencies]: authorities told you to do it. He told you to make it realistic. You've decided to do it. You'd decided to do it twice. Incentive-caused bias. If you pass you save a lot of money. You've got to jump this hurdle before you can sell your new airliner. Again, three, four, five of these things work together and it turns human brains into mush. And maybe you think this doesn't happen in picking investments? If so, you're living in a different world than I am.
Finally, the open-outcry auction. Well the open-outcry auction is just made to turn the brain into mush: you've got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away... I mean it just absolutely is designed to manipulate people into idiotic behavior.
Finally the institution of the board of directors of the major American company. Well, the top guy is sitting there, he's an authority figure. He's doing asinine things, you look around the board, nobody else is objecting, social proof, it's okay? Reciprocation tendency, he's raising the directors fees every year, he's flying you around in the corporate airplane to look at interesting plants, or whatever in hell they do, and you go and you really get extreme dysfunction as a corrective decision-making body in the typical American board of directors. They only act, again the power of incentives, they only act when it gets so bad it starts making them look foolish, or threatening legal liability to them. That's Munger's rule. I mean there are occasional things that don't follow Munger's rule, but by and large the board of directors is a very ineffective corrector if the top guy is a little nuts, which, of course, frequently happens.
2. The second question: Isn't this list of standard psychological tendencies improperly tautological compared with the system of Euclid? That is, aren't there overlaps? And can't some items on the list be derived from combinations of other items? The answer to that is, plainly, yes.
3. Three: What good, in the practical world, is the thought system indicated by the list? Isn't practical benefit prevented because these psychological tendencies are programmed into the human mind by broad evolution so we can't get rid of them? [By] broad evolution, I mean the combination of genetic and cultural evolution, but mostly genetic.
Well the answer is the tendencies are partly good and, indeed, probably much more good than bad, otherwise they wouldn't be there. By and large these rules of thumb, they work pretty well for man given his limited mental capacity. And that's why they were programmed in by broad evolution. At any rate, they can't be simply washed out automatically and they shouldn't be. Nonetheless, the psychological thought system described is very useful in spreading wisdom and good conduct when one understands it and uses it constructively.
Here are some examples:
One: Karl Braun's communication practices. He designed oil refineries with spectacular skill and integrity. He had a very simple rule. Remember I said, "Why is it important?" You got fired in the Braun company. You had to have five Ws. You had to tell Who, What you wanted to do, Where and When, and you had to tell him Why. And if you wrote a communication and left out the Why you got fired, because Braun knew it's complicated building an oil refinery. It can blow up...all kinds of things happen. And he knew that his communication system worked better if you always told him why. That's a simple discipline, and boy does it work.
Two: the use of simulators in pilot training. Here, again, abilities attenuate with disuse. Well the simulator is God's gift because you can keep them fresh.
Three: The system of Alcoholics Anonymous, that's certainly a constructive use of somebody understanding psychological tendencies. I think they just wandered into it, as a matter of fact, so you can regard it as kind of an evolutionary outcome. But just because they've wandered into it doesn't mean you can't invent its equivalent when you need it for a good purpose.
Four: Clinical training in medical schools: here's a profoundly correct way of understanding psychology. The standard practice is watch one, do one, teach one. Boy does that pound in what you want pounded in. Again, the consistency and commitment tendency. And that is a profoundly correct way to teach clinical medicine.
Five: The rules of the U.S. Constitutional Convention: totally secret, no vote until the whole vote, then just one vote on the whole Constitution. Very clever psychological rules, and if they had a different procedure, everybody would've been pushed into a corner by his own pronouncements and his own oratory and his own... And no recorded votes until the last one. And they got it through by a whisker with those wise rules. We wouldn't have had the Constitution if our forefathers hadn't been so psychologically acute. And look at the crowd we got now.
Six: the use of granny's rule. I love this. One of the psychologists who works for the Center gets paid a fortune running around America, and he teaches executives to manipulate themselves. Now granny's rule is you don't get the ice cream unless you eat your carrots. Well granny was a very wise woman. That is a very good system. And so this guy, a very eminent psychologist, he runs around the country telling executives to organize their day so they force themselves to do what's unpleasant and important by doing that first, and then rewarding themselves with something they really like doing. He is profoundly correct.
Seven: the Harvard Business School's emphasis on decision trees. When I was young and foolish I used to laugh at the Harvard Business School. I said, "They're teaching 28-year-old people that high school algebra works in real life?" We're talking about elementary probability. But later I wised up and I realized that it was very important that they do that, and better late than never.
Eight: the use of post-mortems at Johnson & Johnson. At most corporations if you make an acquisition and it turns out to be a disaster, all the paperwork and presentations that caused the dumb acquisition to be made are quickly forgotten. You've got denial, you've got everything in the world. You've got Pavlovian association tendency. Nobody even wants to even be associated with the damned thing or even mention it. At Johnson & Johnson, they make everybody revisit their old acquisitions and wade through the presentations. That is a very smart thing to do. And by the way, I do the same thing routinely.
Nine: the great example of Charles Darwin is he avoided confirmation bias. Darwin probably changed my life because I'm a biography nut, and when I found out the way he always paid extra attention to the disconfirming evidence and all these little psychological tricks. I also found out that he wasn't very smart by the ordinary standards of human acuity, yet there he is buried in Westminster Abbey. That's not where I'm going, I'll tell you. And I said, "My God, here's a guy that, by all objective evidence, is not nearly as smart as I am and he's in Westminster Abbey? He must have tricks I should learn." And I started wearing little hair shirts like Darwin to try and train myself out of these subconscious psychological tendencies that cause so many errors. It didn't work perfectly, as you can tell from listening to this talk, but it would've been even worse if I hadn't done what I did. And you can know these psychological tendencies and avoid being the patsy of all the people that are trying to manipulate you to your disadvantage, like Sam Walton. Sam Walton won't let a purchasing agent take a handkerchief from a salesman. He knows how powerful the subconscious reciprocation tendency is. That is a profoundly correct way for Sam Walton to behave.
Ten: Then there is the Warren Buffett rule for open-outcry auctions: don't go. We don't go to the closed-bid auctions too because they...that's a counter-productive way to do things ordinarily for a different reason, which Zeckhauser would understand.
4. Four: What special knowledge problems lie buried in the thought system indicated by the list?
Well one is paradox. Now we're talking about a type of human wisdom that the more people learn about it, the more attenuated the wisdom gets. That's an intrinsically paradoxical kind of wisdom. But we have paradox in mathematics and we don't give up mathematics. I say damn the paradox. This stuff is wonderfully useful. And by the way, the granny's rule, when you apply it to yourself, is sort of a paradox in a paradox. The manipulation still works even though you know you're doing it. And I've seen that done by one person to another. I drew this beautiful woman as my dinner partner a few years ago, and I'd never seen her before. Well, she's married to prominent Angelino, and she sat down next to me and she turned her beautiful face up and she said, "Charlie," she said, "What one word accounts for your remarkable success in life?" And I knew I was being manipulated and that she'd done this before, and I just loved it. I mean I never see this woman without a little lift in my spirits. And by the way I told her I was rational. You'll have to judge yourself whether that's true. I may be demonstrating some psychological tendency I hadn't planned on demonstrating.
How should the best parts of psychology and economics interrelate in an enlightened economist's mind? Two views: that's the thermodynamics model. You know, you can't derive thermodynamics from plutonium, gravity and laws of mechanics, even though it's a lot of little particles interacting. And here is this wonderful truth that you can sort of develop on your own, which is thermodynamics. And some economists -- and I think Milton Friedman is in this group, but I may be wrong on that -- sort of like the thermodynamics model. I think Milton Friedman, who has a Nobel prize, is probably a little wrong on that. I think the thermodynamics analogy is over-strained. I think knowledge from these different soft sciences have to be reconciled to eliminate conflict. After all, there's nothing in thermodynamics that's inconsistent with Newtonian mechanics and gravity, and I think that some of these economic theories are not totally consistent with other knowledge, and they have to be bent. And I think that these behavioral economics...or economists are probably the ones that are bending them in the correct direction.
Now my prediction is when the economists take a little psychology into account that the reconciliation will be quite endurable. And here my model is the procession of the equinoxes. The world would be simpler for a long-term climatologist if the angle of the axis of the Earth's rotation, compared to the plane of the Euclyptic, were absolutely fixed. But it isn't fixed. Over every 40,000 years or so there's this little wobble, and that has pronounced long-term effects. Well in many cases what psychology is going to add is just a little wobble, and it will be endurable. Here I quote another hero of mine, which of course is Einstein, where he said, "The Lord is subtle, but not malicious." And I don't think it's going to be that hard to bend economics a little to accommodate what's right in psychology.
5. Fifth: The final question is: If the thought system indicated by this list of psychological tendencies has great value not recognized and employed, what should the educational system do about it?
I am not going to answer that one now. I like leaving a little mystery. Have I used up all the time so there's no time for questions?
Moderator: I think that what we're going to do is we're going to borrow a little bit of time from the end of the day questions, and we're going to move it and allocate it to Charles Munger, if that's acceptable to everybody.
Munger: By the way, the dean of the Stanford Law School is here today, Paul Breast, and he is trying to create a course at the Stanford Law School that tries to work stuff similar to this into worldly wisdom for lawyers, which I regard as a profoundly good idea, and he wrote an article about it, and you'll be given a copy along with Cialdini's book. Questions?
Audience Member #1: Will we be able to get a copy of that list of 24 [standard causes of human misjudgment]?
Munger: Yes. I presumed there would be one curious man [laughter], and I have it and I'll put it over there on the table, but don't take more than one, because I didn't anticipate such a big crowd. And if we run short, I'm sure the Center is up to making other copies.
Audience Member #2: If I had listened to this talk I might have thought that Charles Munger was a psychology professor operating in a business school. Every once in a while a micro-issue -- you told us how you would've deal with one of these issues, for example with the unfortunate lady See's -- but you didn't tell us how these tendencies affected you and what's probably the most important, or one of the most important elements of your success, which was deciding where to invest your money. And I'm wondering if you might relate some of these principles to some of your past decisions that way.
Munger: Well of course an investment decision in the common stock of a company frequently involves a whole lot of factors interacting. Usually, of course, there's one big, simple model, and a lot of those models are microeconomic. And I have a little list of -- it wouldn't be nearly 24, of those -- but I don't have time for that one. And I don't have too much interest in teaching other people how to get rich. And that isn't because I fear the competition or anything like that -- Warren has always been very open about what he's learned, and I share that ethos. My personal behavior model is Lord Keynes: I wanted to get rich so I could be independent, and so I could do other things like give talks on the intersection of psychology and economics. I didn't want to turn it into a total obsession.
Audience Member #3: Out of those 24, could you tell us the one rule that's most important?
Munger: I would say the one thing that causes the most trouble is when you combine a bunch of these together, you get this lollapalooza effect. And again, if you read the psychology textbooks, they don't discuss how these things combine, at least not very much. Do they multiply? Do they add? How does it work? You'd think it'd be just an automatic subject for research, but it doesn't seem to turn the psychology establishment on. I think this is a man from Mars approach to psychology. I just reached in and took what I thought I had to have. That is a different set of incentives from rising in an economic establishment where the rewards system, again, the reinforcement, comes from being a truffle hound. That's what Jacob Viner, the great economist called it: the truffle hound -- an animal so bred and trained for one narrow purpose that he wasn't much good at anything else, and that is the reward system in a lot of academic departments. It is not necessarily for the good. It may be fine if you want new drugs or something. You want people stunted in a lot of different directions so they can grow in one narrow direction, but I don't think it's good teaching psychology to the masses. In fact, I think it's terrible.
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WEBINAR FOR CLASS ON COLUMBIA

2007-10-31T13:43:00.001-07:00

http://www1.gsb.columbia.edu/valueinvesting/research/class_recordings.html

good web cast for value investing

2007-10-16T05:51:00.000-07:00

http://gabelli.savvislive.com/ValueInvestingSeminar/index_player.html

How to Calculate Intrinsic Valuefor Stock Investing

2007-10-11T06:28:00.000-07:00

http://www.stock-investment-made-easy.com/calculate-intrinsic-value.html

How to Calculate Intrinsic Valuefor Stock Investing
Summarized Overview
You will find information about,
why you should calculate intrinsic value in stock investing, and
step by step how to do it.
You will also find information about,
which key financial ratios to use, and
what you have to do after calculating intrinsic value.
Why You should Calculate Intrinsic Value
Simply because, you don't buy any stock at any price, do you? Do you know why? Because you want as much return as possible!
The price you are paying is the ultimate determinant for the rate of return that you'll be earning. The higher the price you pay for it, you'll be getting lower rate of return. This is why, you need to know how much a stock worth. Once you know its value, you can identify which stocks are traded at discounted price.
However, buying a stock simply because it is cheap is not the right approach either. This is another reason to calculate intrinsic value. To buy quality stocks at discounted price, value for money right?
How to Calculate Intrinsic Value
The way to go is, search for stocks whose prospects you believe in ( with good stock pick method ) and then use a valuation technique to ensure the purchase price is acceptable. Here, I use net present value (NPV) formula.
How to do it? Let say you are valuing stock ABC,
From 13 years historical data, you get the information as above. To proceed, you also need to firm up your expectation based on your risk profile. In this example:
I set my investment horizon as long as ten years from 2007. So that in 2018 I can use the fund to finance my children's study
I am confident stock ABC will continue growing 13 per cent per year for the next ten years (13 years records prove this stock able to grow 13 per cent EPS per year)
I assume stock ABC will be having the same PER and dividend payout by end of 2017 (or early in 2018)
I am expecting 12 per cent return on investment (ROI) so that my initial investment able to cover my children's tuition costs in ten years time.
Let's start calculating intrinsic value of stock ABC.
Step One: Forecast Share PriceFirst of all, you need to forecast its share price ten years down the road. In this case, I project the price for the next ten years using 13 per cent per year growth.
Step Two: Forecast Total Future ValueSecondly, you need to calculate the total future value. This must include the potential dividend as well.
Look, some investors doesn't care much about dividend. To them, dividend is just too small to be considered. But as it has effect to the total future value, it should be taken into consideration.
By the end of the day, you can compare the stock's profitability to others; which may not pay any dividend at all.
Step Three: Calculate Intrinsic ValueAfter having all these data, then only you can calculate the intrinsic value for stock ABC.
Step Four: Compare with Current Stock PriceThe intrinsic value above is because my goal is to get 12 per cent per annum from this stock. If so, current stock's price, which is $33.50, is acceptable indeed (stock price is below the intrinsic value).

How Do YouCalculateIntrinsic Value?
Discounted Cashflow
Discounted Dividend
Discounted Earnings
Never Calculate
What For?
But if your goal is about getting 25 per cent per annum return on investment, the intrinsic value will be $22. In this case, the current stock price will no longer acceptable for you.
For this same reason, you can say that current stock price is suit to those who are aiming for 15 per cent return per annum (in economics, this called as Internal Rate of Return or IRR)
What's Next?
As you can see, intrinsic value can be relatively different from one investor to another depending on the expected return. Expecting very high return will limit your investment options. On the other hand, having very low expected return may as well better keep the cash in fixed deposit.
As an investor, it is crucial to set a realistic target on the expected profits. It is better if before you calculate intrinsic value of your selected stock, assess your own risk profile first. This will help you to determine your realistic preferred return based on your need, ability and investing habitshttp://www.stock-investment-made-easy.com/calculate-intrinsic-value.html

The Kelly Formula

2007-10-09T05:29:00.000-07:00

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Pabrai Week: The Kelly Formula
Oct4
Pabrai Week: The Kelly Formula
Oct
4Some 50 years ago, John Larry Kelly came up with a formula to determine how much you should bet on a gamble or investment to optimize your bankroll. Now known as the Kelly Formula, the equation determines the optimal percentage of your cash to bet on a favorable bet.

Mohnish Pabrai talks about it. Pabrai applies it to some of Buffett's past purchases. I guess we should take a look at it too. Heck, in this game, it pays to be a copycat.

What Is The Kelly Formula?
If you haven't picked up a copy of Pabrai's The Dhandho Investor, do it now. Pabrai explains it well. In essence, the Kelly Formula is a mathematical formula that is used to maximize the long-term growth rate of a series of repeated bets that have a positive expected value.

Huh?

The Kelly Formula basically figures out how much to bet if the odds are in your favor—in Vegas, in the stock market, in a coin flip...whatever. Pabrai simplifies the equation to:

The actual formula (for purists) is:

A Kelly Example
Let's say you have $1,000 in cash and someone offers you 2-1 on a coin flip. That is, they'll pay you $2 if it comes up heads; you'll lose $1 if it comes up tails. The Kelly Formula will tell you how much you should bet on the coin flip to earn the maximum amount of money.

In this above coin flip, the Kelly Formula tells you that the maximum you should bet on any flip is 25% of your bankroll. Doing so will give you the maximum long-term growth with minimum downside.

The Kelly Guarantees (and Weaknesses)
Don't fool yourself. There is no "perfect" system to avoid all loses. All we can do is minimize losses, maximize gains, and optimize bankrolls. The Kelly Formula insures that you'll never lose everything; still, it doesn't guarantee that you won't lose sometimes.

You never want to overbet the Kelly Formula. That is, you never want to put more of your bankroll than the Formula suggests. In a moment, you'll see how Pabrai puts that to work.

At any rate, investing is just like a coin flip offering favorable odds. On any given flip of the coin, you can lose money. Still, over the long term, if the odds are in your favor (as they are when you buy dollars for fifty cents), you'll make money—good money. In short, the Kelly Formula helps maximize your return (though it does nothing for volatility, so you need to know how to think about stock prices).

Kelly Formula Applied To Investing
There is one major flaw with the Kelly Formula when applying it to investing in businesses when they are on sale: It would force you to put too much of your bankroll into one company.

When you patiently wait for dollars to sell for half off, you are waiting until the odds of winning are so large, and the odds of losing are so small, that you would end up putting 85% or more of your bankroll into one position.

In this video from Morningstar, Pabrai asserts that the percentage would be even larger—upwards of 95%. (The Kelly Formula discussion starts 18 minutes into the video.)

Now, if you actually run the Kelly Formula on most value stocks...what the model will tell you is that you ought to put 97% of capital or 95% of capital, 95% of your bankroll into that bet.
How does that make sense?

...the odds of a loss are so low and the odds of a gain are so high.
So, Why Should We Care About The Kelly Formula?
What does the Kelly Formula do for us if we aren't going to follow it by putting 95% of our bankroll into one company? For one, it helps us understand that it is okay to own just a few holdings—be it five or fifteen. (Pabrai started with ten but is possibly bumping it up to fifteen as his capital base swells)

Don't focus on calculating the Kelly Formula for your investments and diversifying based on mathematical models. Rather, spend the time and energy finding "no-brainers"—investments that would be in that 95%-of-capital range. Then, buy the heck out of them.

Filed under Mohnish Pabrai Thursday, October 4, 2007
Comment on this [ 7 ] By: Joe Ponzio

comments
This site is great. The layout is clean, the content is amazing in that you cover concepts that all investors can understand and learn from, whether they are beginning, interdmediate, or advanced in their knowledge of investing. Thanks. I just hope that "other" gamblers continue to do what they do, so that we can take advantage of the opportunities created by them!

by Allen on October 4, 2007 at 12:36 PMBuffett (and others) have been talking about this stuff for 70 years. I doubt we'll make a dent in the gambler mentality. Lucky us!

by Joe Ponzio on October 4, 2007 at 1:00 PMHi Joe - What's your take on substituting numbers in your valuation analyses?

I'm aware this is a potentially dangerous practice, as one will tend to put a number to justify the conclusions of the analysis, but I was doing a valuation of a corporation that many of the investing "gurus" (including Warren Buffett) seem to be adding to their portfolios, but I can't see why they would believe the business was undervalued according to the financials.

The only thing I can tell is that the last year's free cash flow appears to be an anomaly in that it is much different than the previous 9 years' positive free cash flows (it's negative, and almost 13x worse than the positive FCF in 2005).

If you assume a more "reasonable" FCF in 2006, you get a valuation that is one and a half times the current market price.

Obvoiusly, you need sound reasoning to back up your feeling that last year's performance was an anomaly, but this seems highly subjective. What do you think? Should good investors substitute numbers in their valuations when they believe them to be exceptions or one-time occurences?

by Allen on October 4, 2007 at 5:11 PMAllen,

Everything we do is a guess of the future. We look at the past for consistency. Substitute to your heart's content. Just make sure that your numbers are reasonable and that your reasoning is sound.

Check out Do The Math In Your Head. It is all about false precision and guesstimating.

by Joe Ponzio on October 6, 2007 at 11:13 PMYou should bare in mind that the Kelly formula was worked out for betting on a coin being flipped and the not for stock picking. For example if you have 100 stocks available and they all have the same expected return you should split the money equally whatever the Kelly formula says. It was not worked out for stocks and the maths are different.

I think Parbrai in his book uses it as a general illustration of the virtues of concentrating rather than saying it is mathematically correct.

by Tim on October 7, 2007 at 8:09 AM"He was also an associate of Claude Shannon at Bell Labs. Together they developed a Game theory type method based on the principles of information theory developed by Shannon.[3] It is reported that Shannon and his wife Betty went to Las Vegas with M.I.T. mathematician Ed Thorp, and made very successful forays in roulette and blackjack using this method, later called the Kelly criterion, making a fortune as detailed in the book Fortune's Formula by William Poundstone.[4] Shannon and Thorp also applied the same theory to the stock market with even better results."

http://en.wikipedia.org/wiki/John_Larry_Kelly,_Jr

by Robert Crawford on October 8, 2007 at 6:37 PMThanks Robert. The Kelly Formula was designed (or at least does work) on every possible bet that has an positive expectation - be it in the stock market, the dice table, or a coin flip. But I agree with you Tim - you can't use it to precisely optimize your stock market bankroll. That's why you should always underbet the Kelly. And, as always, MARGIN OF SAFETY!

by Joe Ponzio on October 8, 2007 at 9:31 PM

Harness the power of high returns on invested capital.

2007-10-04T13:21:00.000-07:00

Five Cheap Companies that Create Value
Harness the power of high returns on invested capital.

by Elizabeth Collins | 02-08-06 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints

My favorite financial ratio is--hands down--return on invested capital, or ROIC. I think it's 10 times better than return on assets (ROA) or return on equity (ROE), and net profit margin doesn't even come close. That's because it single-handedly provides a quantitative answer to the question, "Does this company have an economic moat?" (The idea of an economic moat refers to how likely companies are to keep competitors at bay for an extended period.) Given how great the ROIC metric is, I wish there was a stock screener that would help me find companies with high ROICs, but unfortunately one doesn't exist. So let me show you how to calculate ROICs, and then you'll be able to conduct a sniff-test of a company's economic moat by yourself. I'll also discuss some companies that are high-ROIC machines and happen to be selling at 5-star prices. But first let's talk about what exactly ROIC measures, and why it's superior to all other financial ratios.

ROIC is a measure of how much cash a company gets back for each dollar it invests in its business. You're probably saying, "That sounds so similar to ROA and ROE, why not just use those, since they're posted on just about every financial Web site?" I agree that using ROA or ROE would be easier, but in my book they just don't cut it. First of all, the numerator in both of these ratios is net income. In many cases a company's net income has nothing to do with how profitable its operations are. There can be so many things going on "below the line"--interest income, discontinued operations, minority interest, and so on--that net income can make companies with unprofitable operations look profitable, and vice versa.
Further, ROA measures how much net income a company generates for each dollar of assets on its balance sheet. The problem with using this metric is that companies can carry a lot of assets that have nothing to do with their operations, so ROA isn't always an accurate measure of profitability.

ROE looks at how much profit a company makes per dollar of shareholders' equity. Theoretically ROE is a great metric because it measures how efficiently a company is using shareholders' money to generate profits--and as investors, that's something we should care about. But ROE has its limitations, too. By carrying high debt levels and repurchasing shares, management can increase a company's financial leverage, and thus its ROE, but too much of either can produce an unreasonably high ROE that doesn't accurately represent the company's profitability.

As far as net profit margin goes--which is net income divided by sales--frankly, I couldn't care less. Sure it measures how efficient a company is with each dollar of revenues, but that's the money its customers give it. As an investor, I care about what the company does with investors' money. And since net profit margin doesn't tell us anything about the balance sheet, you would never know if a company is posting great margins simply because it's interminably shoveling cash into its business. That can't go on forever.

So how do we calculate ROIC? For the "return" part of ROIC, we don't use net income, but rather earnings after taxes but before interest payments. We do this so that companies won't be penalized for having a lot of debt (and thus high interest payments). For the "invested capital" part, we take all of the company's assets, then subtract all current liabilities (those due within a year) except for short-term debt. Dividing aftertax income by invested capital gives us ROIC. Here's what it looks like:

1. Aftertax income = (operating income) x (1 - tax rate)
2. Invested capital = total assets - (current liabilities - short-term debt)
3. ROIC = aftertax income / invested capital

The beauty of ROIC is that you can make any adjustments that you think are necessary. For example, if I think that a company has a lot of cash on its books that isn't being used for operating purposes, I'll subtract this "nonoperating cash" from total assets. Or if the company is actually paying a lot less in cash taxes than what's showing up on the income statement, I'll add the difference back to the "aftertax income" figure. On the flipside, the fact that an investor needs to make some judgment calls in calculating ROIC is probably what's keeping the metric out of stock screeners.

ROIC by itself doesn't tell us much about a company's economic moat. A company creates value only if its ROIC is higher than its weighted average cost of capital, or WACC. The WACC measures the required return on the company's debt and equity, and takes into account the risk of the company's operations and its use of debt. WACCs typically range between 9% and 12% for large-cap companies, although there are many exceptions. Companies that have generated ROICs higher than their WACC for many years running usually have a moat. But a positive spread between ROIC and WACC alone doesn't justify an economic moat. Investors also have to think about the qualitative attributes--high barriers to entry, huge market share, low-cost production, corporate culture, patents, or high customer switching costs--that create an economic moat around a company's profits. Here's how you can use ROIC: If you think a company has a great business model that enjoys an economic moat, check to see if its historical ROICs are greater than its WACC. If they are, chances are you've found a company that will continue to generate value for its shareholders.

Now let's look into five companies that are ROIC winners. These companies also happen to be trading at prices well below our analysts' fair value estimates here at Morningstar, so we would consider buying these stocks. The stocks mentioned here had Morningstar Ratings of 5 stars--or "consider buying" prices--as of midday on Feb. 7, 2005. The star ratings may change daily due to price fluctuations or other factors.

Strayer Education STRA
Business Risk: Average
Economic Moat: Wide
Strayer--a for-profit post-secondary education company--has generated ROICs that have averaged 95% since 2001, the year the current management team joined the company. Stock analyst Kristan Rowland predicts that ROICs will top 110% in the future. From the Analyst Report: "For-profit education is very profitable, with wide-moat companies such as Apollo Group APOL and Strayer generating returns on invested capital north of 90%. We think these outsized returns are sustainable because of the industry's high barriers to entry. Top-flight firms such as Strayer possess regional accreditation, which is difficult to obtain and contributes to their moats. Membership follows a period of candidacy lasting up to five years, and periodic reviews are required for continued accreditation. Regional accreditation also helps Strayer attract students because it is indicative of quality. Furthermore, it allows institutions to tap into federal student-aid programs, expanding the pool of students that they can attract."

Johnson & Johnson JNJ
Business Risk: Below Average
Economic Moat: Wide
Diversified health-care company Johnson & Johnson has posted ROICs of 25%, on average, during the last five years. Stock analyst Tom D'Amore expects ROICs to be greater than 30% over the next five years. From the Analyst Report: "We think Johnson & Johnson is an exemplary wide-moat company--it boasts trusted brand-name products, world-class R&D and marketing capabilities, and global scale and reach. A key reason for J&J's success is its decentralized management structure--the company encourages entrepreneurship among local managers to stimulate creative new product development. Sales and marketing expertise and quality manufacturing skills are important distinguishing core competencies. In addition, the company keeps a careful watch on costs, which shows in the steady improvement in operating margins."

3M Company MMM
Business Risk: Below Average
Economic Moat: Wide
Manufacturing company 3M has generated 18% ROICs over the last five years, on average, and stock analyst Scott Burns is forecasting ROICs of over 24% over the next five years. From the Analyst Report: "Innovation and strong manufacturing capabilities have long been the trademarks of this company. 3M is synonymous with research and development and a corporate culture that breeds innovation. Another of 3M's advantages is its ability to leverage technologies across different businesses and continuously find new uses for basic technologies. In addition, 3M fiercely protects its patents and uses its protected period to perfect its production processes. Combining this production expertise with the company's global manufacturing base makes it cost prohibitive for rivals to undercut its prices once items fall off patent."

Fastenal FAST
Business Risk: Below Average
Economic Moat: Narrow
Fastenal supplies customers, including manufacturers and commercial construction contractors, with 250,000 varieties of threaded fasteners and 265,000 general-purpose maintenance, repair, and operations products. ROICs have topped 19% on average over the last five years, and stock analyst Matthew Warren expects returns to exceed 24% over the next five years. From the Analyst Report: "Fastenal has translated its unique competitive position into decades of profitable growth. This well-oiled machine continues to turn out new stores and take share in a highly fragmented market. By offering more than a quarter million types of fasteners (and a similar variety of maintenance, repair, and operations--or MRO--products) through its 1,700-plus stores, Fastenal provides enhanced selection and more convenience than broad-line distributors or hardware stores. Also, the company's 12 distribution centers and in-house truck fleet provide a highly efficient path to market, especially for heavy fasteners, which are expensive to ship via parcel carriers. Fastenal's unique offering is rewarded with pricing power--an important attribute, given recent steel price fluctuations."

Sysco SYY
Business Risk: Below Average
Economic Moat: Wide
Sysco--a provider of food-service products--has posted 19% ROICs over the past five years, and stock analyst Greggory Warren expects this strong performance to continue. From the Analyst Report: "Sysco is the dominant food-service distributor in North America. The company generates impressive returns in what has traditionally been a low-margin business, using economies of scale, investments in technology, and a cadre of marketing associates armed with a portfolio of its own branded products to cement its position. Sysco exhibits the very traits we look for in a wide-moat company. Being the market leader in such a highly fragmented industry allows Sysco to grab share from weaker competitors and gives it prime access to customers and acquisitions. We believe part of Sysco's success stems from its unparalleled economies of scale. The food distribution business has high fixed costs, which means that only companies capable of spreading those costs over a larger base will generate above-average returns. Finally, Sysco's investments in technology and in its distribution network have allowed it to lower its procurement and delivery costs and cement its position as the low-cost provider in the industry."

Robert Olstein Looks Behind the Numbers in Financial Reports?

2007-10-02T12:43:00.000-07:00

http://www.gurufocus.com/news.php?id=14072

Robert Olstein Looks Behind the Numbers in Financial Reports?
September-26-2007

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GuruFocus Home >> News Home >> Robert Olstein Looks Behind the Numbers in Financial Reports?

Robert Olstein Looks Behind the Numbers in Financial Reports?
September-26-2007

As value investors, we need to have an idea of the intrinsic value of a stock before we commit our capital. The calculation of the intrinsic value is dependent so much on the financial reports of the company. A lot of times it is the management's best interest to report better than expected earnings. How can we look through the reported numbers and find out the real information?

Robert Olstein is a CPA-turned money manager. He manages the $2 billion The Olstein Funds. Before he started his fund, he publishes a financial alert newsletter called "Quality of Earnings Report", which used inferential financial screening techniques to analyze balance sheets and income statements to alert institutional portfolio managers to positive or negative factors affecting a company's future earnings power and value of a company's stock. Since incepted in 1995, his fund has returned 14.89% in average per year. The key to his success is his capability of looking behind the numbers. In his most recent annual report, Robert Olstein detailed how he looks behind the numbers with financial reports. We have summarized and excerpted his key points here. You can certainly learn a thing or two from him.

Robert Olstein: All GAAP reporting systems rely on management judgment, leaving room for potential abuse or unrealistic assumptions.
It is important to note that all (GAAP) reporting systems rely on management judgment, leaving room for potential abuse or unrealistic assumptions.
Today, a wealth of additional information is contained in the footnotes and management discussions in annual reports, data which were not available 30 years ago for anyone who wanted to read with a skeptical eye.
... Generally Accepted Accounting Principles (GAAP) require that a company report earnings based on accrual accounting. The first premise of accrual accounting states that revenue is recognized when a transaction occurs in which value has been exchanged. The revenue recognition may lead or lag the passing of cash.
The other basic premise of GAAP accrual accounting is that the cost of a transaction should be recognized over the same period of time that the revenue associated with the cost is generated. The cost or expense recognition also may lead or lag the passing of cash.
In reporting GAAP-based earnings, companies are given wide discretion within the rules. Some companies make conservative assumptions, while others are overly aggressive, which can produce widely differing results depending on how management sees the future. In our opinion, most companies (including companies in our portfolio) engage in some type of earnings management. It is our job to determine the economic realism of management’s assumptions and to eliminate management biases by making the appropriate adjustments to reported earnings data. We believe there is nothing wrong or illegal about earnings management within limits. However, some companies exceed acceptable limits. In cases such as Lucent, Boston Chicken and Sunbeam, the financial statements may have been in accord with GAAP, but we don’t believe they were in accord with economic reality.
It is in management’s best interest to report the best earnings possible to preserve financing alternatives, keep their stock options valuable and exercisable, and to keep shareholders happy through increasing stock prices. Thus, when a company’s management identifies problems deemed to be temporary, management has the option to adopt more optimistic assumptions. The optimism could result in income being recognized more rapidly because reserves are lowered or depreciation has been lengthened (over more years). The end result is that the reporting of an earnings disappointment is virtually eliminated under the belief that short-term problems will soon end.
Unfortunately, in many cases, the future earnings disappointment that has been temporarily shelved becomes larger as the optimistic assumptions can no longer be justified. So even under GAAP (which we doubt was practiced by Enron), a true measure of the earnings power of a firm’s basic business can be distorted based on management’s biased view of reality.
Robert Olstein: How to look behind the numbers
Using the company’s cash-flow statements, we begin by reconciling the difference between free cash flow and reported earnings under accrual accounting. The smaller the difference between free cash flow and reported earnings, the higher the quality of earnings.
Our next step is to look at a company’s footnote on taxes, which reconciles the differences between earnings reported to shareholders under accrual accounting and earnings reported to the IRS under the cash basis of accounting. The lesser the difference, the higher the quality of earnings.
We then analyze receivables and inventories to determine changes in each relative to changes in sales. Inventories or receivables increasing faster than sales could be early warning alerts of future slowdowns.
The company’s investment activities are also extremely important to us, and we always compare depreciation provisions to capital expenditures when assessing sustainable free cash flow, the potential for future growth and management’s ability to create shareholder value. For example, a key alert to our purchase of Hasbro in February 2002 was that Hasbro’s cash earnings were being understated for many years as a result of depreciation exceeding capital expenditures. The excess depreciation was a result of expensing past capital spending on unprofitable licensing agreements that had since been terminated.
The next step in our quest to measure the quality of earnings is to look for non-recurring factors that have contributed to or reduced earnings.
Balance sheet ratios, especially relating to debt and returns on equity, are carefully assessed to determine a company’s ability to withstand temporary problems or an economic downturn without adopting harmful short-term strategies. The quality of earnings analysis relies heavily on analyzing these ratios. 7 Another important factor that we consider is the repetitiveness of socalled non-recurring losses, which we believe represent corrections to historical financial statements.
Robert Olstein: Top twenty quarlity of earning alerts
Material deviations between net income and free cash flow
Material differences between the tax books and shareholder books as measured by deferred taxes
aterial changes in balance sheet debt and liquidity ratios
Inventories, especially finished goods or raw materials, increasing or decreasing faster than sales
Accounts receivable increasing or decreasing faster than revenue
Deviations between depreciation and capital expenditures
The repetitiveness and materiality of non-recurring write-offs
The role that non-trend line changes in reserves contribute to, or negatively impact, current earnings
The repetitiveness and materiality of non-recurring gains such as sales from venture capital portfolios
The impact and reality of a company’s deferred expense capitalization policies as it effects reported free cash flow
Discretionary expenses deviating materially above and below trend lines
The reality, consistency and conservativeness of revenue recognition techniques when measured against the passing of cash
The impact that acquisitions have on sustainable free cash flow and the growth thereof
Changes in other asset accounts
The impact of transactions with special-purpose vehicles
Pension income and expense recognition measured against the pension plan’s assumptions and the funded status of the plan
Large deviations between pro forma and reported earnings
The impact of option transactions on reported free cash flow and the impact on future results and valuations of the company
The capabilities of management as measured by their long-term decision- making capabilities; especially when problems develop; their attitude toward risk as measured by the quality of the balance sheet; and their preparation for a rainy day; their methodology of communicating with shareholders; and finally their ability and emphasis on returning value to shareholders
Disclosure of material information needed to assess the value of the company
GuruFocus Comments:
Are all these procedures sufficient to eliminate mistakes? Robert Olstein wrote: "Despite an exhaustive inferential analysis of their financial statements prior to purchase, once in a while one of the companies in our portfolio surprises us by engaging in questionable accounting practices." With more than 30 years of experience, the CPA-turned money manager still misses the questionable accounting practices sometimes. How can others without this strong accounting background do it? A few thoughts here:

Buy simple business only. This is what Warren Buffett has been telling us. A simple business is easier to understand, and the chances of making questionable accounting practices are reduced.
Stay in your circle of competence. Invest in industries you understand. Again Warren Buffett has been telling us this all the time.
Buy companies with large insider ownership only, especially those operated by original founders. Owning a large portion of their company makes the CEOs think long term. Short term stock price moves are not in their interest.

Discuss this story

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2007-09-21T11:25:00.000-07:00

http://vinvesting.com/docs/munger/art_stockpicking.html
Art of Stock Picking
By Charlie Munger, (Warren Buffett's partner at Berkshire Hathaway)
I'm going to play a minor trick on you today because the subject of my talk is the art of stock picking as a subdivision of the art of worldly wisdom. That enables me to start talking about worldly wisdom a much broader topic that interests me because I think all too little of it is delivered by modern educational systems, at least in an effective way.And therefore, the talk is sort of along the lines that some behaviorist psychologists call Grandma's rule after the wisdom of Grandma when she said that you have to eat the carrots before you get the dessert.The carrot part of this talk is about the general subject of worldly wisdom which is a pretty good way to start. After all, the theory of modern education is that you need a general education before you specialize. And I think to some extent, before you're going to be a great stock picker, you need some general education.So, emphasizing what I sometimes waggishly call remedial worldly wisdom, I'm going to start by waltzing you through a few basic notions.What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form.You've got to have models in your head. And you've got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience on a latticework of models in your head.What are the models? Well, the first rule is that you've got to have multiple models because if you just have one or two that you're using, the nature of human psychology is such that you'll torture reality so that it fits your models, or at least you'll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine.It's like the old saying, "To the man with only a hammer, every problem looks like a nail. "And of course, that's the way the chiropractor goes about practicing medicine. But that's a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you've got to have multiple models.And the models have to come from multiple disciplines because all the wisdom of the world is not to be found in one little academic department. That's why poetry professors, by and large, are so unwise in a worldly sense. They don't have enough models in their heads. So you've got to have models across a fair array of disciplines. You may say, "My God, this is already getting way too tough. "But, fortunately, it isn't that tough because 80 or 90 important models will carry about 90% of the freight in making you a worldly wise person. And, of those, only a mere handful really carry very heavy freight.So let's briefly review what kind of models and techniques constitute this basic knowledge that everybody has to have before they proceed to being really good at a narrow art like stock picking.First there's mathematics. Obviously, you've got to be able to handle numbers and quantities basic arithmetic. And the great useful model, after compound interest, is the elementary math of permutations and combinations. And that was taught in my day in the sophomore year in high school. I suppose by now in great private schools, it's probably down to the eighth grade or so.It's very simple algebra. It was all worked out in the course of about one year between Pascal and Fermat. They worked it out casually in a series of letters.It's not that hard to learn. What is hard is to get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically consonant with the way that the world works. And it's fundamental truth. So you simply have to have the technique.Many educational institutions ‑ although not nearly enough have realized this. At Harvard Business School, the great quantitative thing that bonds the first year class together is what they call decision tree theory. All they do is take high school algebra and apply it to real life problems. And the students love it. They're amazed to find that high school algebra works in life....By and large, as it works out, people can't naturally and automatically do this. If you understand elementary psychology, the reason they can't is really quite simple: The basic neural network of the brain is there through broad genetic and cultural evolution. And it's not Fermat / Pascal. It uses a very crude, shortcut type of approximation. It's got elements of Fermat / Pascal in it. However, it's not good.So you have to learn in a very usable way this very elementary math and use it routinely in life ‑ just the way if you want to become a golfer, you can't use the natural swing that broad evolution gave you. You have to learnto have a certain grip and swing in a different way to realize your full potential as a golfer.If you don't get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one‑legged man in an ass‑kicking contest. You're giving a huge advantage to everybody else.One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations....Obviously, you have to know accounting. It's the language of practical business life. It was a very useful thing to deliver to civilization. I've heard it came to civilization through Venice which of course was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.And it's not that hard to understand.But you have to know enough about it to understand its limitations ‑ because although accounting is the starting place, it's only a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know.In terms of the limitations of accounting, one of my favorite stories involves a very great businessman named Carl Braun who created the CF Braun Engineering Company. It designed and built oil refineries ‑ which is very hard to do. And Braun would get them to come in on time and not blow up and have efficiencies and so forth. This is a major art.And Braun, being the thorough Teutonic type that he was, had a number of quirks. And one of them was that he took a look at standard accounting and the way it was applied to building oil refineries and he said, "This is asinine."So he threw all of his accountants out and he took his engineers and said, "Now, we'll devise our own system of accounting to handle this process. "And in due time, accounting adopted a lot of Carl Braun's notions. So he was a formidably willful and talented man who demonstrated both the importance of accounting and the importance of knowing its limitations.He had another rule, from psychology, which, if you're interested in wisdom, ought to be part of your repertoire ‑ like the elementary mathematics of permutations and combinations.His rule for all the Braun Company's communications was called the five W's ‑ you had to tell who was going to do what, where, when and why. And if you wrote a letter or directive in the Braun Company telling somebody to do something, and you didn't tell him why, you could get fired. In fact, you would get fired if you did it twice.You might ask why that is so important? Well, again that's a rule of psychology. Just as you think better if you array knowledge on a bunch of models that are basically answers to the question, why, why, why, if you always tell people why, they'll understand it better, they'll consider it more important, and they'll be more likely to comply. Even if they don't understand your reason, they'll be more likely to comply.So there's an iron rule that just as you want to start getting worldly wisdom by asking why, why, why, in communicating with other people about everything, you want to include why, why, why. Even if it's obvious, it's wise to stick in the why.Which models are the most reliable? Well, obviously, the models that come from hard science and engineering are the most reliable models on this Earth. And engineering quality control ‑ at least the guts of it that matters to you and me and people who are not professional engineers ‑ is very much based on the elementary mathematics of Fermat and Pascal:It costs so much and you get so much less likelihood of it breaking if you spend this much. It's all elementary high school mathematics. And an elaboration of that is what Deming brought to Japan for all of that quality control stuff.I don't think it's necessary for most people to be terribly facile in statistics. For example, I'm not sure that I can even pronounce the Poisson distribution. But I know what a Gaussian or normal distribution looks like and I know that events and huge aspects of reality end up distributed that way. So I can do a rough calculation.But if you ask me to work out something involving a Gaussian distribution to ten decimal points, I can't sit down and do the math. I'm like a poker player who's learned to play pretty well without mastering Pascal.And by the way, that works well enough. But you have to understand that bell‑shaped curve at least roughly as well as I do.And, of course, the engineering idea of a backup system is a very powerful idea. The engineering idea of breakpoints that's a very powerful model, too. The notion of a critical mass that comes out of physics is a very powerful model.All of these things have great utility in looking at ordinary reality. And all of this cost-benefit analysis ‑ hell, that's all elementary high school algebra, too. It's just been dolled up a little bit with fancy lingo.I suppose the next most reliable models are from biology/ physiology because, after all, all of us are programmed by our genetic makeup to be much the same.And then when you get into psychology, of course, it gets very much more complicated. But it's an ungodly important subject if you're going to have any worldly wisdom.And you can demonstrate that point quite simply: There's not a person in this room viewing the work of a very ordinary professional magician who doesn't see a lot of things happening that aren't happening and not see a lot of things happening that are happening.And the reason why is that the perceptual apparatus of man has shortcuts in it. The brain cannot have unlimited circuitry. So someone who knows how to take advantage of those shortcuts and cause the brain to miscalculate in certain ways can cause you to see things that aren't there.Now you get into the cognitive function as distinguished from the perceptual function. And there, you are equally more than equally in fact likely to be misled. Again, your brain has a shortage of circuitry and so forth and it's taking all kinds of little automatic shortcuts.So when circumstances combine in certain ways or more commonly, your fellow man starts acting like the magician and manipulates you on purpose by causing your cognitive dysfunction you're a patsy.And so just as a man working with a tool has to know its limitations, a man working with his cognitive apparatus has to know its limitations. And this knowledge, by the way, can be used to control and motivate other people....So the most useful and practical part of psychology which I personally think can be taught to any intelligent person in a week is ungodly important. And nobody taught it to me by the way. I had to learn it later in life, one piece at a time. And it was fairly laborious. It's so elementary though that, when it was all over, I felt like a fool.And yeah, I'd been educated at Cal Tech and the Harvard Law School and so forth. So very eminent places mis-educated people like you and me.The elementary part of psychology ‑ the psychology of misjudgment, as I call it is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.Terribly smart people make totally bonkers mistakes by failing to pay heed to it. In fact, I've done it several times during the last two or three years in a very important way. You never get totally over making silly mistakes.There's another saying that comes from Pascal which I've always considered one of the really accurate observations in the history of thought. Pascal said in essence, "The mind of man at one and the same time is both the glory and the shame of the universe."And that's exactly right. It has this enormous power. However, it also has these standard malfunctions that often cause it to reach wrong conclusions. It also makes man extraordinarily subject to manipulation by others. For example, roughly half of the army of Adolf Hitler was composed of believing Catholics. Given enough clever psychological manipulation, what human beings will do is quite interesting.Personally, I've gotten so that I now use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? And second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things which by and large are useful, but which often malfunction.One approach is rationality the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions many of which are wrong.Now we come to another somewhat less reliable form of human wisdom microeconomics. And here, I find it quite useful to think of a free market economy or partly free market economy as sort of the equivalent of an ecosystem....This is a very unfashionable way of thinking because early in the days after Darwin came along, people like the robber barons assumed that the doctrine of the survival of the fittest authenticated them as deserving power you know, "I'm the richest. Therefore, I'm the best. God's in his heaven, etc."And that reaction of the robber barons was so irritating to people that it made it unfashionable to think of an economy as an ecosystem. But the truth is that it is a lot like an ecosystem. And you get many of the same results.Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world ‑ and get very good because they specialize frequently find good economics that they wouldn't get any other way.And once we get into microeconomics, we get into the concept of advantages of scale. Now we're getting closer to investment analysis because in terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.For example, one great advantage of scale taught in all of the business schools of the world is cost reductions along the so-called experience curve. Just doing something complicated in more and more volume enables human beings, who are trying to improve and are motivated by the incentives of capitalism, to do it more and more efficiently.The very nature of things is that if you get a whole lot of volume through your joint, you get better at processing that volume. That's an enormous advantage. And it has a lot to do with which businesses succeed and fail....Let's go through a list albeit an incomplete one of possible advantages of scale. Some come from simple geometry. If you're building a great spherical tank, obviously as you build it bigger, the amount of steel you use in the surface goes up with the square and the cubic volume goes up with the cube. So as you increase the dimensions, you can hold a lot more volume per unit area of steel.And there are all kinds of things like that where the simple geometry the simple reality gives you an advantage of scale.For example, you can get advantages of scale from TV advertising. When TV advertising first arrived when talking color pictures first came into our living rooms it was an unbelievably powerful thing. And in the early days, we had three networks that had whatever it was say 90% of the audience.Well, if you were Proctor & Gamble, you could afford to use this new method of advertising. You could afford the very expensive cost of network television because you were selling so many cans and bottles. Some little guy couldn't. And there was no way of buying it in part. Therefore, he couldn't use it. In effect, if you didn't have a big volume, you couldn't use network TV advertising which was the most effective technique.So when TV came in, the branded companies that were already big got a huge tail wind. Indeed, they prospered and prospered and prospered until some of them got fat and foolish, which happens with prosperity ‑ at least to some people....And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime?So, in effect, Wrigley , simply by being so well known, has advantages of scale what you might call an informational advantage.Another advantage of scale comes from psychology. The psychologists use the term “social proof”. We are all influenced subconsciously and to some extent consciously by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. We don't like to be the one guy who's out of step.Again, some of this is at a subconscious level and some of it isn't. Sometimes, we consciously and rationally think, "Gee, I don't know much about this. They know more than I do. Therefore, why shouldn't I follow them?"The social proof phenomenon which comes right out of psychology gives huge advantages to scale ‑ for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola is that it's available almost everywhere in the world.Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup which is slowly won by a big enterprise gets to be a huge advantage.... And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you.There's another kind of advantage to scale. In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm.The most obvious one is daily newspapers. There's practically no city left in the U.S., aside from a few very big ones, where there's more than one daily newspaper.And again, that's a scale thing. Once I get most of the circulation, I get most of the advertising. And once I get most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner take all situation. And that's a separate form of the advantages of scale phenomenon.Similarly, all these huge advantages of scale allow greater specialization within the firm. Therefore, each person can be better at what he does.And these advantages of scale are so great, for example, that when Jack Welch came into General Electric, he just said, "To hell with it. We're either going to be # 1 or #2 in every field we're in or we're going to be out. I don't care how many people I have to fire and what I have to sell. We're going to be #I or #2 or out."That was a very tough‑minded thing to do, but I think it was a very correct decision if you're thinking about maximizing shareholder wealth. And I don't think it's a bad thing to do for a civilization either, because I think that General Electric is stronger for having Jack Welch there.And there are also disadvantages of scale. For example, we by which I mean Berkshire Hathaway ‑ are the largest shareholder in Capital Cities /ABC. And we had trade publications there that got murdered where our competitors beat us. And the way they beat us was by going to a narrower specialization.We'd have a travel magazine for business travel. So somebody would create one which was addressed solely at corporate travel departments. Like an ecosystem, you're getting a narrower and narrower specialization.Well, they got much more efficient. They could tell more to the guys who ran corporate travel departments. Plus, they didn't have to waste the ink and paper mailing out stuff that corporate travel departments weren't interested in reading. It was a more efficient system. And they beat our brains out as we relied on our broader magazine.That's what happened to The Saturday Evening Post and all those things. They're gone. What we have now is Motorcross which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. But they care about it. For them, it's the principle purpose of life. A magazine called Motorcross is a total necessity to those people. Arid its profit margins would make you salivate.Just think of how narrowcast that kind of publishing is. So occasionally, scaling down and intensifying gives you the big advantage. Bigger is not always better.The great defect of scale, of course, which makes the game interesting ‑ so that the big people don't always win ‑ is that as you get big, you get the bureaucracy. And with the bureaucracy comes the territoriality ‑ which is again grounded in human nature.And the incentives are perverse. For example, if you worked for AT&T in my day, it was a great bureaucracy. Who in the hell was really thinking about the shareholder or anything else? And in a bureaucracy, you think the work is done when it goes out of your in-basket into somebody else's in-basket. But, of course, it isn't. It's not done until AT&T delivers what it's supposed to deliver. So you get big, fat, dumb, unmotivated bureaucracies.They also tend to become somewhat corrupt. In other words, if I've got a department and you've got a department and we kind of share power running this thing, there's sort of an unwritten rule: "If you won't bother me, I won't bother you and we're both happy. "So you get layers of management and associated costs that nobody needs. Then, while people are justifying all these layers, it takes forever to get anything done. They're too slow to make decisions and nimbler people run circles around them.The constant curse of scale is that it leads to big, dumb bureaucracy ‑ which, of course, reaches its highest and worst form in government where the incentives are really awful. That doesn't mean we don't need governments ‑ because we do. But it's a terrible problem to get big bureaucracies to behave.So people go to stratagems. They create little decentralized units and fancy motivation and training programs. For example, for a big company, General Electric has fought bureaucracy with amazing skill. But that's because they have a combination of a genius and a fanatic running it. And they put him in young enough so he gets a long run. Of course, that's Jack Welch.But bureaucracy is terrible.... And as things get very powerful and very big, you can get some really dysfunctional behavior. Look at Westinghouse. They blew billions of dollars on a bunch of dumb loans to real estate developers. They put some guy who'd come up by some career path ‑ I don't know exactly what it was, but it could have been refrigerators or something ‑ and all of a sudden, he's loaning money to real estate developers building hotels. It's a very unequal contest. And in due time, they lost all those billions of dollars.CBS provides an interesting example of another rule of psychology namely, Pavlovian association. If people tell you what you really don't want to hear what's unpleasant there's an almost automatic reaction of antipathy. You have to train yourself out of it. It isn't foredestined that you have to be this way. But you will tend to be this way if you don't think about it.Television was dominated by one network ‑ CBS in its early days. And Paley was a god. But he didn't like to hear what he didn't like to hear. And people soon learned that. So they told Paley only what he liked to hear. Therefore, he was soon living in a little cocoon of unreality and everything else was corrupt although it was a great business.So the idiocy that crept into the system was carried along by this huge tide. It was a Mad Hatter's tea party the last ten years under Bill Paley.And that is not the only example by any means. You can get severe malfunction in the high ranks of business. And of course, if you're investing, it can make a lot of difference. If you take all the acquisitions that CBS made under Paley, after the acquisition of the network itself, with all his advisors his investment bankers, management consultants and so forth who were getting paid very handsomely it was absolutely terrible.For example, he gave something like 20% of CBS to the Dumont Company for a television set manufacturer which was destined to go broke. I think it lasted all of two or three years or something like that. So very soon after he'd issued all of that stock, Dumont was history. You get a lot of dysfunction in a big fat, powerful place where no one will bring unwelcome reality to the boss.So life is an everlasting battle between those two forces ‑ to get these advantages of scale on one side and a tendency to get a lot like the U.S. Agriculture Department on the other side ‑ where they just sit around and so forth. I don't know exactly what they do. However, I do know that they do very little useful work.On the subject of advantages of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization.If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.The reverse is demonstrated by the little store where one guy is doing all the buying. It's like the old story about the little store with salt all over its walls. And a stranger comes in and says to the storeowner, "You must sell a lot of salt." And he replies, "No, I don't. But you should see the guy who sells me salt."So there are huge purchasing advantages. And then there are the slick systems of forcing everyone to do what works. So a chain store can be a fantastic enterprise.It's quite interesting to think about Wal-Mart starting from a single store in Bentonville, Arkansas against Sears, Roebuck with its name, reputation and all of its billions. How does a guy in Bentonville, Arkansas with no money blow right by Sears, Roebuck? And he does it in his own lifetime ‑ in fact, during his own late lifetime because he was already pretty old by the time he started out with one little store....He played the chain store game harder and better than anyone else. Walton invented practically nothing. But he copied everything anybody else ever did that was smart ‑ and he did it with more fanaticism and better employee manipulation. So he just blew right by them all.He also had a very interesting competitive strategy in the early days. He was like a prizefighter who wanted a great record so he could be in the finals and make a big TV hit. So what did he do? He went out and fought 42 palookas. Right? And the result was knockout, knockout, knockout 42 times.Walton, being as shrewd as he was, basically broke other small town merchants in the early days. With his more efficient system, he might not have been able to tackle some titan head-on at the time. But with his better system, he could destroy those small town merchants. And he went around doing it time after time after time. Then, as he got bigger, he started destroying the big boys.Well, that was a very, very shrewd strategy.You can say, "Is this a nice way to behave? "Well, capitalism is a pretty brutal place. But I personally think that the world is better for having Wal-Mart. I mean you can idealize small town life. But I've spent a fair amount of time in small towns. And let me tell you ‑ you shouldn't get too idealistic about all those businesses he destroyed.Plus, a lot of people who work at Wal-Mart are very high grade, bouncy people who are raising nice children. I have no feeling that an inferior culture destroyed a superior culture. I think that is nothing more than nostalgia and delusion. But, at any rate, it's an interesting model of how the scale of things and fanaticism combine to be very powerful.And it's also an interesting model on the other side how with all its great advantages, the disadvantages of bureaucracy did such terrible damage to Sears, Roebuck. Sears had layers and layers of people it didn't need. It was very bureaucratic. It was slow to think. And there was an established way of thinking. If you poked your head up with a new thought, the system kind of turned against you. It was everything in the way of a dysfunctional big bureaucracy that you would expect.In all fairness, there was also much that was good about it. But it just wasn't as lean and mean and shrewd and effective as Sam Walton. And, in due time, all its advantages of scale were not enough to prevent Sears from losing heavily to Wal-Mart and other similar retailers.Here's a model that we've had trouble with. Maybe you'll be able to figure it out better. Many markets get down to two or three big competitors or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth.If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure ‑ a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.Yet, in other fields like cereals, for example almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%.But why are cereals so profitable despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it.And maybe the cereal makers by and large have learned to be less crazy about fighting for market share ‑ because if you get even one person who's hell-bent on gaining market share.... For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it.In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model for predicting how that's going to happen.For example, if you look around at bottler markets, you'll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you'd have to know the people involved to fully understand what was happening.In microeconomics, of course, you've got the concept of patents, trademarks, exclusive franchises and so forth. Patents are quite interesting. When I was young, I think more money went into patents than came out. Judges tended to throw them out based on arguments about what was really invented and what relied on prior art. That isn't altogether clear.But they changed that. They didn't change the laws. They just changed the administration ‑ so that it all goes to one patent court. And that court is now very much more pro-patent. So I think people are now starting to make a lot of money out of owning patents.Trademarks, of course, have always made people a lot of money. A trademark system is a wonderful thing for a big operation if it's well known.The exclusive franchise can also be wonderful. If there were only three television channels awarded in a big city and you owned one of them, there were only so many hours a day that you could be on.So you had a natural position in an oligopoly in the pre-cable days.And if you get the franchise for the only food stand in an airport, you have a captive clientele and you have a small monopoly of a sort.The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you.And most people do not get this straight in their heads. But a fellow like Buffett does.For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles which are a real commodity product. And one day, the people came to Warren and said, "They've invented a new loom that we think will do twice as much work as our old ones."And Warren said, "Gee, I hope this doesn't work because if it does, I'm going to close the mill." And he meant it.What was he thinking? He was thinking, "It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers.B ut we're not going to put huge amounts of new capital into a lousy business."And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.That's such an obvious concept ‑ that 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.Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and got new fancy computers and so forth, all of the savings would come right through to the bottom line.In all cases, the people who sell the machinery ‑ and, by and large, even the internal bureaucrats urging you to buy the equipment show you projections with the amount you'll save at current prices with the new technology. However, they don't do the second step of the analysis which is to determine how much is going stay home and how much is just going to flow through to the customer. I've never seen a single projection incorporating that second step in my life. And I see them all the time. Rather, they always read: "This capital outlay will save you so much money that it will pay for itself in three years."So you keep buying things that will pay for themselves in three years. And after 20 years of doing it, somehow you've earned a return of only about 4% per annum. That's the textile business.And it isn't that the machines weren't better. It's just that the savings didn't go to you. The cost reductions came through all right. But the benefit of the cost reductions didn't go to the guy who bought the equipment. It's such a simple idea. It's so basic. And yet it's so often forgotten.Then there's another model from microeconomics which I find very interesting. When technology moves as fast as it does in a civilization like ours, you get a phenomenon which I call competitive destruction. You know, you have the finest buggy whip factory and all of a sudden in comes this little horseless carriage. And before too many years go by, your buggy whip business is dead. You either get into a different business or you're dead ‑ you're destroyed. It happens again and again and again.And when these new businesses come in, there are huge advantages for the early birds.And when you're an early bird, there's a model that I call "surfing" ‑ when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he gets off the wave, he becomes mired in shallows....But people get long runs when they're right on the edge of the wave ‑ whether it's Microsoft or Intel or all kinds of people, including National Cash Register in the early days.

http://valueinvestingresource.blogspot.com/2007/07/bill-miller-whats-luck-got-to-do-with.html

2007-07-24T05:35:00.000-07:00

Question: What's the Kelly criterion?
Answer: The Kelly criterion is named after J.L. Kelly, Jr., who in 1956 wrote a paper for The Bell System Technical Journal called "A New Interpretation of the Information Rate," drawing on work by Claude Shannon, the father of information theory.
What Kelly did was to take an aspect of Shannon's work and derive a formula that had broad applicability outside of information theory. What it enabled you to do was to maximize the growth rate of anything, if you used this formula. So gamblers quickly used it to adopt money management strategies.
It's known as a fixed fraction strategy. So what it tells you is what fraction of your bank roll you should commit to any particular probabilistic endeavor, whether it be a gambling debt, or an investing debt, if you know the probabilities that pertain to it. And if you know those preconditions, you will either maximize your bankroll at the fastest possible rate, or you'll minimize your loss at the slowest possible rate.
The rough formula, in a grossly oversimplified form just for the purposes of discussion, is:
2p - 1
where p is the probability [converted from percentage to decimal form]. So, to make it easy, if you were 100% certain that a particular investment would pay off at your expected rate, then 2 times that p is 2.0, minus 1, yields 1. That means 100% of your bankroll should go into that investment.
Now if you were only 60% sure, then it would be two times .60, which is 1.20, minus 1, equals .20. So 20% of your bankroll should go into that proposition.
What the Kelly criterion does is it gets you to focus on the probability that you are correct in your assessment, and then to understand that the amount of money you should commit is directly related to the probability that you are correct. It also shows that if you have less than a 50/50 proposition, you shouldn't bet at all. Which again, makes perfect sense.
Question: Let's boil all that down for people who can't do 2p - 1, because it's too much math.
Answer: (Laughter) Well, what Kelly says is the same thing Puggy Pearson says, which is you have to know the 60/40 end of the proposition. You have to be confident that you have an edge, that you have some positive probability of an expected positive gain, before you commit any amount of money. And if you can't identify that edge, you probably don't have it. And if you can't identify it, you probably shouldn't commit the capital to it.
Question: Right. And how much capital you commit -
Answer: - depends crucially on your assessment of how big your edge is. And that's why the government punishes inside information. Right? If you have a tip that comes from somebody that knows Company X is bidding for Company Y, then you would commit large amounts of your personal capital to that, following perfect Kelly fashion.
Question: Right, because your P is 100.
Answer: Exactly. Your P is 100.
Question: But doesn't this bring us to a really difficult problem which is that since humans have an incorrigible tendency to be overconfident, how do you calibrate your P so that it's correctly less than 100?
Answer: Well, I wouldn't advise people to go so far as to try to do calibrations on it. I would advise them basically to understand, A) people are overconfident, and B) that therefore whatever probability you think you have of being right, it's probably less than you think.
So if you think you have a small edge, you probably don't have any edge at all.
Full Interview