Learning from John D Rockefeller

We’ve all heard of today’s Titans; those business moguls that possess incredible net worth that rivals almost all others. Bezos, Musk, Gates, even Buffett and Munger. These are household names to both investors and businesspeople the world over. But there was one Titan that could rival them all, and indeed is regarded as the richest American to ever live. Who was it?

John D Rockefeller.

With an estimated net worth of $400b today, how did he earn that title? How did one man find himself literally crushed by money and yet was still able to retire in his mid 50’s?

He did it by owning a great business - which is key to long term investment success. The very best businesses aren’t just slightly better than their competition, they’re orders of magnitude better. Businesses which can grow their earnings and compound their investor’s capital can underwrite their share price performance for years to come - making them one of the safest and surefire ways to investment success.

At the foundation of history’s greatest businesses is usually a powerful business model. In the case of Rockefeller’s Standard Oil, it was ‘Owning the Choke-Point,’ the narrow part of an hour glass separating suppliers and consumers; the centre of the ecosystem. It’s an enduring business model that has delivered windfall profits to company shareholders for centuries.

“Rockefeller had an annual untaxed income of $58m in 1902 - or about a billion dollars in tax-free income per annum in today’s money.”

If the names Chevron, Conoco, Exxon, Mobil or Amoco ring a bell, you’re already familiar with the legacy of Rockefeller’s business, The Standard Oil Trust. An indomitable energy company whose activities spanned production, storage, transport, infrastructure, distribution and retailing that touched consumers and businesses the world over. Standard Oil has long been considered the greatest monopoly of all time.

There are a myriad of lessons for today’s investor in the history of John D Rockefeller and Standard Oil; owning the choke-point, keeping prices low, leveraging and sharing scale, embracing technology, continuously innovating, empowering employees, decentralising, aligning management, growing the market, spurning debt, encouraging internal competition and harnessing tailwinds are as relevant today as they were over a hundred years ago.

Standard Oil’s ability to consistently increase profitability and defy the notoriously boom-bust nature of its industry descended from its ownership of the choke-point; the point where oil supply was transformed into commercial products and distributed for sale.

Rockefeller started out in refining, recognising the benefits of scale, he amalgamated capacity to extract favourable terms from the railways. As refining competitors buckled, Rockefeller drove further consolidation; taking partial stakes, retaining management, and using scrip based funding ensured interests were aligned - creating emergent effects.

Rockefeller recognised the benefits in keeping prices low; the pool of potential buyers was expanded while new competition was deterred from entering the industry. Ever frugal, Rockefeller focused on costs and looked for ways to increase efficiencies; embracing new technologies, constantly innovating and leveraging economies of scale ensured competition was muted. By 1907, the Standard Oil leviathan refined 87% of the kerosene market and was more than twenty times the size of its most serious competitor.

Having come of age in an era of emerging corporate dominance and nascent regulatory oversight, Standard Oil’s anti-competitive tactics [there were many!] eventually attracted Government attention. In 1911, after forty-one years of existence, the Supreme Court ordered the Trust be dismembered into thirty-seven subsidiary companies [including those five companies mentioned above]. The post split performance of Standard Oil Trust might prove a useful guidepost given the regulatory concerns overhanging some of today’s tech titans.

By his mid-fifties, Rockefeller had retired, yet the enormous tailwind of the automotive generation would make him far richer in retirement than in his working life. An abiding self-belief that he was fulfilling God’s wish to earn and share wealth had created a predilection for charity from an early age. At the time of Rockefeller’s death, a few weeks short of his 98th birthday, his career would be defined as much by his philanthropic endeavours as it was by his business success.

Rockefeller’s incredible story has been told in the wonderful book, ‘Titan’, by Ron Chernow.

“Another book that I liked very much was ‘Titan’, the biography of the original John D. Rockefeller. That’s one of the best business biographies I have ever read. And it’s a very interesting family story, too. That was just a wonderful, wonderful book. And I don’t know anybody who’s read it who hasn’t enjoyed it. So I would certainly recommend that latest biography of John D. Rockefeller the first.” Charlie Munger

‘Titan’ is a fantastic journey into the highly complex and contradictory mind of one of the world’s shrewdest businessmen. While not an easy read (bring a dictionary!) it’s worth the effort. While barely scratching the surface of this epic biography, I’ve included some favourite extracts below.

Education and Smarts

“‘I was not an easy student, and I had to apply myself diligently to prepare my lessons.’ said Rockefeller, who described himself accurately as ‘reliable’ but not ‘brilliant.’”

“[When playing childhood games] to ensure that he won, he submitted to games only where he could dictate the rules.”

“‘I was trained from the beginning to work and save,’ Rockefeller explained. ‘I have always regarded it as a religious duty to get all I could honourably and give all I could.’”

“Once Rockefeller spent three days helping a local farmer dig potatoes for 37 cents per day. This set up an instructive contrast for the frugal boy when, soon afterward, he loaned one farmer $50 at 7 percent interest and collected $3.50 at year’s end - without a stitch of work. He was thunderstruck by the happy math, which hit him with the force of a revelation. ‘The impression was gaining ground on me that it was a good thing to let the money be my slave and not make myself a slave to money.’”

Optimism

“[Rockefeller] was a confirmed exponent of positive thinking.”

“Like other Gilded Age moguls, Rockefeller was shaped by his faith in economic progress, the beneficial application of science to industry, and America’s destiny as an economic leader.”

“[After the 1929 market crash, Rockefeller was encouraged to make a calming statement] Rockefeller issued a press release, ‘These are days when many are discouraged. In the ninety years of my life, depressions have come and gone. Prosperity has always returned, and will again.’ In his peroration, he said, ‘Believing that the fundamental conditions of the country are sound, my son and I have been purchasing sound common stocks for some days.’”

Embrace Technology

“The firm relied upon the railroad and the telegraph, the two technologies then revolutionising the American economy.”

“Standard Oil also profited immeasurably from the revolution in oil transport as barrels gave way to tank cars.”

“The railroads balked at investing in rolling stock that couldn’t also transport general freight, So Rockefeller stepped boldly into the breach… As the owner of almost all the Erie and NY Central tank cars, Standard Oil’s position grew unassailable.”

“Only belatedly did Rockefeller discern the full potential of pipelines… [Ultimately] gaining uncontested control of all major pipeline systems connecting oil wells to railroad trunk lines. ‘Practically not a barrel of oil could get to a railroad without Rockefeller’s consent… ‘Rockefeller’s firm had now advanced far beyond the railroads to more efficient pipelines.’”

Understand the Business

“For Rockefeller, ledgers were sacred books that guided decisions and saved one from fallible emotion. They gauged performance, exposed fraud, and ferreted out hidden inefficiencies. In an imprecise world, they rooted things in solid empirical reality. As he chided slipshod rivals, ‘Many of the brightest kept their books in such a way that they did not actually know when they were making money on a certain operation and when they were losing.’”

Efficiency and Scale Advantages

“The proliferation of railroads enabled Rockefeller to extract discounts from them by playing one off against the other.”

“Rockefeller’s ceaseless search for even minor improvements meant that within a year refining had overtaken produce as the most profitable side of the business. Despite the unceasing vicissitudes of the oil industry, prone to cataclysmic booms and busts, he would never experience a single year of loss.”

“His tight-fisted control of details and advocacy of unbridled expansion. Daring in design, cautious in execution - it was a formula he made his own throughout his career.”

“[Rockefeller] was a mastermind of many negotiations with the railroads.. Since oil was a relatively cheap, standardised commodity, transportation costs inevitably figured as a critical factor in the competitive struggle.”

“Rockefeller had built gigantic plants so he could drastically slash his unit costs. Even his first partner remembered that ‘the volume of trade was what he always regarded as of paramount importance.’ Early on, Rockefeller realised in the capital-intensive refining business, sheer size mattered greatly because it translated into economies of scale.”

“Once describing the ‘foundation principle’ of Standard Oil, Rockefeller said it was the ‘theory of the originators’ .. that the larger volume the better the opportunities for the economies, and consequently the better opportunities for giving the public a cheaper product without .. the dreadful competition of the late ‘60’s ruining the business. During his career, Rockefeller cut the unit costs of refined oil almost in half, and he never deviated from this gospel of industrial efficiency.”

Emerging Effects

“Rockefeller activated a self-sustaining movement as his new allies agreed to consolidate business in their localities and supervise the purchase of remaining independent refiners. A massive chain reaction was thus set in motion that rippled through both refining centres, with local businessmen acting as Rockefeller’s agents.”

Owning the Choke-Point

“The spot chosen for the new refinery tells much in miniature about Rockefeller’s approach to business… Able to ship by water or land, Rockefeller gained the critical leverage he needed to secure preferential rates on transportation - which was why he agonised over plant locations throughout his career.”

“[Rockefeller’s] overriding reason for his attachment to Cleveland: It was the hub of so many transportation networks that he had tremendous room to manoeuvre in freight negotiations.”

“Rockefeller’s first visit to Pennsylvania must have persuaded him that he had picked the right entry point to the business. Searching for oil was wildly unpredictable, whereas refining seemed safe and methodical by comparison. Before too long, he realised that refining was the critical point where he could exert maximum leverage over the industry.”

“Rampant speculation had so overbuilt the industry that total refining capacity in 1870 was triple the amount of crude oil being pumped. By then, Rockefeller estimated 90 percent of all refiners were operating in the red. Producers and refiners didn’t shut down operations in the expected numbers causing Rockefeller to doubt the workings of Adam Smith’s invisible hands: ‘So many wells were flowing that the price of oil kept falling, yet they went right on drilling.’ The industry was trapped in a full blown crisis of overproduction with no relief.’ Thus in 1869, Rockefeller feared his wealth might be snatched away from him. As someone who tended toward optimism, ‘seeing opportunity in every disaster’, he studied the situation exhaustively instead of bemoaning his luck. He saw that his individual success as a refiner was now menaced by industrywide failure and that it therefore demanded a systematic solution. This was a momentous insight, pregnant with consequence. Instead of just tending to his own business, he began to conceive of the industry as gigantic, interrelated mechanism and thought in terms of strategic alliances and long term planning. Rockefeller cited the years 1869 and 1870 as the start of his campaign to replace competition with cooperation in the industry. The culprit, he decided, was ‘the over-development of the refining industry,’ which had created ‘ruinous competition.’ If this fractious industry was to be made profitable and enduring, he would have to tame and discipline it. A trailblazer who improvised solutions without any guidance from economic texts, he began to envision a giant cartel that would reduce overcapacity, stabilise prices, and rationalise the industry.”

“Between February 17 and March 28 1972 - between the first rumours of the SIC [proposed agreement between Standard Oil and the railways] and the time it was scuttled - Rockefeller swallowed up twenty-two of his twenty-six Cleveland competitors… Another businessman might have started with small, vulnerable firms, building on easy victories, but Rockefeller started at the top, believing that if he could crack his strongest competitor first, it would have tremendous psychological impact.”

“In retrospect, it seems peculiar that Standard Oil - omnipotent in refining, transportation, and distribution - owned just four production properties in the early 1880’s… He had long profited from the juxtaposition of cooperation in refining and competition in production.”

“Rockefeller applied to iron ore [interests] lessons he had learned in oil, such as controlling an industry through transportation and demoralising competitors with prices too low for them to match.”

“The unity of Standard Oil partners was especially impressive given the organisation’s byzantine structure, a far-flung patchwork of firms, each nominally independent but in reality taking orders from 26 Broadway [Standard Oil head office].”

Innovation

“Scarcely dreaming that oil would ever supersede their main [agricultural produce] commodity business, they [Rockefeller & partner] considered it ‘a little side issue.’”

“Rockefeller wasn’t stultified by precedent or tradition, which made it easier for him to innovate. He continued to value autonomy from outside suppliers. At first, he paid small coopers up to $2.50 for white oak barrels before he showed, in an early demonstration of scale, that he could manufacture dry, tight casks.. for less than a dollar a barrel. The Cleveland coopers bought and shipped green timber to their shops, whereas Rockefeller had the oak sawed in the woods and dried in kilns, reducing its weight and slicing transportation costs in half.”

“Regarding each plant as infinitely perfectible, Rockefeller created an atmosphere of ceaseless improvements.”

“Below the executive committee came a battery of specialised committees dedicated to transportation, pipelines, domestic trade, export trade, manufacturing, purchasing and so on. These committees standardised the quality of subsidiaries engaged in similar work, enabling managers to swap insights and align their operations… These were chosen experts who had daily sessions and study of the problems, new as well as old, constantly arising. The benefit of their research, their study, was available for each of the different concerns.”

“Rockefeller created the model for the vertically integrated oil giants that would straddle the globe in the twentieth century.. By 1891 Rockefeller had gained control of a quarter of American oil production.”

Tailwinds

“The [civil] war had stimulated growth in the use of kerosene by cutting the supply of southern turpentine .. kerosene emerged as an economic staple and was primed for a furious postwar boom.”

“The [civil] war markedly accelerated the timetable of economic development, promoting the growth of factories, mills, and railroads. By stimulating technological innovation and standardised products, it ushered in a more regimented economy. The world of small farmers and businessmen began to fade, upstaged by a gargantuan new world of mass consumption and production.”

“Europe emerged rapidly as the foremost market for American kerosene, importing hundreds of thousands of barrels yearly during the civil war. Perhaps no other American industry had such an export outlook from its inception. By 1866, fully two-thirds of Cleveland kerosene was flowing overseas.”

Low Prices

“Rockefeller’s goal was to forestall potential competitors through low prices and thus minimise risk and chance disruptions.”

“Standard Oil had not kept prices low out of altruism but to deter competition and ‘keep our profits on such a basis that others would not be stimulated to enter the field of competition with us.’ This belied Rockefeller’s frequent claim that his motive was to bequeath cheap oil to the working people.”

“Rockefeller was obsessed with high-volume, low cost production to maintain market share, even if he temporarily sacrificed profit margins. As he noted, ‘This fact the Standard Oil Company always kept in mind: that they must render the best service and be content with largely increasing volume of business, rather than increase the profit so as to tempt others to compete with them.’ When discussing prices with subordinates, he frequently reminded them, ‘We want to continue, in reason, that policy which will give us the largest percentage of business.’”

“In general, Standard Oil did an excellent job at providing kerosene at affordable prices. It boasted far lower unit costs than competitors and relentlessly drove down costs over the years.’ Between 1880 and 1885, its average cost of processing a gallon of crude oil went from 2.5 to 1.5 cents. [In the 20 years to 1890] the retail prices of kerosene had plunged from 23.5 cents to 7.5 cents per gallon.”

“But Standard Oil never sought a perfect monopoly because Rockefeller realised that it was politically prudent to allow some feeble competition.. A very smart monopolist, Rockefeller kept prices low enough to retain control of the market but not so low as to wipe out all lingering competition.”

“Rockefeller new that if he got greedy, other products could be substituted for kerosene, and this, too, curbed his appetite for excess profits.”

“Rockefeller keenly felt a need to freeze the industry’s size, stymie new entrants, and create an island of stability in which expansion and innovation could then occur unimpeded.”

John D Rockefeller’s NY Residence

Empowering People

“Rockefeller wanted to be surrounded by trustworthy people who could inspire confidence in customers and bankers alike.”

“In the early days, Rockefeller knew the name and face of each employee.”

“Rockefeller generally received excellent reviews from employees who regarded him as fair and benevolent, free of petty temper and dictatorial airs.”

“So highly did Rockefeller value personnel that during the first years of Standard Oil he personally attended to routine hiring matters.”

“‘The ability to deal with people is as purchasable a commodity as sugar or coffee,’ Rockefeller once said, ‘and I pay more for that ability than for any other under the sun.”

“Employees were invited to send complaints or suggestions directly to Rockefeller, and he always took an interest in their affairs. His correspondence is replete about sick or retired employees. Reasonably generous in wages, salaries, and pensions, he paid somewhat above the industry average.”

“His employees tended to revere Rockefeller and vied to please him. As one said, ‘I have never heard of his equal in getting together a lot of the very best men in one team and inspiring each man to do his best for the enterprise.”

“At first, Rockefeller tested employees exhaustively, yet once he trusted them, he bestowed enormous power upon them and didn’t intrude unless something radically misfired.”

“People who worked for Rockefeller usually found him a model of propriety and paternalistic concern.”

“Rockefeller’s decided the leading men [management co-owners] would receive no salary but would profit solely from the appreciation of their shares and rising dividends - which Rockefeller thought a more potent stimulus to work.”

“When it came to mergers, Rockefeller didn’t fight for the last dollar and tried to conclude matters cordially. Since he aimed to convert competitors into members of his cartel and often retained the original owners.”

“The creation of Standard Oil was often less a matter of stamping out competitors than of seducing them into co-operation. In general, Rockefeller was so eager to retain original management that he accumulated expensive deadwood on the payroll and, for the sake of intra-empire harmony, preferred to be conciliatory.”

“One of Rockefeller’s greatest talents was to manage and motivate his diverse associates. As he said, ‘It is chiefly to my confidence in men and my ability to inspire their confidence in me that I owe my success in life.”

“Free of an autocratic temperament, Rockefeller was quick to delegate authority and presided lightly, genially, over his empire, exerting his will in unseen ways.”

“The Trust’s formation created negotiable securities, and this profoundly affected the Standard Oil culture. Not only did Rockefeller urge underlings to take stock but made money abundantly available to do so. As such shareholding became widespread, it welded the organisation more tightly together, creating an esprit de corps that helped in steamrolling competitors and government investigators alike. With employees receiving huge capital gains and dividends, they converted Standard Oil into a holy crusade.”

“Rockefeller hoped the Trust would serve as a model for a new populist capitalism, marked by employee share ownership. ‘I would have every man a capitalist, every man, women and child,’ he said, ‘I would have everyone save his earnings, not squander it; own the industries, own the railroads, own the telegraph lines.”

“[Rockefeller’s] committee system was an ingenious adaption, integrating the policy of constituent companies without stripping them of all autonomy. We must remember that Standard Oil remained a co-federation and most of its subsidiaries were only partially owned. A top down hierarchical structure might have hampered local owners whom Rockefeller had promised a measure of autonomy in running their plants. The committee system galvanised their energies while providing them with general guidance. The committee encouraged rivalry among local units by circulating performance figures and encouraging them to compete for records and prizes. The point is vitally important, for monopolies spared the rod of competition, can easily lapse into sluggish giants.”

Walk The Floors

“In the first years of Standard Oil, Rockefeller regularly toured his facilities and was extremely inquisitive and observant, soaking up information and assiduously quizzing plant superintendents. In his pocket, he carried a little red notebook in which he jotted suggestions for improvements and always followed up on them.”

Financial Strength

“[Rockefeller] always moved into battle backed by abundant cash. Whether riding out downturns or coasting on booms, he kept plentiful reserves and won many bidding contests simply because his war chest was deeper.”

“Standard Oil weathered the six-year depression magnificently, a fact Rockefeller attributed to its conservative financial policy and unparalleled access to bank credit and investor cash.”

“The Standard Oil Trust’s resilience during the depression of the 1890’s, its tested immunity from market fluctuations, cheered Rockefeller, who attributed this to Standard’s large cash reserves and conservative dividend policy.”

“Since the early 1880’s, Standard Oil had been self-financing, very liquid at all times, and free from the thrall of Wall Street bankers.”

Grow the Market

“To inflate demand, Rockefeller sold hundred of thousands of cheap lamps and wicks and sometimes distributed them gratis with the first kerosene purchase.”

“Rockefeller also sold, almost at cost, heaters, stoves, lamps, and lanterns to widen the market. In the manner of a modern corporation, Standard Oil created demand as well as satisfied it.”

“Rockefeller continually extended the market for petroleum by-products, selling benzine and paraffin, and petroleum jelly in addition to kerosene.”

Fanaticism & Obliquity

“Rockefeller derived a glandular pleasure from work and never found it cheerless drudgery. In fact, the business world entranced him as a fount of inexhaustible wonders. ‘It is by no means from money alone that these active-minded men labor - they are engaged in a fascinating occupation.’ he wrote in his memoirs. ‘The zest of the work is maintained by something better than mere accumulation of money.”

“Rockefeller seemed destined to succeed as much from his fastidious work habits as from innate intelligence.”

“Even in as a young man, Rockefeller was extremely composed in crisis. In this respect, he was a natural leader; The more agitated others became, the calmer he grew.”

“The passion for excellence originated with Rockefeller and radiated throughout the organisation. The ethos of Standard Oil’s operations around the world was John D Rockefeller’s personality writ large.”

“Rockefeller inspired subordinates with his fanatic perfectionism.”

Humility

“Aside from the occasional courtesy call from other moguls, he hobnobbed with the same family members, old friends, and Baptist clergy who had always formed his social circle.”

“When someone expressed surprise to Rockefeller that he had not gotten a big head, he replied, ‘Only fools get swelled up over money.’ Comfortable with himself, he needed no outward validation of what he had accomplished.”

“Rockefeller preferred outspoken colleagues to weak-kneed sycophants and welcomed differences of opinion so long as they weren’t personalised.”

Frugality

“From his mother he learned economy, order, thrift, and other bourgeois virtues that figured so largely in his success at Standard Oil.’”

“Rockefeller engaged in strenuous rituals of austerity, and grimly sought to simplify his life and reduce his wants. He liked to say that ‘a man’s wealth must be determined by the relation of his desires and expenditures to his income. If he feels rich on ten dollars, and has everything else he desires, he really is rich.’”

“Rockefeller spent a ridiculous amount of time protesting bills both large and small.”

“[Rockefeller would say,] save when you can and not when you have to.”

“The world’s richest man never lost the thrifty boyhood habits that had made him the nonpareil of American business.”

Secrets

“Rockefeller trained himself to reveal as little as possible.”

“He learnt to cultivate a secretive style and a defiant attitude toward strangers.”

“Rockefeller never allowed his office decor to flaunt the prosperity of his business, lest it arouse unwanted curiosity.”

“Rockefeller was concerned that if he advertised his own wealth through fancy houses, he might attract investors into the refining business and only worsen the excess capacity problem.”

“Ever alert against industrial espionage, Rockefeller never wanted people to know more than was required and warned one colleague, “I would be very careful about putting someone into a position where he could learn about our business, and be troublesome to us.”

“Rockefeller equated silence with strength. Weak men had loose tongues and blabbed to reporters, while prudent businessmen kept their own counsel.”

Anti-Competitive Tactics

“Since the rules of the game had not yet been encoded into law, Rockefeller and his fellow industrialists had forged them in the heat of combat. With his customary thoroughness, Rockefeller had devised an encyclopaedic stock of anti-competitive weapons. Since he had figured out every conceivable way to restrain trade, rig markets, and suppress competition, all reform-minded legislators had to do was study his career to draw up a comprehensive antitrust agenda.”

“Rockefeller perfected a monopoly that indisputably demonstrated the efficiency of large scale-business.”

Post Split

“During the ten years after Standard Oil’s 1911 dismantling, the assets of its constituent companies quintupled in value.”

“Those who had seen the Standard Oil dissolution as a condign punishment for Rockefeller were in for a sad surprise: It proved to be the luckiest stroke of his career. Precisely because he lost the antitrust suit, Rockefeller was converted from a mere millionaire, with an estimated net worth of $300 million in 1911, into something just short of history’s first billionaire.”

“What quickly grew apparent, however, was that Rockefeller had been extremely conservative in capitalising Standard Oil and that the split-off companies were chock full of hidden assets. Two other factors encouraged a veritable feeding frenzy in the stocks. For years, the shares of Standard Oil of New Jersey had been depressed by the antitrust litigation, but with the litigation ended, they bounced back to more normal levels. And the explosion of the automobile industry created euphoria about the endless growth prospects of the petroleum industry.”

“Many of the newly independent companies were powerful enough to inspire fear as freestanding entities. Standard Oil of New Jersey remained the world’s largest oil company, second only to US Steel in size among American enterprises and retaining 43% of the value of the old trust.”

Philanthropy

“During his first year on the job, the young [Rockefeller] donated about 6 percent of his wages to charity, some weeks much more. ‘I have my earliest ledger and when I was only making a dollar a day I was giving five, ten, or twenty-five cents.”

“Even as a teenager, he took palpable pleasure in distributing money for charitable purposes, and he insisted that from an early date he discerned the intimate spiritual link between earning and dispensing money.”

“Since his adolescence, charity had been interwoven with the fabric of his life.”

“Rockefeller argued that the rich should donate large sums to worthy causes during their lifetimes, less their money be frittered away by idle heirs.”

“Rockefeller regarded his fortune as a public trust, not as a private indulgence, and pressure to dispose of it grew imperative in the 1900’s as his Standard Oil stock and other investments appreciated fantastically.”

“Rockefeller believed that certain universal principles of businesslike efficiency should apply to non-profit ventures no less than to profit-making ones.”

“Never before had a rich benefactor spent his money in this area.. ‘It marked the first large public recognition of medical education and research as a rewarding subject of philanthropy.’”

“Rockefeller Foundation played an integral part in the rise of American medicine to the pinnacle of world leadership.”

“Rockefeller’s philanthropy was more orientated toward the creation of knowledge, and if it seemed more impersonal, it was also far more pervasive in its effect.”

“The fiercest robber baron had turned out to be the foremost philanthropist.”

“Rockefeller established the promotion of knowledge, especially scientific knowledge, as a task no less important than giving alms to the poor or building schools, hospitals, and museums.”

Summary

Studying history’s great businesses and managers can enlighten us to factors that characterise success and help shed light on new investment opportunities. While technologies change and economies evolve, the business models that define these great companies can endure for decades, even centuries.

Since the days of Standard Oil, many businesses have achieved effective ownership of the choke-point. Even the Mafia recognised the significant benefits accruing to such a position when they controlled New York’s concrete industry in the 1980’s. Collecting a tax of 1-2 percent on every new skyscraper - if you wanted to build you had to talk to the Mob.

More recently we’ve witnessed a multitude of companies monopolising industry choke-points. The capital-light nature of some of these technology businesses with their first mover advantages, network effects, increasing returns and winner-take-all dynamics may mean even longer life cycles.

Businesses which can compound capital for decades are the holy grail of investing. Charlie Munger likes to remind us, "There are certain fundamental models out there that do not take the kind of ability that quantum mechanics requires. You just have to know a few simple things and really know them.” The choke-point is one of them.

“There was only one John D Rockefeller,” concludes Chernow’s epic biography. Indeed, there was.

Reference:
‘Titan - The Life of John D Rockefeller, Sr,’ Ron Chernow, 1998, Random House.

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Learning from Honey Bees

The great investors never stop learning. Warren Buffett, Charlie Munger and John Templeton all continued to learn well past the age of most people’s retirement, and despite decades of investment success, they all had the humility to recognise there was so much more to learn. More recently, the eminently successful practitioners, Howard Marks and Dan Loeb have each acknowledged their continued evolution as investors.

And the information they absorb can come from a multitude of sources. At MastersInvest we have looked at what can be learned from a variety of areas, many of which upon first reflection you would consider to be only tenuously related to investing at best. Interestingly though, often the better learning is to be found in the most unlikely of places.

“Camel's nostrils are miracles of heat exchange and water recovery engineering. We are currently looking at cuttlebone and bird skulls to help design more efficient concrete structures for office buildings. The combustion chamber in the abdomen of a bombardier beetle mixes two high explosives from fuel tanks with valves that open and close 200 times a second—it is being studied in order to develop needle-free medical injections, more efficient fuel injection systems and more effective fire extinguishers.” Michael Pawlyn

This field is called biomimicry; a discipline that looks at nature's best ideas to inspire solutions to human problems. When it comes to continuous innovation and devising strategies for success, nature has a three billion year head start on us humans. While we’ve barely scratched the surface when it comes to understanding the world we live in, it’s no reason to be despondent. The world is just far too complex and ever changing. There’s much to learn and everyday those learnings can help in all facets of life.

A recent article in The Economist titled, ‘The nose knows - Flies, worms and bees could help detect illness’ provides an enlightening example. While everybody knows dogs have a much better sense of smell than us, few would realise they can smell things at concentrations of one part in a trillion. That’s equivalent to a single drop in a pond the size of 20 Olympic swimming pools! While trials have shown that dogs can detect human disease - cancer, diabetes, tuberculosis, and malaria - recent research shows bees have senses just as good. Imagine such an expendable resource providing an economical, easy and non-invasive way of detecting cancer.

“The imagination of nature is far, far greater than the imagination of man. No one who did not have some inkling of this through observations could ever have imagined such a marvel as nature is.” Richard Feynman

Many great investors have found lessons in life within nature itself. The learnings that she can offer us are many and varied, and so upon recommendation by both Michael Mauboussin and James Anderson, I recently delved into an interesting book called, ‘Honeybee Democracy.’

In this fascinating treatise, the world-renowned animal behaviourist Thomas Seeley delves into the life of a honey bee swarm. These tiny creatures face a life-or-death problem when choosing a new home, effectively ‘staking everything on a process that includes collective fact-finding, vigorous debate, and consensus building.’

It all starts with the honey bee colony’s reproduction process. In the late spring and early summer, as a bee colony becomes overcrowded, a third of the hive stays behind and rears a new queen, while a swarm of thousands departs with the old queen to produce a daughter colony. As part of this process, a small percentage [c2%] of the hive’s worker bees, referred to as scouts, will independently search for a new nest site.

Experimental studies have found these scout bees to have an innate sense of what comprises the ideal location; a small entrance, plentiful volume for honey storage to survive winter, a suitable height above the ground, etc. Each scout bee’s job is to independently search for new locations and report them back to the hive. This communication process is achieved through a form of ‘ritual dance’ which signals both the location of the sites and the scout bee’s relative keenness on it.

Upon witnessing the dances, other scout bees will then visit the advertised sites and make their own independent assessment of the location’s merits and once again communicate this to the colony. Over time, each scout gradually reduces their marketing efforts regardless of how suitable the site is. The most keenly marketed sites attract more scouts who then inspect and, if appropriate advertise the site, creating a positive feedback loop. In contrast, lower quality sites are abandoned. When a quorum of bees is reached at the optimum site, the swarm will depart and take up residence in its new home.

An intelligent decision making process emerges from a group of less sophisticated beings; the wisdom of the hive is greater than that of any individual bee. This decision making process, honed over millions of years, almost always leads to the optimal site selection. There is no central decision maker; the queen bee plays no role in the process.

There are lessons in this decision making process that can help improve group decision making. Thomas Seeley recommended four things:

1) make sure the group is sufficiently large for the challenges it faces
2) make sure the group consists of people with diverse backgrounds and perspective
3) foster independent exploratory work by the group’s members
4) create a social environment in which the group’s members feel comfortable about proposing solutions

Every bee in the hive starts with a common purpose. The individuals and the hive’s interests are aligned - to the point where it is a life or death decision. When it comes to human decision making, ensuring a group understands the entities goals, have alignment and are incentivised appropriately, is fundamental.

The scout bees possessed an innate sense of what constitutes an optimal nest site. Extrapolating this to an investment group requires agreement on the attributes of a ‘good investment.’ Defining qualities such as a businesses’ purpose, a good culture, enduring competitive advantages, high returns on capital, management alignment and capability are perhaps, pre-requisites to consider. Filtering out unsuitable opportunities is an important part of the process.

Just as each bee doesn’t compare and contrast every site, but investigates a diverse range of sites, investment analysts should search widely for potential opportunities. Each analyst however, must be discerning in their selection process before reporting back to the group. Other analysts can then independently investigate those companies and a debate can be held about the merits of each.

While it might sound like common sense, collective groups of people have a tendency to make poor decisions. It’s uncanny the extent to which Thomas Seeley’s findings and recommendations parallel with those that the renowned Yale psychologist, Irving Janus described in his famous book, ‘Groupthink.’

Summary

One recurring trait of the great investors is their dedication to continuous learning. And its astounding from how many diverse fields they can draw life’s lessons from. At Mastersinvest we’ve drawn on teachings from great Investors, Businesses, CEO’s, Navy Captains, Psychologists, Physicists, Artists - and now - Honey Bees!

As humans, we understand just a fraction of what there is to know, which should make one optimistic about the amazing things we will achieve in the future. I’ll leave you with one of my all time favourite quotes from Ray Dalio, it connects the concept of nature and humility far better than I ever could.

“While I spend the most time studying how the realities that affect me most work—i.e., those that drive the markets and the people I deal with — I also love to study nature to try to figure out how it works because, to me, nature is both beautiful and practical. Its perfection and brilliance staggers me. When I think about all the flying machines, swimming machines, and billions of other systems that nature created, from the microscopic level to the cosmic level, and how they interact with one another to make a workable whole that evolves through time and through multi-dimensions, my breath is taken away. It seems to me that, in relation to nature, man has the intelligence of a mould growing on an apple—man can’t even make a mosquito, let alone scratch the surface of understanding the universe.” Ray Dalio, Principles 2011.

Source:
‘Honeybee Democracy,' Thomas Seeley, 2010, Princeton University Press.

Further Reading:
‘Avoiding Groupthink,’ Investment Masters Class, 2016.

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The Good Life Podcast

I recently had the pleasure of chatting to Sean Murray from ‘The Good Life.’ We talked about all things investing including quality companies, powerful business models, developing a multi-disciplinary mindset and the common threads evident amongst the very best investors, CEOs and businesses.

I’m a big fan of Sean’s work, be sure to check out his other interviews with the likes of Robert Cialdini, Annie Duke, Michael Abrashoff, Morgan Housel and William Green.

I hope you enjoy the episode…

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Learning from Chick-fil-A’s S.Truett Cathy

The business world is diverse, with companies operating in a variety of industries, some of which are more complex and difficult to compete with than others.

In the next few years, the world’s leading semiconductor company will release a chip with almost 300 million transistors per square millimetre! Hard to copy? Unquestionably. How about a fast food outlet selling chicken sandwiches? On the face of it, not that hard to compete with. You can replicate the ingredients, the store fit-outs, the locations, the marketing and the packaging - but the one secret ingredient you might struggle to copy is the culture.

Consider Chick-fil-A, the fast food business that’s taken over America. A private company, Chick-fil-A is now the third largest chain behind McDonalds and Starbucks. In 2019, it generated more than $US11 billion in revenue, signifying 52 consecutive years of sales growth. When it comes to sales-per-store, no major US fast food chain comes close; the average store turns over more than a Burger King, KFC, Domino’s and Subway combined. And the stores are closed on Sunday!

On the basis of sales per store you’d expect Chick-fil-A could achieve a premium for the franchises it sells. It costs more than $US1 million to open a McDonald’s, a Burger King, or a KFC restaurant, and yet opening a Chick-fil-A restaurant costs just $US10,000.

Charlie Munger’s counsel to understand Chick-fil-A and it’s incredible success would be to ask his favourite question, ‘What in hell is going on here?’

Luckily for us, Chick-fil-A’s founder, S. Truett Cathy, addressed just such a question in his book, ‘How did you do it, Truett?' The answer aligns with another of Charlie’s mental models, ‘businesses that go ridiculously far in maximising and/or minimising one or a few variables tend to have the winning systems.’

“I’d recommend a book by S. Truett Cathy who started Chick-fil-A, the chicken burger chain. The book, ‘How did you do it Truett?,’ was really good. I've been hoping that Chick-fil-A becomes a public company since then.” Francois Rochon

Legendary customer service lies at the heart of Chick-fil-A’s success. There’s even such a thing as Chick-fil-A memes; Parodies of the lengths employees will go to delight their customers. A few years ago a video of a 20-year-old Chick-fil-A worker went viral, ‘The way you interact with people really matters, it transforms their day,’ the eager employee later explained. Termed ‘second-mile-service,’ staff have been known to change a customer’s tyre or drop their lost keys or cell phone home, earning the company the top spot amongst fast food chains in the American Customer Satisfaction Index in each of the last seven years.

Source: QSR 2020 Ranking the Top 50 Fast-Food Chains

The late S. Truett Cathy understood that a business has a higher purpose than just making money. From the humble beginnings of a single restaurant, S. Truett Cathy rode the tailwind of America’s urbanisation, living his religious values, empowering his franchisees, listening to his customers, encouraging innovation, embracing crises, exceeding his patron’s expectations and taking a long term view. In the process he created a multi-billion dollar fast food enterprise.

S. Truett Cathy has shared his experiences and wisdom in a collection of short business books. Highly engaging, the lessons of ‘servant leadership,’ managing growth, selecting and valuing employees, delivering quality and setting the tone from the top are but a few of the mental models to be gleaned. Chick-fil-A’s unconventional approach to franchising provides a bounty of lessons in itself.

I’ve include some of my favourite S. Truett Cathy quotes below.

Education and Smarts

“As a young boy I had a speech impediment so severe I could not pronounce my own name.”

“When I was in school, I never was an achiever. I wasn’t able to make the chorus, I could never play a musical instrument, I didn’t excel in sports, and I certainly didn’t excel academically. But I had established some good work habits and had an attitude that has been very beneficial to me.”

Keep it Simple

“Every day, we remember the Chick-fil-A Chicken Sandwich is really a simple concept. We take advantage of our biggest opportunities when we keep it simple, focusing on serving great tasting food in a clean, wholesome environment with great customer service. That hasn’t changed in the sixty-one years I’ve been in the restaurant business.”

Customers

“Be kind to your customers. It’s the key to success… You can’t beat the Golden Rule as a business philosophy: Do unto others as you would have them do unto you.”

“The customer is always king. He or she is always right. You know the kind of service you like to have from people behind the counter. That’s the kind of service we want you to offer the customers.”

“Listening to my customers - One of the first things I learned in the restaurant business was to find out what my customers wanted then provide it to them.”

“The key to succeeding with a paper route - and the restaurant business, I would learn later on - is to take care of the customer.”

“Ever since I was a teenager delivering newspapers, I have tried not to lose a single customer. I treated each one like the most important person in the world, and delivered each paper as if I was delivering it to the front door of the Governor’s Mansion.”

“The customer is always right, and I always oblige the customer.”

“Courtesy is cheap to provide, and it pays great dividends.”

“The bottom line is, the customer standing right in front of you is funding your paycheck, and perhaps your future. Treat that one person right. Give him or her all of your attention for the moment. Have a servant’s attitude. The customer is always right, even when he or she is wrong.”

“We are building success one loyal customer at a time, and we make sure that everyone who comes in leaves with the intention of coming back.”

“We outperform other quick-service restaurant chains because of the courtesy and kindness we offer our customers. We advertise on radio, television, and in newspapers, but none of that takes the place of having customers as our cheerleaders.”

Servant Spirit

S Truett Cathy [Source: Chick-fil-A]

“To often these days, especially in retail situations, when I say, ‘Thank you,’ the response is ‘No problem.' Or worse, just a grunt. It seems the best I can hope for is, ‘You’re welcome’. I asked our Operators, team members, and corporate headquarters to say, ‘My pleasure’ whenever someone thanked them. The purpose was not just to change the words we say, but to remind those we serve, as well as ourselves, of the ‘servant spirit’ and ‘second-mile’ orientation we are continually building into our business.”

“Second-Mile service is about the heart, and it goes above and beyond the requirements, making sure customers not only get what they expect, but something more that makes them say, ‘Wow!’ Almost everyday we hear about a team member helping change a customer’s tire or making an extra effort to return lost keys or a cell phone that was left behind.”

“You can do a lot of things short of giving away food to express hospitality, but the most important thing is to feel in your heart the desire to serve.”

Competitive Advantages

“Chick-fil-A is what it is today because of its product, people, and purpose.”

“Businesses don’t succeed or fail. People do.”

“I believe the reason Chick-fil-A is so successful is simple - we care much more than our competitors. Being successful requires more than just unlocking the doors every day. Our philosophy of ‘doing the right thing and doing things right’ is hardly ever the easiest solution. It is, however, always the best solution.'“

Source: Chick-fil-A

“Because almost all Chick-fil-A franchised Operators have only one restaurant, they’re in the store virtually every day and have the best interest of their particular restaurant in mind. They care about the quality of people on their team and the quality of the food they serve. Better people and better food means higher sales and higher profits for the Operator.”

“Two things set our people apart: We’re happy to be here, and we have the spirit of a servant. In our restaurant, both of those feelings must come from me, the Operator.” Charles Gibson, Chick-fil-A Operator

“Today we go out of our way to keep people from being able to figure out our product. Our company makes our seasonings, and another makes the breading.”

“Raising prices for me has always been the absolute last resort - after we squeeze out every bit of waste we can.”

“Although we’ve been closing my places of business on Sunday for more than forty years [in deference to S. Truett Cathy’s religious beliefs], I keep hearing the same comments and questions. I don’t believe we’ve lost any sales in the long run. In the shopping malls we usually generate more sales per square foot in six days than many others do in seven. We also believe that by giving employees that free day, we attract the kind of people who want Sunday off because of their own convictions.”

Associate with Quality People

“Associate yourselves only with those people you can be proud of whether they work for you or you work for them.”

“You’ll be the same person five years from now as you are today except for the books you read and the people you associate yourself with. I hope I’m not the same person today that I was five years ago.”

Hiring & Firing

“If you really aren’t interested in serving others, you don’t need to be in the restaurant business in the first place. We like to say we recruit smiles. You can’t teach a sour person to be joyful.”

Source: Chick-fil-A

“A good attitude is one of the best guarantees of success. A less qualified individual with a good attitude would be more welcomed at my company than a highly talented individual with a bad attitude.”

“From the beginning, and until only recently, I interviewed every new candidate. I knew all the Operators by name, and most of their spouses and children.”

“I never want to fire someone simply to save money. I want everyone who works at Chick-fil-A to feel secure that we will not resort to layoffs because we have overextended.”

“We don’t hire people because they need a job. We hire people because we need them. We must be very selective... The wrong person working just ten hours a week can run off a lot of customers.”

“The biggest impact on service is our people.”

“Motivation expert Zig Zigler has said that among the top twenty-five attributes companies look for in an executive, not one of them deals with experience. Character traits are most important. Everything else can be learned.”

Hire Better People

“When you get to this size, you grow through the talent of others - people I have attracted through the years who make my job look easy. I divided the tasks among other people more skilled in their areas than I am, and I trust them to do the job well.”

Trust

“Loyalty begins with trust. My policy has always been to select trustworthy people - then trust them!”

“Success in any relationship or endeavour begins with trust. It’s amazing how much you can accomplish when you trust the people around you and they trust you.”

“A lot of what we do is trust. The Chick-fil-A franchise Operator Agreement is based on trust. It’s the biggest key to our success.”

“We trust our Operators to make good decisions - and they do.”

Obliquity

“It’s an axiom of business that if you help people get what they want, you’ll get what you want.”

“Profits should be the score of the game, not the name of the game.”

“What counts in this business is not how much money we make or how much chicken we sell. What counts is the difference we make in the lives of others.”

Reciprocation

“We would be loyal to [the Operators], treating them as we wished to be treated, and they would reciprocate. They did. Fewer than five percent of our Operators leave the chain in any given year. Other chains tout their ‘knowledge management’ with their computer and communications systems; we manage knowledge by keeping people - and their knowledge - in the organisation.”

“I look for ways to do special things for customers. Like when I see a customer three or four times in the same week, I go to their table and give them a ‘Be Our Guest’ card. I figure if they’re spending fifteen or twenty dollars a week, I’ll give them a free sandwich. All of this fits into the Chick-fil-A philosophy that I first experienced when I went to work for the company.” Chick-fil-A Employee

Value Employees

“The most important people in this business are our employees. Some people will say customers are most important, but if we create the right atmosphere where our employees enjoy their jobs and have opportunities for growth, they will get a kick out of their work. Then that feeling will spill right over to the customer.”

“Studies show that between 65% and 80% of working people do not like what they are doing for a living. That’s a sad fact because a person spends one-third of his life on the job.”

Operators

“We do all we can to make our Operators successful because if they’re successful, so is the company.”

“The most important decision we make at Chick-fil-A is selecting restaurant Operators who care about others, who can motivate their team, and who understand how to run a business. Our franchise Operators determine the success of the chain. They’re the ones meeting customers and selling chicken sandwiches.”

“The Operator selection process can be lengthy, sometimes as long as a year, because we want to be certain before we make a franchise commitment that we believe the relationship will last.”

“Our relationship with our Operators begins with the assumption that we have the same goals and we all plan to succeed. Our operators own their own business, but our relationship is extremely close.”

“It’s easy to apply for a position as an Operator of a Chick-fil-A Unit, but hard to qualify... We don’t select or even seriously consider an Operator or a member of staff unless we want the individual to be with us until one of us retires or dies. Because of that, Chick-fil-A has one of the lowest turnover rates in the restaurant industry.”

“Two requirements of being an Operator are that the Operator run only one restaurant and must be on-site to manage it.”

“We supply the initial capital for the restaurant, so we don’t have to limit our search for Operators to people with high personal net worth. The only money required is $5,000 refundable initial capital commitment. To fuel the kind of growth we desire, we need eager, talented, honest, dependable, people-orientated Operators who are hungry to succeed in the restaurant business.”

“The first question most people ask about our [Operator] agreement is, ‘How could you afford such a generous arrangement with Operators?’ The answer is obvious. We love it when an Operator earns a lot of money because that means we are also earning a lot of money from the restaurant. The more successful we make the Operator, the more successful we are.”

“We are placing our reputation and our future in the hands of one individual. Because we build the Unit and then lease it to the Operator, the ability and the character of the individual are more important than his money.”

“The more we can foster the feeling that we are a group of people working together, depending on each other, and not just bound by a franchise agreement, the more likely we are to be loyal to each other.”

“In my first meeting with a potential Operator, I explain that our commitment is going to be like a marriage, with no consideration given to divorce. We’re much more careful about selecting Operators when we know we cant easily get rid of them.”

“Our lifelong commitment to the success and well-being of Operators has resulted in loyal Operators who then experience tremendous loyalty from their team members - and, in turn, their customers - especially when compared to the rest of the quick-service restaurant business.”

“We have created this ‘loyalty effect’ at Chick-fil-A through a unique relationship with our Operators.”

“The Operator is the CEO, manager, president, and treasurer of his or her own business. I haven’t changed the basic agreement with Operators since my first Chick-fil-A restaurant opened in 1967.”

“Our Operators work closely with us, but they are the owners of their own business.”

Chick-fil-A - Closed Sunday

“Another key to Operator loyalty lies in our decision to allow each Operator to have only one restaurant… A few Operators believe that because they have trained their staff well, their presence isn’t needed. But I’ve found that team members will always perform better when the Operator is on site.”

“We have a saying around the office, ‘An Operator gets the people he or she deserves to have.’ Good people attract good people.”

“We had our design people spend a lot of time in the field talking with Operators and seeing how they ran their business. Experienced operators know better than anybody how to serve people quickly and efficiently.”

“We screen very carefully our Unit Operators. Therefore, we assign our unit realising that this is the most important decision we make. We can decorate it beautifully and out the best equipment in there are prepare the very best food, but if we don’t have the very best Operator, we have blown the whole thing.”

“Another question we often hear is, ‘Why don’t you offer typical franchises where the franchisee makes a substantial investment?’ The answer is similar to my answer regarding a public offering, and can be found in our needs. A restaurant company needs two things to succeed, capital and talent. Franchise restaurant corporations raise capital by selling the rights - usually for hundreds of thousands of dollars - to open a restaurant to people who have already succeeded in business and are looking for a good investment. Sometimes the franchise owner will work directly in the restaurant, but most of the ones I have met are looking to own several units from which they draw income. They aren’t interested in actually wearing a uniform and serving customers. Restaurant magazines are full of articles discussing franchisees blaming franchisers for their lack of success, when the problem is their own lack of time in the restaurant.”

Commitment

“I want everyone at Chick-fil-A to know that we don’t build and open restaurants just so we can close them if they don’t work out. We must be careful about how we build them, where we put them, and who we put in there to run them. Anybody can open a restaurant. All it takes is money. But keeping one open is what makes the difference.”

Family

“We felt like a family, and in many cases we actually had family members working together.”

“When we have team members working together like a family, they extend that feeling to their customers.”

“When Paul Richards was a manager of the Dwarf House [S Truett Cathy’s first restaurant], he mailed out about four hundred birthday cards with handwritten notes to customers every year. He visited them when they were sick and sent food when there was an illness or death. Customers knew we cared. That’s really the key: caring.”

Take Risks & Accept Contrarian Views

“We don’t want to scare people into thinking they can’t take any risk or push limits of their responsibility, or we’ll end up with a bunch of timid Operators. We encourage people to think and to experiment under reasonable circumstances.”

“I want people who work with me to feel completely relaxed when they take a viewpoint opposite mine. I respect their opinions - I would not have hired them if I didn’t - and I want them to feel my acceptance and appreciation for them when we disagree. When you have a dynamic atmosphere, you never know where great ideas will come from. They just come.”

“We prosper by debating ideas and voicing our opinions.”

“Ideas for new products come from Operators, staff members, and customer surveys… We introduce new products only after letting our customers try it out in test conditions in a few restaurants throughout the change.”

Appearances

Source: Chick-fil-A

“Customers can choose from many places to eat. They are quick to pick the most appealing restaurant, the the appearance of the people who work in it can affect such decisions favourable or unfavourably.”

“We concentrate on making sure the back of the restaurant is manicured nicely. Our drive-thru customers spend a lot of time back there, and if they see that area is clean and pleasant, they can be assured that everything is clean inside as well.”

Humility & Tone from the Top

“Everyone from the Operator to the newest hire must be willing to do any job in the restaurant: prepare food, wash dishes, mop floors, clean restrooms. I was the janitor at the Dwarf House, and it’s still my job to pick up paper on the floor, or whatever else needs attention.”

“When top executives demonstrate that they don’t mind doing the dirty jobs, team members understand that every job is important.”

Incentives

“Each year Chick-fil-A brings all our Operators and their spouses together for a business seminar in an exotic resort complex. Through Chick-fil-A’s ‘Symbol of Success’ program we give a new car to an Operator to use for one year if sales in his or her unit increase by 40% or more in one year. If that Operator shows at least a 40% increase the second year, he or she gets the title to the car. We awarded forty-six in 1984 alone. Other incentive awards for Operators include trips, merchandise and cash bonuses.”

Consistency

“I tell our Operators at Chick-fil-A Units today: Consistency is one of the most important aspects of the food business. You can even build your business on bad coffee as long as your’e consistent. Customers are very sensitive to change.”

“We hope customers visiting anywhere in the country know the Chick-fil-A Chicken Sandwich they order will taste just like the ones they eat back home. Few things are more important that consistency in the food business.”

Word of Mouth & Retaining Customers

“Word of mouth in the food business is more important than any other source of advertising. It’s better to maintain your present customers than to spend a lot of time and expense replacing them with new ones.”

Imitate

“Business often remained on my front burner even when we were traveling on family trips… We made lots of stops along the way. Whenever I saw a fast-food restaurant I hadn’t visited, I stopped, went in, and observed their operations, taking away ideas on what was or wasn’t working.”

Evolve & Adapt

“Many successful people I know set magnificent goals for themselves, then let nothing stand in the way of their achievement. I don’t engage in that kind of long-range planning. Instead, I leave myself and our company available to take advantage of opportunities as they arise.”

Frugal

“Some people think I’m a penny pincher today, but when you grow up in a family and in a time where every dollar must be stretched as far as it will go, you learn to watch where your money goes.”

Managing Growth

“To succeed we knew we had to start small and grow slowly. This is where so many start-up companies today make their mistake. Dreamers dream big, and they want to reach their goals quickly. There’s nothing wrong with big dreams. But my experience tells me that we’re more likely to reach our dreams if we climb with care and caution, putting one foot in front of the other.”

Source: Chick-fil-A

“In all my years in the restaurant business, I have tried never to overextend. I’m satisfied stepping from one plateau to the next, making sure we’re doing every thing right before moving on. Financial experts tell me our strength would allow us to open restaurants at a much more aggressive pace than our current seventy per year. But I’d rather have seventy restaurants operating efficiently and professionally than 500 restaurants where half are run well and the others are not.”

“The most common reason companies fail, I believe, is their desire to grow faster than they can manage. This can be particularly true with companies that make a public offering and find themselves staring at a pile of money. All they want to do is grow. But you have to digest growth as you go.”

Debt

“New units are built from the profits of Chick-fil-A. We try not to go into debt to expand.”

“Companies may set goals, and if all goes according to plan everything works out well. But if they have extended themselves to the limits of their finances and their talent, even a slight economic downturn can force them to lay off employees to salvage the company. You don’t build a good reputation by discharging people, but rather by developing people.”

“I am conservative in the amount of money I will borrow to build a new restaurant. I also prefer to own the real estate under our restaurants rather than to lease. The initial investment is greater, but when the loan is repaid, the advantage is clear.”

Private Company

“Chick-fil-A is now one of the largest privately owned restaurant companies in the country. Many others have achieved our size by offering ownership in their companies to the public. We have resisted and will continue to resist that status.”

“In the early years we did not offer stock for sale because I could not predict how fast the company might grow or what dividends we might pay to anyone who might invest. Additionally, I’m afraid the directors, if we had a bad year, might tell me I’m old fashioned and fire me. Too often, Wall Street analysts are more interested in profits than they are in principles and people.”

“Our system puts the cash in the hands of the Operators today, instead of sometime down the road with a lump sum, and encourages them to earn all they can, save all they can, and give all they can right now. Their focus is on today’s customer.”

“Stanley Marcus, retired chairman of Neiman Marcus, said, ‘A public corporation concentrates on profits while a private company concentrates on its people’. By operating one of the country’s largest privately held restaurant chains, Chick-fil-A has been able to do a lot of things that would not be allowed by others in the industry. For example, as a public company, we could not easily give away brand-new Lincoln automobiles, sponsor annual business seminars in posh resorts, offer $1,000 scholarships to our young people, or help support Winshape Centre and Berry College, to name a few projects.”

Letter from Warren Buffett

Community Engagement & Ecosystem

“Our people contribute to their community in ways they could not if they were associated with any other company. They feel a sense of significance.”

“Another key to success in our little corner of the world is community involvement. If somebody calls and asks for something, we give them something. And if churches and schools don’t call us, we call them, and make the offer.”

“It seems the more we give to our community, the more customers support us.”

“The pure and simple bottom line at Chick-fil-A is a commitment to people, and that’s the staff, operators, crew, and the public. From the outset we wanted to have a positive influence on all who came in contact with Chick-fil-A.”

Summary

Today’s business landscape is changing at the fastest rate in history. Technology advancements have disrupted businesses and competitive moats have been filled like never before. Yet, there are some things that haven’t changed and likely won’t. Customers will always enjoy exceptional service and they’ll reciprocate, it’s human nature.

Almost forty years ago, the research underlying Tom Peters’ book, ‘In Search of Excellence’ found, ‘The intensity of customer orientation that exists within top performing companies seems to be one of the best kept secrets in American business.’ Warren Buffett’s exposure to countless businesses across a multitude of different industries has made him conscious of the value in delighting customers, “Don’t just satisfy your customers – delight them .. Anybody who has happy customers is likely to have a pretty good future.” It’s little surprise Buffett expressed an interest in acquiring Chick-fil-A [see letter above].

When it comes to finding great businesses, being able to filter out the noise and identify the key variables that won’t change is hugely valuable. The same ingredients that have delivered Chick-fil-A success for more than 70 years, are likely to deliver success in the future. When ‘delighting the customer’ defines a business’ culture, the results can be extraordinary. That’s how S. Cathy Truett did it.

Sources:
“How did you do it Truett?” S Truett Cathy, 2007.
“Eat Mor' Chikin - Doing Business the Chick-fil-A Way,’ S.Truett Cathy, 2002.
“It’s Easier to Succeed Than to Fail,” S.Truett Cathy, 1989.

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Lights Out - Learning from GE

MastersInvest has spent a lot of time studying businesses and business leaders that have been successful, some remarkably so. Those companies that have forged not only stellar reputations in their fields, but also those who have succeeded in industries where success is not a common commodity. And whilst a solid working knowledge of these success stories is vital for any investor to know, its also incredibly valuable to look at the other side of the coin - those businesses that have failed.

Warren Buffett and Charlie Munger have long espoused the benefits of studying failure. Armed with the foresight of what not to do can help an investor avoid the key risk to any investment program - the permanent loss of capital. With this insight in mind, and having read a short synopsis in Bill Gates Summer Reading List, I looked forward to reading the book, ‘Lights Out - Pride, Delusion and the Fall of General Electric’ by Ted Mann and Thomas Gryta. An easy read, the book details the multitude of problems which beset GE coupled with a cornucopia of red flags to look out for in your own investments.

“I like to study failure… we want to see what has caused businesses to go bad." Warren Buffett

Once a storied industrial leader, the last few decades have been nothing short of brutal for GE. While a toxic culture of ‘making the numbers’ seemed ingrained at the time Jack Welch handed the reigns to Jeff Immelt, Immelt’s sixteen year term atop GE earned him a scathing review. Characterised with an incessant focus on the share price, always coveting Wall Street’s admiration, ignorant of tail risks, obstructive to feedback, turning a blind eye to questionable accounting and an absence of humility were the hallmarks of a failed leadership tenure. If the expression, ‘an institution is the lengthened shadow of one man’ rings true, this isn’t a book for Immelt’s trophy cabinet.

Gates Notes - ‘5 Ideas for Summer Reading’ 2021

Perhaps unsurprisingly, the company’s travails were strikingly at odds with the traits that have defined the great businesses we’ve reviewed in the past. Below I’ve called out some red flags and accompanying lessons from GE. Notwithstanding the accounting misconduct, most of the tell-tale signs of trouble are qualitative and behavioural in nature.

S&P500 [grey] vs General Electric [blue] Normalised - 2000 - 2021 [Source: Bloomberg]

Financials Above Purpose

In the superb book, ‘In Search of Excellence,’ Tom Peters noted, “We found that companies whose only articulated goals were financial did not do nearly as well financially as companies that had broader sets of values.”

“The Growth Playbook [was] a grueling annual examination of GE’s eight major business leaders. It was here that GE hammered out targets for sales and profits, setting the underlying assumptions for the financial estimates it would give investors. Under Immelt, the point of the exercise was determining how his executives would get to their financial targets - though not how they would determine what output the business would produce as a starting point. This practice had been ingrained at GE from the days of Welch.” Lights Out

“The problems stemmed not from any single action but from the practices of accountants on staff at the dozen or so plants in the division. They’d reported their numbers by working backward: starting with a profit target and then working out what their sales figures would have to show to get there, rather than simply running the business and reporting their results to headquarters every three months.” Lights Out

The best business leaders have long recognised a company’s share price is a function of long term business performance. Solve for the latter, and in time, the share price will look after itself. At GE the financials dictated strategy.

“Investors and executives need to realise that the creation of shareholder value is an outcome — not an objective.” Terry Smith

“Stock price is an outcome. You can’t manage the outcome. You manage the inputs.” James Gorman

“We want corporate management to solve for value creation, not security price.” Dan Loeb

“Companies that focus on their stock price will eventually lose their customers. Companies that focus on their customers will eventually boost their stock price. This is simple, but forgotten by countless managers.” Morgan Housel

“When it comes to discussing a company’s strategy, it is alarming how frequently one finds confusion about what a strategy actually is. Often a CEO mistakes a short-term target, say an earnings per share target or a return on capital threshold, with a strategy.” Marathon Asset Management

“Some would claim that maximising profits is a business’s ultimate purpose. Yet it is often when companies become exclusively profit orientated – and explicitly define this as their objective - that things go wrong. The end result of what investors seek, good shareholder returns, is invariably better achieved obliquely.” Nick Train

“An annual report with a numbers obsession speaks volumes about what’s important.” Marianne Jennings

Jeff Immelt’s strategy was directed with reference to the share price; providing guidance, smoothing earnings, setting optimistic long term EPS targets, undertaking acquisitions and divestments to appease Wall Street, appealing to big investors and ‘making the numbers’ regardless of cost. All are misguided short cuts.

Focus on Share Price

Of all the books on great businesses I’ve read, I can’t recall one where a company’s share price featured so prominently. Great businesses are all about empowering people, innovating, delighting customers, tolerating mistakes, focusing on the long term, upholding values, embracing change and remaining humble, to name but a few - none of which rated barely a mention.

“The stock market didn’t appreciate what GE was really worth. And it was driving Jeff Immelt crazy. His handlers claimed that he didn’t watch the daily movement in the shares, but his actions betrayed him. The stock market was the ultimate scoreboard tracking his performance.” Lights Out

“‘The stock is currently trading at one of the lowest earnings multiples in a decade,’ Immelt wrote in his annual letter to investors in early 2006. ‘Investors decide the stock price, but we love the way GE is positioned. We know it is time to go big!’ he wrote.” Lights Out

“Always aware of the stock’s reflection on his leadership, Immelt was trapped in a waking nightmare.” Lights Out

“GE’s stock price and its miserable performance were a constant cloud over Immelt’s head.” Lights Out

A management’s obsession with their share price is often a tell for investors; as recognised by some of the world’s best.

“Today, it seems to be regarded as the duty of CEOs to make the stock go up. This leads to all sorts of foolish behaviour.” Charlie Munger

“[The managers we have owned] don’t have a screen in their office showing them the price of their stock. And lots of them do. Sometimes you find it in the lobby of a company and sometimes you find it on the CEO’s desk. That doesn’t interest us. Their focus is on the wrong thing, in our judgement.” Chuck Akre

“We’ve been suspicious of companies that place a whole lot of emphasis on the price of their stock. When we see the price of a stock posted in the lobby of the headquarters or something, things like that make us nervous.” Warren Buffett

“A worrying sign is a CEO with a subscription to Bloomberg as this may indicate an unhealthy interest in stock prices and short-term news flow to the detriment of long-term thinking.” Marathon Asset Management

Quarterly Earnings

The best investors have a long-term orientation, focused on where a business might be in three to five years or more, rather than next quarter’s result. GE spent their time trying to please short-term investors.

“We do not worry about the stock price in the short run, and we do not worry about quarterly earnings. Our mindset is that we consistently build the company — if you do the right things, the stock price will take care of itself.” Jamie Dimon

“The investor wanting maximum results should favour companies with a truly long-range outlook concerning profits.” Phil Fisher

“We really think that an undue focus on quarterly earnings, not only is probably a bad idea for investors, but we think it’s a terrible idea for managers. If I had told our managers that we would earn three dollars and 17 1/2 cents for the quarter, you know, they might do a little fudging in order to make sure that we actually came out at that number.” Warren Buffett

Business Results Aren’t Linear

Smart investors recognise the business environment and economy are not conducive to a perfect earnings trajectory. GE failed to understand this, deploying unethical and in some case illegal short cuts to deliver.

“GE executives have acknowledged that they worked to make sure earnings were growing in a nice smooth trajectory.” Lights Out

“When Fortune’s Carol Loomis once told Welch that the smoothing practice was terrible, he vehemently disagreed with her. ‘What investor would want to buy a conglomerate like GE unless its earnings were predictable?” Lights Out

“The concept of managing earnings, another wonderful numbers term that infiltrates the numbers-pressure culture that leads to ethical collapse. It’s not cooking the books, it is managing earnings. A numbers obsession finds employees and officers not managing strategically but manipulating numbers for results.” Marianne Jennings

“Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no surprise environment, and earnings simply don't advance smoothly. Charlie and I not only don't know today what our businesses will earn next year we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future and we become downright incredulous if they consistently reach their declared targets, Managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.” Warren Buffett

“Businesses do not meet expectations quarter after quarter and year after year. It just isn’t in the nature of running businesses. And, in our view, people that predict precisely what the future will be are either kidding investors, or they’re kidding themselves, or they’re kidding both.” Warren Buffett

Promoting the Stock

“In the [2015] annual letter, Immelt wrapped up his lecture on the limitless superlatives of GE with an awkward plea to major institutional investors.. ‘We have delivered for you in the last five years. But we are still under-owned by big investors. In this time of uncertainty, why not GE?’ he wrote, like a heartbroken lover begging for reconciliation. ‘We have a ton of cash that can protect you,’ he added.” Lights Out

“[At the annual Electrical Products Group conference for industrial investors and executives] Immelt, as he had done before, argued that investors had GE all wrong and were mispricing a stock that should have been above $30 a share.” Lights Out

“We suspect that business leaders who are busy promoting themselves or their stock are not properly focused on running their companies. We go out of our way to look for management that cares about shareholder value but doesn't hype its stock.” Marathon Asset Management

“People who have a proclivity for announcing how valuable their stock is, are I think, people who you ought to be very cautious of.” Warren Buffett

Fancy Predictions

“As the [2016] year came to an end, Immelt planted a flag that would define the rest of his career: he declared that GE would produce at least $2 of profit per share in 2018. It was an unusually long-term projection, and its meaning was undeniable to Immelt.” Lights Out

“It was wishful thinking at best that GE could deliver the $2 of earnings Immelt had promised.” Lights Out

“Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic – but others will turn out to be congenital optimists, or even charlatans. Unfortunately, it’s not easy for investors to know in advance which species they are dealing with.” Warren Buffett

Candor and Bad News

“Faced with the prospect of telling their tempestuous CEO that the new product was a disaster, the managers chose another route. They massaged the numbers.” Lights Out

“There was no market for hard truths or bad news. Not as far as the guy at the top was concerned.” Lights Out

“It was better to figure out a better way to deliver the bad news, or make it go away somehow, than to present it to Immelt straight.” Lights Out

Great businesses are tolerant of mistakes. Great Leadership recognises businesses grow through trial and error. When problems aren’t addressed they fester and the eventual impact on a business can be disastrous.

“Almost every business has problems, and we’d just as soon the manager would tell us about them. We would like that in the businesses we run. In fact, one of the things, we give very little advice to our managers, but one thing we always do say is to tell us the bad news immediately. And I don’t see why that isn’t good advice for the manager of a public company. Over time, you know, I’m positive it’s the best policy.” Warren Buffett

“Bad news concealed over time doesn’t get any better. See those studies again: companies with the most candid disclosures in their financial statements perform better over the long term and have higher share prices.Companies that put their current positions and performance right out there for investors and analysts to study are the companies to put your money in.” Marianne Jennings

A Culture of Making the Numbers

“The pressure to perform inside GE is omnipresent, and missed goals can be fatal, a tradition true at all levels of the company.” Lights Out

“Management expectation about the sales growth and profit they should be able to hit didn’t reflect the dim reality of the market, team members told Steve Bolze [CEO GE Power] and Paul McElhinney, the head of the unit that administers the service contracts. Vocal complaints about management’s view diverging from the reality of the market, or from basic math, were common among lower level Power executives. When the concerns were raised to leaders like McElhinney, they were stopped cold... ‘Get on board,’ McElhinney said. ‘We have to make the numbers.’” Lights Out

“When Immelt took over the Plastics operation, the previous management hadn’t been playing it straight. Under pressure from Welch, the division had stretched to make the numbers, including misreporting inventory figures to reduce the cost of goods sold.” Lights Out

“Welch would argue that he pushed his underlings to produce results, not fraud. But even if the CEO didn’t bend the rules himself, Welch cultivated an environment of pressure that incentivised people to do just that.” Lights Out

“If you couldn’t do the job and hit your targets, they all knew, Jack Welch would get someone else who could.” Lights Out

“Jeff Immelt’s assignment was clear: keep the earnings machine of GE humming steadily along, as it had under Welch.” Lights Out

“GE regularly leaned on [GE Capital] to make sure that profits stayed steady.” Lights Out

“Few fates were worse than missing your numbers at GE. Executives assigned targets to underlings, rather than lower-rung workers passing information up the ladder, so projections were based on market realities.” Lights Out

“Salespeople relied on financing provided by the stub of GE capital to prop up customer demand.” Lights Out

Marianne Jennings wonderful book, ‘The Seven Signs of Ethical Collapse - How to Spot Moral Meltdowns in Companies... Before It's Too Late’ cites ‘Pressure to Maintain Those Numbers’ as the number one sign of ethical collapse; “All companies experience pressure to maintain solid performance. The tension between ethics and the bottom line will al-ways be present. Indeed, such pressure motivates us and keeps us working and striving. But in this first sign of a culture at risk for ethical collapse, there is not just a focus on numbers and results but an unreasonable and unrealistic obsession with meeting quantitative goals. ‘Meet those numbers!’ is the mantra.”

“Charlie and I have been around the culture, sometimes on the board, where the ego of the CEO became very involved in meeting predictions which were impossible and everybody in the organisation knew, because they were very public about it, what these predictions were and they knew that their CEO was going to look bad if they weren’t met. And that can lead to a lot of bad things. You get enough bad things, anyway, but setting up a system that either exerts financial or psychological pressure on the people around you to do things that they probably really don’t even want to do, in order to avoid disappointing you, that’s a terrible mistake. And, you know, we’ll try to avoid it.” Warren Buffett

“We really believe in the power of incentives. And there’s these hidden incentives that we try to avoid. One we have seen more than once, is when really decent people misbehave because they felt that there was a loyalty to their CEO to present certain numbers, to deliver certain numbers, because the CEO went out and made a lot of forecasts about what the company would earn. I’ve seen a lot of misbehaviour that actually doesn’t profit anybody financially, but it’s been done merely because they don’t want to make the CEO look bad, in terms of his forecast.” Warren Buffett

“You really have to be very careful in the messages you send as a CEO. If you tell your managers you never want to disappoint Wall Street, and you want to report X per share, you may find that they start fudging figures to protect your predictions. And we try to avoid all that kind of behaviour at Berkshire. We’ve just seen too much trouble with it.” Warren Buffett

If a culture is broken and toxic the best advice is to steer clear. It’s almost impossible to turn around a poor culture.

“You can’t buy a company that’s got a dishonest culture and turn it into an honest culture." Bradley Jacobs

Cost Cutting

“The Corporate cost cutting program [was'] called ‘Simplification.’ That program had zeroed in on worker pensions and retiree health insurance as a good place to tighten the company belt.” Lights Out

'Whenever I read about some company undertaking a cost-cutting program, I know it's not a company that really knows what costs are all about. Spurts don't work in this area. The really good manager does not wake up in the morning and say, 'This is the day I'm going to cut costs,' any more than he wakes up and decides to practice breathing.'' Warren Buffett 

“You can’t cut a company to greatness.” Charles Schwab

“Almost every firm engages in bouts of cost cutting. Exceptional firms, however are involved in a permanent revolution against unnecessary expenses.” Marathon Asset Management

Losing Your Competitive Position

“If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors. Charlie is fond of quoting Ben Franklin’s ‘An ounce of prevention is worth a pound of cure.’ But sometimes no amount of cure will overcome the mistakes of the past.” Warren Buffett

“Companies which underinvest in their franchise in order to meet short term targets are not good candidates for compounding wealth.” Terry Smith

Accounting Irregularities

Pressure from the top to hit numbers coupled with an unwarranted focus on the share price, can tempt employees to fudge the numbers. Once again, Marianne Jennings observed, ‘A declining stock price can cause bizarre accounting behaviour. The drive for numbers, number, numbers can take us right to the slippery slope and into ethical collapse.”

“GE Power had sold service guarantees to many of its customers that extended out for decades. By tweaking its estimate of the future cost of fulfilling those contracts, it could boost its profits as needed.” Lights Out

“These reviews [of GE’s service contracts] produced profits that GE could use to hit targets for Wall Street, but they were really future profits, produced by accounting adjustments alone. There was no actual cash coming in… [They] can be red flags to investors… To pad the hole, GE now began selling its receivables - bills its customers owed over time - to GE Capital in order to generate short-term cashflow, making it appear that those newfound profits were matched by cash flowing in the door.” Lights Out

“The SEC concluded its investigations into GE accounting practices, having found multiple instances of misbehaviour in the pursuit of financial targets. The company had overstated its earnings by hundreds of millions of dollars and stretched the accounting rules to their breaking point.” Lights Out

“The SEC described [GE as] a company that lied to investors in its regulatory filings and in its public statements, that ignored growing risks, and that worked to keep those risks hidden.” Lights Out

“Over the years, Charlie and I have seen all sorts of bad corporate behaviour, both accounting and operational, induced by the desire of management to meet Wall Street expectations.” Warren Buffett

Hitting Guidance

“What starts as an ‘innocent’ fudge in order to not disappoint “the Street” – say, trade-loading at quarter-end, turning a blind eye to rising insurance losses, or drawing down a “cookie-jar” reserve – can become the first step toward full-fledged fraud. Playing with the numbers ‘just this once’ may well be the CEO’s intent; it’s seldom the end result. And if it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalise similar behaviour.” Warren Buffett

Acquisitions & Divestments

Immelt wanted to appease Wall Street and convince them to place a higher multiple on the stock. Historically GE had enjoyed a premium valuation providing the currency for accretive acquisitions. As GE Capital grew, a complex finance business within an industrial company, Wall Street applied a lower multiple. Immelt believed shrinking GE Capital would fix the problem.

“GE could use its unusually high price-to-earnings ratio for an industrial company as high-value currency to pay for deals. By acquiring companies with a lower price-to-earnings ratio, GE was getting an automatic earnings boost.” Lights Out

“Immelt needed to make moves that would finally impress upon Wall Street that he had found a way to lead the old GE into a new economic paradigm.” Lights Out

Capital Management

“GE had been sending cash out the door to repurchase its stock but wasn’t bringing in enough cash from its regular operations to cover its dividend.” Lights Out

“Buybacks were a regular fixture under Immelt, who spent more than $108 billion on them after 2004. At the end of 2018, GE’s entire market value was $67 billion.” Lights Out

Group Think

“The oversight role of the board was minimal.” Lights Out

“The board, made up of current and retired business executives and academics, as a group, liked Immelt and didn’t want to challenge him.” Lights Out

“Top GE executives, including Immelt, would say that they never heard any serious dissent about the Alstom deal.” Lights Out

“The absence of robust opposition [to the Alstom deal] also pointed to the broader problem, long cultivated and growing into a quiet crisis within the company of real candor and self-awareness. When it had come time for lower levels of management to stand up to the ultimate boss and tell him that his legacy play wasn’t going to work - and in fact, had been a clumsy mistake all along - no-one was willing to do so.” Lights Out

“Vice Chair John Krenecki, insiders said, had been forced out by Immelt, in part because he had already seemed a little too prone to disagreeing with the CEO or telling him no.” Lights Out

“GE’s board of directors was unquestionably weakened from having the CEO as the chairman of the Board.” Lights Out

“While Immelt said he encouraged debate, [Board] meetings often lacked critical questioning.” Lights Out

“The seventeen independent directors got a mix of cash, stock, and other perks worth more than $300,000 a year.” Lights Out

“[Board] directors rarely challenged Immelt.” Lights Out

“The [Board] directors had amassed impressive titles in their own career and in many cases undeniable achievement. They had resumes a yard long, most of them had personal fortunes, and they were presumed in all company to have unusually astute minds for business - not least because each one was a highly compensated director of GE. And yet, on their fiduciary watch, with whatever caveats about individual misjudgement and macroeconomic trends, they had done nothing to stop one of the world’s most solid industrial companies from lunging off a commercial cliff.” Lights Out

“Sycophants are the enablers of ethical collapse. Fear and silence are the enemies of an ethical culture.” Marianne Jennings

“If you arrange your organisation so that you basically have a bunch of sycophants who are cloaked in titles, you are going to leave your prior conclusions intact, and you’re going to get whatever you go in with your biases wanting. And the board is not going to be much of a check on that. I’ve seen very, very few boards that can stand up to the CEO on something that’s important to the CEO and just say, you know, ‘You’re not going to get it.’” Warren Buffett

Complexity

“Inside GE’s legendary management machine was a complex mechanism that used [GE Capital’s] deals to help the company meet its profit goals.” Lights Out

“GE Capital was always a problem. It was utterly complex and filled with risk, and its tentacles reached everywhere in the company.” Lights Out

“[The financial services] balance sheets were treacherously complex, and deep risks lurked there and were not always easily spotted in the quarterly profits and losses.” Lights Out

“[GE Capital was] essentially operating a high-powered hedge fund.” Lights Out

“Where you have complexity, by nature you can have fraud and mistakes.. This will always be true of financial companies. If you want accurate numbers from financial companies, you’re in the wrong world.” Charlie Munger

Cyclical Industries

GE ventured into the highly cyclical oil business with optimistic forecasts, little experience and no margin of safety.

“GE was going big into the oil business.” Lights Out

“Now GE became, in a series of high-dollar acquisitions, a player in the oil and gas equipment market virtually overnight.” Lights Out

“While Immelt heard, and was annoyed by, the chirping of some analysts who felt he’d paid a premium to leap into the oil and gas industry several years after his competitors, the company’s leadership was sure that the ensuing years would show the bet payoff.” Lights Out

“GE’s ‘base case’ assumption for all of the rosy pictures it was painting about its oil unit was $100 for a barrel of oil. Brent crude had closed out the previous month at more than $105 a barrel, only a little off its summer peak.” Lights Out

“Afloat on fracking profits during an oil boom, Lufkin had caught GE’s eye and been swallowed up at an expensive price, only to become a casualty when the conglomerate couldn’t abide the hit to earnings that a prolonged dip in the price of oil represented.” Lights Out

Insurance Tail Risks

“Everyone - reporters, analysts, investors - thought that the company had sold the insurance business long ago, significantly de-risking GE Capital. In often highlighting this point, Immelt and his top executives hadn’t minced words: GE was out of insurance.” Lights Out

“The core problem was that GE had made some bad decisions in reinsuring the long-term care policies.” Lights Out

“GE needed $15 billion to cover its liability.” Lights Out

"Virtually all surprises in insurance are unpleasant ones." Warren Buffett

“You can make big mistakes in insurance… You can make mistakes in something like insurance reserving, big time.” Warren Buffett

Bigger than Life CEO

Jeff Immelt almost personified the ‘bigger-than-life’ CEO. It’s a characterisation Marianne Jennings identified as another red flag for investors.

“Immelt knew the power of his influence, and he wasn’t above calling these subordinates [below the divisional heads] to make sure they knew the stakes and urge them to hit their targets.” Lights Out

“The structural component that fuels fear and silence and numbers pressure is the presence of an iconic CEO who is adored by the community, media, and just about anyone at a distance.” Marianne Jennings

Humility & Tone from the Top

“Immelt was required by the board to use only the company’s planes and was barred from flying commercial.” Lights Out

“Immelt, his good cheer notwithstanding, was not interested in hearing his judgement questioned. ‘My job is to make the company perform,’ Immelt told a newspaper reporter, ‘and my job is to make sure that nobody defines this company other than me.” Lights Out

“[Owning GE Capital meant] Immelt enjoyed having the accompanying seat at the table with Wall Street power players.” Lights Out

“Owning NBC gave Immelt and Welch access to red carpets.” Lights Out

“It had taken two corporate jets to take Jeff Immelt around the world. For much of his career [Immelt] often had an empty jet follow his GE-owned Bombardier or Gulfstream to far-flung destinations, just in case there was a mechanical issue that could lead to delays.” Lights Out

“No effort was spared by the staff to ensure that meeting venues were cooled to meat-locker temperatures to accommodate Immelt’s preference, irrespective of whether anyone had ever heard him make such a demand out loud.” Lights Out

“Was a CEO supposed to object that the temperature was not to his liking, or demand that elevators were always open and waiting for him? Or that the cold diet sodas he liked were always present on a sideboard when he entered a room, no matter how far-flung the visit or conference room he walked into?” Lights Out

“But GE has stood for well-bred hubris as well. Under Immelt, the company believed that the will to hit a target could supersede the math, even when hundred of thousands of livelihoods - those of investors, customers, and suppliers, to say nothing of workers, retirees, and their families - hung in the balance." Lights Out

Smart Investors

The emergence of a smart investor on the register is no panacea for investment success. Activist investor Nelson Peltz’s fund emerged with a $2.5 billion stake in 2015. Even the great investors make mistakes.

“Trian’s endorsement was the stamp of approval that Immelt thought would help others realise the full legitimacy of GE’s expected turnaround.” Lights Out

“In every great stock market disaster or fraud, there is always one or two great investors invested in the thing all the way down. Enron, dot-com, banks, always ‘smart guys’ involved all the way down.” Jim Chanos

Summary

The ‘pressure to maintain those numbers’, a culture of ‘fear and silence’, a bigger-than-life CEO, and a weak board conspired against the investors of General Electric; red flags that stand firmly in the qualitative camp, not to be found in a spreadsheet.

These misdeeds aren’t unique or new to investing. After more than two decades of research and observation, Marianne Jennings identified each of them in her book, ‘The Seven Signs of Ethical Collapse.’ They didn’t go amiss at Berkshire either, given Munger and Buffett’s astute understanding of human behaviour.

History is littered with similar corporate disasters to GE. They serve as a warning for analysts, investors, portfolio managers, boards and CEO’s alike; Forewarned is forearmed. Understanding those qualitative tools that may suggest not all’s right with a company might help you ‘keep the lights on,’ when the next GE turns up.

“I think that many CEOs get carried away into folly. They haven’t studied the past models of disaster enough and they’re not risk-averse enough.” Charlie Munger

Source:
“Lights Out - Pride, Delusion and the Fall of General Electric,” by Ted Mann and Thomas Gryta, Mariner Books, 2020.

Further Suggested Reading:
“The Ten Commandments of Business Failure,” Investment Masters Class, 2016.
“The Seven Signs of Ethical Collapse - How to Spot Moral Meltdowns in Companies... Before It's Too Late,” Marianne Jennings, MacMillan, 2006.
“Avoiding Group Think,” Investment Masters Class, 2016.

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Learning from Estée Lauder's Leonard Lauder

‘Paris, the Eiffel Tower, Estée Lauder.’

Kind of rolls off the tongue doesn’t it? Now try this one: ‘Esther Lauter, Brooklyn, Business Fanatic.’ While the former conjures up images of glamour and beauty, the latter does so less, and is rather the story of one woman’s unrelenting drive and obsession to create a luxury brand renowned the world over.

From the start, Estée recognised the psychological benefits of a name that sounded feminine and vaguely European, distinctive but elegant, and easy to pronounce and remember. She settled on her baby nickname ‘Estee’ and added an accent mark to make it a little French while softening the hard German Lauter to a more amorous Lauder.

I recently enjoyed reading ‘The Company I keep - My Life in Beauty,’ the story of one family’s journey to the top of the world’s cosmetic and beauty stage. The story is told by Estée’s son Leonard who joined the company in 1958 when it was still a fledging mom-and-pop company, with less than $1m in revenue and product distribution limited to just a small handful of prestige specialty stores. In time, Estée’s creativity, intelligence and fanaticism combined with Leonard’s business acumen and acquisition prowess created the powerhouses that are The Estée Lauder Companies today.

The Lauder’s were applying a repertoire of ‘influencing’ tools long before Charlie Munger’s favourite psychologist, Robert Cialdini, identified them in his bestselling book of a similar name. A Clinique beauty expert dressed in a lab coat and armed with the ‘Clinique computer’ would trigger the power of authority; free samples and gifts would engage the reciprocation tendency; Saks 5th Avenue provided the requisite social proof; glamorous models and compliments from the beauty counter initiated the liking disposition; while limited distribution created a sense of scarcity.

“The [Clinique] beauty experts exuded exactly the right combination of scientific authority and style.”

Two of my favourite takeaways from the book were Leonard’s insights into the creation and evolution of prestige brands and their delicate relationship with distribution channels and his ‘modus operandi’ of ensuring constant competition within the business. The book is brimming with business lessons; the need for patience; the danger of becoming a prisoner of the P/E ratio, staying under the radar, the value of a diverse workforce, setting the tone from the top, and the benefits of ‘walking the floor’ to name but a few.

There’s a plethora of mental models you’ll recognise from many of the other great businesses we’ve studied. Hopefully there’s one or two new ones you can add to your own investing toolkit. Below you’ll find some of my favourites.

Estée Lauder vs SP500 1995-2021 [Source: Bloomberg]

Family

“The company and I grew up together, our lives as closely paired as twins. It has always been more than a family company: it was - and continues to be - my family.”

“My mother strongly believed in ‘family’ as a powerful asset, and she was right. There's a lot of research comparing the sustainability and profitability of family companies whether the family is in control or "just" works there, to non-family companies. Because of their sense of stewardship, the family companies tend to be more profitable and more sustainable in the long run.”

“Family for me is not limited to my blood relatives; the concept extends to all of our employees at The Estée Lauder Companies. We make a big effort to make everyone in the company feel part of the Estée Lauder family.”

“It’s been said that there are two things that can destroy a family business: the family and the business, and they both have to be kept in order.”

Culture

“Seeing how Revson [Revlon CEO] treated some of his top executives pointed me in a direction that I think always worked out for us. You can make a nice place to work and still make money.”

Quality

“I learned early that being a perfectionist and providing quality was the only way to do business.”

“My mother was a stickler for quality. Quality was, to use a modern term, a differentiator.”

“Never skimp on quality; put your heart and soul into producing the best-quality products to present to your public. Don’t let anyone talk you out of it.”

Reciprocation

“My mother had discovered what she called ‘The sales technique of the century’: free samples.”

‘A Gift for You’ - Estée Lauder advert 1989

“A free sample was the basis on which Estée Lauder was built.”

“‘I visited the sales personal in the dress department, the hat department, the shoe department, as well as other cosmetic departments,’ she [Estée Lauder] later wrote. ‘To each saleswoman, I brought a gift of my makeup or cream, exactly what I’d be giving away to customers as they claimed their free gifts they’d been promised in advertisements. ‘I learned the merchandising method of inducing the whole store to speak for my products,’ she concluded. ‘The point was to keep placing the products in the public eye, keep devising new ways of capturing the consumer’s attention.’”

“The giveaways created an opportunity to exercise the high-touch Estée Lauder sales approach, encourage spontaneous buying, increase loyalty among existing customers, and bring in new ones.”

Value Employees

“If you respect the people that work for you, they will respect you.”

“As time went on, I made a habit of writing once a year to everyone who worked behind the counter, expressing my recognition of and gratitude for their hard work. I’d write individual notes - not ‘Dear Everyone’ form letters - and I’d sign each one. As the company grew, I had to resort to dictation, but each letter was personalised - and each one signed by me.”

“I firmly believe that people don’t work only for money. They work for recognition.”

“Find a way to congratulate someone for a job well done. Even if your note is just a little one-liner, when you say ‘thank you for doing a good job,’ it’s more likely the recipient will go to the ends of the earth for you.”

“When we went public in 1995, I persuaded all the members of the Lauder family to carve out a portion of their personal stock and give it as a gift to the employees of Estée Lauder. It wasn't enough to enable everyone to splurge on a yacht, but it was enough to make each person feel that we were all in this together.”

Ideas

“I’m a big believer in what I call ‘lateral creativity’ - getting ideas from everywhere.”

Competitive Advantage

“My mother didn’t realise it at the time, but her insistence on personally training saleswomen would be a key differentiator when she eventually opened counters in department stores.”

“My parents didn’t have the capital to create even one such salon, let alone a chain of salons that could compete against Miss Arden and Madame. Instead, my mother hones in on a different platform to reach her customers: select specialty stores.”

“My mother instinctively knew that a brand is defined by its distribution. If we were sold in Saks Fifth Avenue, then we had made it. How to get Estée Lauder products into Saks was the main topic of dinner conversation every night.”

Estée Lauder / Saks Fifth Avenue

“At Estée Lauder, everything was and still is about training. It’s one of our key differentiators from our competitors. Training is all about teaching people that they can achieve anything if they know what to do and how to do it and giving them the confidence to do it well.”

Competitive Strategy - Avoid Competitors

“Backing into the fragrance market through bath oils taught me another lesson. Our non-threatening strategy enabled Estée Lauder to stay below the radar of major competition. French perfume manufacturers scoffed, saying, ‘We don’t do bath oils.’ Meanwhile, sales of Youth Dew skyrocketed. I learned the importance of choosing my battles - and not to dismiss a competitor just because they seem innocuous.”

“The lesson my mother drummed into me: Everyone is a competitor or a potential competitor. You can’t ignore anyone.”

Change

“In 1960, there were 4,500 malls accounting for 14 percent of retail sales. By 1975, there would be 16,400 shopping centres scooping up 33 percent of retail sales… We owned the suburban stores. First to market always wins.”

Economic Resilience

‘My mother was onto something: even in 1933, one of the worst years of the Depression, cosmetic sales were higher than they had been before the crash.”

Compete with Yourself

“I learned a valuable lesson [running two film clubs at college]: you can compete with yourself and win. It was a lesson that, a decade later, would spawn Clinique and would eventually inform the thinking behind The Estée Lauder Companies’ portfolio of brands.”

“Instead of waiting to see what our rivals might dream up and then respond, wouldn’t it be better for us to leapfrog them and create our own competitor first? A multi-brand model for Estée Lauder had always been in my mind. I thought, ‘I know just what I’d do if I were competing with Estée Lauder. Why let a competitor do it? I’ll do it.”

“Clinique wasn’t just a new line of skin-care or makeup: it was an entirely new way of thinking about beauty.”

“In retrospect, the Clinique and Estée Lauder brands both competed and complemented each other. Clinique was the ‘anti-cosmetic,’ so wherever Estée Lauder sold well, Clinique didn’t. And where Estée Lauder lagged, Clinique did well.”

Clinique's first computer, launched in 1968, was used to determine skin type and deliver personalised results.

“I created Clinique specifically to compete with Estée Lauder. Competing against myself is an idea that never grows old. Who was going to compete with M.A.C? The answer, unquestionably, was Bobbi Brown Cosmetics. [When we acquired] Bobbi Brown it was the perfect counterbalance to M.A.C.”

“Creating our own competition both brings about something and prevents something. What I was trying to bring about was becoming the market leader, and we’ve done that: we are the largest supplier of prestige cosmetics in the world and we are the dominant player in almost every prestige market, largely because of that strategy. Second, I knew that a brand can’t live forever. I had seen older brands, which were once market leaders fade away. People would come up to me and say, ‘Oh, Estée Lauder, my grandmother loves your products.’ If they said, ‘My daughter loves your products,’ I’d be thrilled. But ‘my grandmother?’ Not as great. So we kept on acquiring companies or launching our own competitors so that as new consumers came into the market, they would discover their own newer brands and they would make them theirs.”

Humility

“Being a waiter was a good experience because I believe you have to do grunt work in order to appreciate the big things.”

Patience

“It didn’t happen overnight. The sampling and Gift-with-Purchase programs were like planting an accord. They didn’t really bear fruit for another year, and only then did Youth Dew [fragrance] itself start to take off. This would be a valuable lesson in patience that I would apply to subsequent fragrance launches.”

“We took a bath before Clinique started paying off… just six months after the launch of Clinique, our cashflow problem had become a crisis.”

Brands

“The navy also taught me about strategy. The aircraft carrier was always accompanied by several destroyers, which served as a screen for the large ship. I would use that analogy in business: The small brands would protect the main brand. Clinique was the first screen for the Estée Lauder aircraft carrier, followed by Origins and Prescriptives. Later, the brands we acquired for the The Estée Lauder Companies’ portfolio would support the heritage brands.”

“My dream was to make Estée Lauder the General Motors of the beauty business, with multiple brands, multiple product lines, and multinational distribution.”

‘In 1956 Estée Lauder advertising proudly lists price at an unprecedented $115 a jar’ Source: Estée Lauder Companies

“[Launching in Europe] we deliberately chose a different approach: Re-Nutriv, the most expensive cream in the world… [Treatment] creams were unabashedly expensive - and that was one of their selling points. Estée Lauder led this rarefied club.. Not only was it a terrific product; it had one of the most brilliant positioning statements we’ve ever made: the most expensive cream in the world… it was the positioning, not the ingredients, that propelled its success.”

“I wanted Estée Lauder to be the most upmarket brand there was. I wanted to have limited distribution so that every store that was selling our product knew that the person they were selling to could only come back to them; conversely, the person who was buying revelled in the exclusivity of where she bought it. That’s how you build a great brand and a great business.”

“I knew that out products had to be the highest quality, unique, creative, original, and, of course, efficacious. The Lauder brand would be synonymous with luxury, and Re-Nutriv would be the epitome and standard-bearer of luxury products.”

“We wanted to sell our products in high-end specialty stores because their prestige gave us prestige.”

“Positioning a brand says, “This is who we are.” I’ve seen too many companies fail by trying to reposition a brand. Know who you are and stick to it. Enhance your brand but don’t reposition it.”

“Up until then, every cosmetic ad was designed to sell a product. I decided that rather than selling only a product, our ads would sell the brand.. All our advertising would be orientated toward the brand. Focusing on the brand would hone our identity and be our North Star. Marketing a brand gives you more pricing power. If a product is a musical instrument, a brand is the entire orchestra.”

“The launch of Clinique was a classic case of leveraging market segmentation. Looking back, this was probably the most important lesson I learned in my career: if you understood market segmentation, you understood everything.”

“Its well known in our industry that when customers like one product from one brand, they’re willing to try - and maybe buy - other products. Fragrance, in other words, broadened the profit stream for the entire Estée Lauder brand.”

“Fragrance became an intrinsic part of the all-round concept of being an Estée Lauder woman. Our fragrance advertising sold romance and prestige. You can’t sell romance with an anti-wrinkle cream.”

“A few years earlier, I had retained Harvard Business School professor Michael Porter to consult on the future of Estée Lauder. His advice: ‘Never get stuck in the middle.’ If you’re in the middle you’re nowhere. You’re neither value line nor the prestige line, so what are you?”

“Brands have their own DNA and don't always follow the story you script for them. It’s like when a child is born: you think she's going to become a doctor and she decides instead to become an astronaut or an actor. We thought [with Prescriptives] we were launching another treatment line - another anti-Lauder line, a’la Clinique—but that morphed into a cosmetics/colour line driven by the Calyx fragrance.”

“I had an epiphany: I realised we needed new brands to understudy our existing brands as well as to fill in the gaps and expand the company as a whole. We needed to launch or acquire competitors so that as newer consumers came into the market, they could discover new brands and make them their own.”

“Creating a new brand that really is new is very difficult to do. It’s even more difficult to do from inside an established organisation. Outsiders are all about blowing up conventions: ‘I’ve got to beat the old guys.’ People inside the organisation, however, hesitate: ‘Let’s be careful in creating something new, so we don’t destroy what we have.’ Playing it safe sabotages boldness.”

“I’m a risk taker and I always have been. In order to survive, you have to take chances. But I don’t believe you should destroy the old before building the new, you’ll have no ground to build on. Brands need to change to stay relevant. Consumers are constantly evolving in ways you can’t even imagine.”

“As I saw it, acquiring brands was - and remains - a great way to expand our customer base. In order to grow, we needed to acquire not just new brands but new thinking. The best way to acquire new thinking was to acquire a company with the founders, who could then, with our help, drive their original creation to new heights.”

“There’s nothing more high-touch that a freestanding store, no better way to protect the brand and control the customer experience.”

Autonomy

“M.A.C Cosmetics would have an organisation all of its own, from top to bottom. They would be able to create their own world without anyone saying, ‘You can’t do that.’ There wouldn’t be any naysayers around.”

Distribution

“One of our most important epiphanies was, ‘You’re defined by your distribution.’ For us, that meant luxury department and specialty stores, pure and simple.”

“You’re known as much by where you don’t sell as by where you do sell.”

“I’ve said it a thousand times: you’re defined by your distribution. If you’re in luxury, stay in the luxury segment. Don’t be bewitched by the volume that can be gleaned by selling in a distribution channel that does not match the equity of your brand.”

“In the prestige sector, no brand is strong enough to withstand over-distribution. Distribution is forever.”

“Financial analysts always praise ‘distribution expansion.’ But without realising it, they’re encouraging slow death because over-distribution kills a luxury brand. Over-distribution certainly killed the Prescriptives stores. And that is especially poignant, because over-distribution went against everything we stood for. We had become a prisoner of our P/E.”

Growth

“I decided to focus on growth: growth of market share and rate of growth. America loves growth. Growth is a story that gets people excited.”

Keep it Simple

“Our formula was simple; limited distribution in prestige specialty and department stores accompanied by the personal touch of a beauty advisor.”

Hiring & Firing

“[The Navy taught me the greatest lesson of my life…] no matter how smart you think you are, there’s always someone who’s smarter. No matter how good you are, there’s always someone better. I vowed that when I got out of the Navy and went into business, I would search out and hire exactly those people. So if they were the head of sales, they would sell better than me. If they were a copywriter, they would write better copy. They all had to be better. I would respect and celebrate their abilities and never be threatened by them. This belief would play an enormous role in the growth of Estée Lauder and help us build a company of the greatest people in the world.”

“Don’t hire your best friend and don’t hire former classmates. In short, don’t hire people that you can’t fire. Friendship is friendship but business is business.”

“My father had a saying when he had to fire someone: ‘Better a sharp pain in the end than pain without end.’ If you’re having trouble with a person who looks like they will not be able to improve, it’s better to help them to leave than to suffer with them. There is a point beyond which patience becomes neglect, Fail fast. Cut your losses.”

“Everyone in the world has worth. If you cannot get someone to produce for you in a satisfactory manner, it is almost always your fault and you should acknowledge that, honestly and with respect. When I have to fire someone, I’ll say to them, ‘It’s really not your fault, it’s our fault." We probably didn’t train you right, we didn’t supervise you well, we didn’t work with you properly, and we didn’t put you in the job most suited to your talents. The reason I’m asking you to leave is not because you are no good. It’s because we’re not good enough to be able to use the great talents you have.”

Win-Win

“During our promotions the first floor of the stores reported sales increases well over 100 percent. Thanks to limited distribution, the stores got a fantastic return on investment.”

“The intimacy of our relationship with our stores was crucial to our growth... It’s often said that you can only be as good as the people who work for you want you to be. I would add, we could only be as good as the people we are selling to want us to be, too. Our message: ‘Support Estée Lauder and you support your store.’ To enable them to support us, we supported them with a lot of work behind the scenes. Each store was given an annual program, broken down month by month, of what we would do to improve our business - and theirs.”

“We’d always had a partnership with our stores: more than a partnership, the stores were part of the extended Estée Lauder family.”

Diversity / Women

“Almost the entire Clinique leadership team was composed of women. (Over the years, when Clinique was run by women, its P&L was always higher than any of our other P&L’s). This was the secret sauce. In fact, I would turn it into a management formula. Every time I set up a new international office, I always wanted to have two people in charge: a man and a woman.”

“Our great strength has derived from the fact that from the beginning, we had women giving women the products and knowledge to make themselves feel beautiful, as opposed to Charles Revson [Revlon] telling women that he, as a man, knew what would make women desirable to men. Today, this is what is called ‘mirroring’ the market.”

“The last thing you want is a team of mini-mes. Difference - whether it’s a different background, different ethnicity, age, or different gender - is a source of strength.”

Committees

“I never relied on a committee for a final decision. Committees are the death of creativity and productivity.”

Mistakes

“Never be afraid to admit you’ve made a mistake. It shows you’re human and people will respect you more.”

Market Share / Private Company

“I never, ever forgot that once you've lost market share, you can't get it back again so easily. And I was always going to protect our market share, no matter how much it cost. As a private company, we had a huge advantage over our publicly held rivals: we could spend years nursing along a new brand or spending to gather market share because we didn't have to answer to our shareholders.”

“We were always contrarian. When the competition tightened its budget, we increased ours: we doubled down to protect out market share.”

“It would have been difficult to sustain the flexibility that nurtured Clinique and Origins if we had shareholders demanding a steady stream of profits and growth. The hard fact is, I don’t think we would have been able to maintain either brand if we had been a public company.”

“Getting ahead of the curve also means imaging and preparing for what might go wrong. Don’t wait for bad things to happen to you. Don’t wait to defend your market share. Fight for every percentage point while you’re growing because by the time you lose it, it will be too expensive to get it back.”

Frugality

“My wife liked to regale people with stories of my frugality. For example, I couldn’t understand why she had to take a taxi to visit stores in Brooklyn. ‘Why can’t you take the subway?’ I’d gripe. Anyway, because our overhead was so low, we could afford to use - in fact, we could insist on using - expensive ingredients.”

“I am the legendary Scrooge-in-Chief.”

Instinct

“As I established my place at Estée Lauder, I learned the most important lesson that would shape my career and life inside and outside the company: to trust my instincts. Instinct is something that is natural and ingrained: however, instinct has its foundation in experience. If you have enough experience, somewhere along the line, instinct will kick in. If we’re making a decision to buy a company, my experience helps me connect the dots faster and see bellwethers others might not. Then my instinct will take over and make the decision.”

First to Market

“First to market always wins.”

“My dream was to put our stake in the ground. We had a once-in-a-lifetime opportunity: to be the first brand of prestige cosmetics in what could become an enormous market. Deep in my gut, I knew that Europe was ready for Estée Lauder.”

Clinique Computer (Source: Estée Lauder Companies)

“Launch first, launch strong, and stay strong: it worked for us then and continues to work for us today.”

“Whenever possible, we created product lines that would open new market segments where Estée Lauder would be first.”

“My radar was honed for overlooked demographics. That led to the 1963 launch of Aramis, the first prestige men’s fragrance and the cornerstone of a collection of men’s grooming aids.”

“When you launch first, you have no competition to sweep aside. You automatically become the authority.”

“We became the first prestige brand to advertise on television.”

“Our objective was to have at least 33 percent of our business each year be totally new products.”

Walk the Floor

“Listen to and learn from people on the ground. They’re the ones who really know what’s going on.”

“It taught me a valuable lesson: to listen to our customers and the people who worked behind the counter. They were my consumer research. And it was free.”

“One of the most rewarding - and certainly one of my favourite - activities in helping build the Estée Lauder business was visiting our stores. These visits had several objectives. The first was to listen to our consultants and buyers and learn what was really going on. The second was to let the people in the trenches know that their work was recognised and appreciated, and inspire them to do better. The third was to send a message to everyone who worked for us that store visits were an important thing to do.”

“Retailers in the ‘mass business’ call these ‘store checks.’ However, I don’t consider these visits check-ups. They are a learning tool for management and a motivational tool for everyone.”

“If you study military history, you'll find that the most effective leaders are those who engage with their troops on the eve of battle: Henry V speaking to his ‘band of brothers’ before Agincourt; Vice Admiral Horatio Nelson signalling the British fleet that ‘England expects every man to do his duty" as the Battle of Trafalgar commenced; General Dwight D. Eisenhower shaking the hands of the paratroopers before they jumped on D-Day. We at Estée Lauder were fighting a war on two fronts—our ‘class’ competitors in prestige stores and our ‘mass’ rivals elsewhere. We needed to do more than just ‘check the store.’ We needed to learn and inspire our employees, our stores, and ourselves.”

“I’d ask the counter manager questions: What was the best-seller at that particular moment? What were people asking for? What were people liking - and not liking? Which products would she like to see us add to the line?”

“Store visits were deep dives that delivered ideas in droves. I loved those van trips. They were the oil that helped our company run smoothly and built Estée Lauder and Clinique into powerhouse brands.”

“When I visited a store, my job was to connect with people and listen.”

Tone at the Top

“It’s very important for a leader to send the right message through his actions. For example, on one of the van trips I was having breakfast at a swanky hotel with two friends who were art dealers. The discussion drifted to the fact that I would only fly economy. ‘'Economy?’ they asked, shocked that the president of a luxury beauty company would take a seat in the back of the plane. ‘How can you fly only economy?’ I answered, ‘If I'm going to make all our executives fly economy, then I'll fly economy, too.’ That's how we were able to build a fast-growing business without ever having to borrow one dollar from the bank—and they knew it.”

“When I walk through the hall of the company, if I see a piece of paper on the floor, I pick it up. It’s important for employees to see you doing that. Because if you don’t care, why should they?”

Crisis

“Crisis can be a means of fusing the company together. Laughter helped smooth the path through hard times.”

Tactical versus Strategic Mistakes

“When it comes to strategy, you can make tactical mistakes but you cannot afford to make a strategic mistake. What do I mean? A tactical mistake is one that, if you make it today, will only cost you today. A strategic mistake is one that, if you make it today, will cost you tomorrow - and tomorrow and tomorrow.”

Long Term

“I’ve always felt that you can’t deal with the day after tomorrow. You have to deal with the decades after decades. One of the things that made Estée Lauder so successful in my thinking is that we think in decades, not in the short term.”

“We prided ourselves on our patience. My son William likes to use the term ‘patient capital,’ shorthand for how we allocate our resources. Knowing that it often takes years for a new brand to become profitable, we could afford to invest the time and money [when we were a private company] to let a brand grow at its own pace and mature in particular markets.”

“Patient capital enables you to launch for the long term. Some people think that if you introduce a new product today, you need to make money immediately or have to pull the plug. After you’ve been around a while, you know that if the product makes money year one, you can almost guarantee it won’t make money in the future. It’s a flash in the pan. But if you hang in until year three, it will pay off for the long term.”

Invert

“I always work backward to move forward. I start imaging what I want to see happen in three to five or even ten years from now, and then I worked backward to articulate steps I have to take today and tomorrow and next year and the year after.”

IPO

“I felt the price [of the initial public offering] should be modest, so that the aftermarket would see strong growth and give our investors confidence that the company was a good investment.”

Wall Street Journal 1989 (Source: Estée Lauder Companies)

“The scrutiny you face from being in the public eye is a different experience than you've ever had if you've been a privately held, family company. Instead of steering the ship on our own, we'd have to answer to partners. The aims and considerations of outside shareholders are often very different from your own. They tend to eschew the long-term good for the immediate reward of short-term gains.”

“I swore to myself and my colleagues that we would continue to run Estée Lauder as a privately held company: Our decisions would be steered by what was good for either market share, long-term profits, and/or brand equity, rather than what Wall Street wanted.”

Acquisitions

“I think of myself not as a brand buyer but as a brand builder.”

“The first two acquisitions sparked a sea change in my thinking: from then on, I would look to the entrepreneurs to come up with ideas that we couldn't imagine. We would try to enlist and support these new creators, make their operations more efficient, but never change their DNA. In return, we would offer them a chance to expand their company's name and footprint and their life. We could make them and their employees richer and happier.”

“My strategy was to target brands that were either beating us in a particular category or pioneering a new path in the luxury market. I looked for companies that showed a track record and momentum, had an infrastructure that was working, and understood their distribution and how that distribution supported their brand. We could build upon and boost what their founders had started. I avoided big companies with entrenched identities. I wanted small businesses with plenty of room to grow - with our help. I’d rather buy a $1m company and build it to $100m than try push a $100m company to $200m.”

“We only bought companies that already had momentum. Newton's law of inertia says that an object in motion tends to stay in motion. Look for brands and products that are growing; the consumer is giving you millions of dollars of market research that you don't need to purchase.”

“I was never interested in turnarounds. I didn’t have the patience to bring the troubled brand to health, and they were probably in trouble for good reason.”

“We’ve since expanded our portfolio of acquisitions to include more than twenty-five brands. It’s a carefully constructed collection that gives us balance - in the brands we own, in the markets where we do business, and in the diversity a global company needs to protect itself from the ebb and flow of world economies. This balance gives us competitive strength and consumer appeal.”

Summary

The Estée Lauder Companies have survived and thrived in a constantly evolving and intensely competitive industry through empowering and engaging their salespeople, supplementing existing brands with new ones and exercising the patience required for them to succeed. While the business has recognised and engaged many of the psychological tools of influence, long term sustainability comes from pleasing an ever changing customer.

Leonard’s engaging book sheds light on many of the qualitative characteristics we’ve witnessed in the other great businesses we’ve studied; factors that have been creating competitive advantages in companies for decades. When you find a combination, you’ll often see the lollapalooza outcomes; so desired by Charlie Munger.

Many of the timeless lessons espoused by Leonard and his mother will be as relevant tomorrow as they have been through the more than 70 years The Estée Lauder Companies have been thriving in business. Leonard has been generous to share them with us and if we listen, it should allow our investments to harness a beauty of their own.

Source:
‘The Company I Keep - My Life in Beauty,’ Leonard A. Lauder, HarperCollins 2020.
‘Key Moments of History,’ Estée Lauder Companies - website.
'The Estée Story,’ Estée Lauder Companies - website.

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Master Series: David Rolfe

Warren Buffett has long likened compounding to a snowball of sticky snow, and the longer the runway the snowball has to gather that sticky snow, the better. One manager that started rolling that ball a quarter of a century ago, was David Rolfe of Wedgewood Partners. And thanks to the power of compounding that snowball has grown a lot faster than the S&P500, with annual returns of 13.1%pa gross compared to 9.6%pa for S&P500. In part, Wedgewood’s market-beating performance stemmed from a preparedness to embrace technology stocks and challenge traditional value investing heuristics. I was fortunate to chat to David recently where we discussed his strategy, portfolio management, Berkshire and all things investing. I hope you enjoy the insights as much as I did.

Early Career

“The planets aligned for me really early in my career. Wedgewood was founded in 1988 by my current business partner Tony Guerrerio. 1988 was also coincidentally the year that I left the sell-side of the Street. I left PaineWebber in 1987 after being there for about a year and a half out of college. In early 1988, shortly after the crash in 1987, I was very fortunate to get a job as a portfolio manager at a big bank in St. Louis called Centerre Trust, the old First National Bank of St. Louis. Shortly after I joined, they merged with the second largest bank in St. Louis called Boatmen's, and they kept the name Boatmen's. So my CV says Portfolio Manager of Boatmen's Trust.

What's really key to this time period, is that the combined banks did a huge custody business. And pre-internet, it's kind of funny to think about this, we had annual reports, quarterly reports, mutual fund reports, money manager commentaries from the outside money managers that the clients used from the bank; all of that information came in and it was being filed. So my continuing study of the great investors of the day really launched – particularly the focused managers. There's a file of all the old shareholder letters from Mason Hawkins at Southeastern before he launched the Longleaf fund, mutual fund reports from the original gang at Janus – Bailey, Craig and I think Marsico joined them in 1986.  A ton of reports from John Neff’s Windsor fund.  The great writings from George Michaelis at Source Capital. A ton of Mario Gabelli. There were annual reports from Berkshire Hathaway going back into the early 1970’s. We even had the internal corporate reports from the old Templeton Investment Counsel before Franklin bought them in 1992. It was a goldmine!

So in 1988, I became a portfolio manager and what was really fortunate for me at a very young age all of the portfolio managers at Boatmen's Trust, were assigned fully discretionary equity accounts that we could do whatever we wanted with. If you beat the S&P, you got a bonus. It was a one, two and three year rolling metric, audited by the old Arthur Andersen. I did pretty good those four years beating the S&P 500 in three of those. So our current focused strategy was born back in early 1988 and I have been on the performance clock ever since going on 33 years.

I did that for almost four years until I heard through the grapevine at a meeting of the CFA Society of St. Louis that this investment firm out in St. Louis County, had a founding CIO who was leaving. And so with track record in hand, at the ripe old age of 30 and I knew all the mysteries of the stock market at the age of 30 [laughs], I met my partner, my then boss, Tony Guerrerio.

My predecessor, God bless him, he passed away recently, what a great guy. He was very nice to me. He was older than Tony, he retired. Wedgewood only had $10 million or so under management. The other side of the business, a discount brokerage like Quick & Reilly or Schwab that kept the lights on. So literally as the new CIO I had a whiteboard to start the investment management side of Wedgewood. And I've been doing the same thing ever since 1992.”

Wedgewood Team

“There’s just four of us on the Team – but if I may brag on the crew, a highly productive crew. Tony Guerrerio, Michael Quigley and Chris Jersan and I make up the team. Tony’s primary role is as portfolio manager for our older private family relationships that go as far back prior to Tony founding Wedgewood Partners in 1988. Michael Quigley has been with Wedgewood since interning in high school. He is an ‘old,’ very experienced forty year-old since he has been on the team since 2006. Chris Jersan joined Wedgewood in 2016. Chris has extensive investment experience as both analyst and portfolio management since entering the business in 1998. Michael, Chris and I wear the CFA hats. We are all analysts and portfolio managers – essentially generalists. Given that our focused portfolio typically contains just 20 stocks I want the entire team to have a ‘career-ownership stake’ in the entire portfolio. As CIO I have veto power. The culture of the team is one of intense collaboration on security analysis and portfolio management. Key too is making fewer but more impactful decisions, plus making sure there aren’t too many cooks in the kitchen.”    

Mental Frameworks

“Every successful active manager has a competitive edge. And it must be repeatable. Focus is our edge. We have layered in a synthesis of the classic tenets of both growth company and value investing. Specifically, we want to own a select list of companies that are competitively advantaged earning high returns on capital, but also have the ability to reinvest a healthy portion of retained earnings at continued high rates of capital. We then try to have patience to buy at intelligent valuations. Rinse and repeat. But not too often.  Our annual portfolio turnover is typically between 20 to 25%.

We embrace the founding philosophical thoughts and wisdom from the greats like Warren Buffett, Charlie Munger, Benjamin Graham, Charlie Ellis, Sir John Templeton and such, plus the focused greats of our era. Price is what you pay, value is what you get rings true with everything we do here at Wedgewood.”

Tech Investing

“Investing in ‘technology’ stocks has evolved over the years. Particularly in the so-called capital ‘V’ value crowd. I think some of these mental frameworks like circle of competence and moats and all these other Buffett, Munger type of attributes of how you should think and act are wonderful, but sometimes I think maybe people take them to extremes.

It wasn't that long ago the value investing mindset was ‘there's no such thing as value in tech, period. Technology stocks don’t have ‘moats.’  You don't know what the business models are going to look like, so how can you even estimate five or ten years out’. Only a rare specialist will possess a ‘circle of competence’ investing in tech.   

When you think back to Buffett's early aversion to tech, you've got to go back in time. Buffett made that great call to shut down his partnership in '68 and he has talked often about the conglomerates which all blew up back then. Of course there was the '73, '74 brutal market decline – really a long, slow-motion crash. But before that I think maybe a little bit less known, which I can't help but think had a significant impact on Buffett, was the tech crash of 1968 through 1970. Stocks like NCR, EDS, Control Data, Mohawk Data, that were largely hardware tech, which back in the day wasn't so much personal computing, it was tech for businesses fell 70 to 80%. It was cyclical, it was cutting edge CapEx and as the economy headed into a little bit of a recession the first thing that probably gets cut is this new tech stuff, ‘let's cut the orders for IBM, et cetera’. Even the ‘blue-chip’ tech stocks got smoked.  Texas Instruments, IBM, General Instruments, Polaroid, Xerox.  Of course the ‘Too Many Fred’ conglomerates like Litton, LTV, Levin-Townsend and Kidde literally vanished.

If you think back to the fact of how much tech was really hardware, enterprise hardware before software. And even with Microsoft in the early days of software, it was kind of boom-bust, you didn't have this subscription stuff. You would buy software and you'd get your floppy disk and then when the company came out with their new improved version a year and a half later, they did everything they could to get you to buy that. So, I get all of the elements of tech is hard to figure out, but maybe in terms of evolution, tech has evolved. Tech is very different these days and tech has vastly more consumer discretionary and non-discretionary attributes.

But for the longest time, too many in the value crowd said, ‘If Buffett can’t figure out tech, then who am I to even try?’ It became a crutch.

Well, fast forward today, and much has changed. ‘Tech’ has become quite common place across the investment style spectrum. Heck, even notable ‘deep value’ guru Seth Klarman at Baupost currently has big positions in both Facebook and Google. Even Buffett took a swing at IBM building a $14 billion position in the stock by 2015. His IBM position was notable still for being, at the time, his largest equity position by cost ever – even eclipsing his $13 billion, 500 million cost stake in Wells Fargo. IBM was a bust for him, but not to be deterred, he immediately started building a mammoth position in Apple. His cost in Apple peaked in 2018 at $36 billion.  

Speaking of Apple, we first invested in Apple in '05. It wasn't that long ago obviously that Apple was mainly hardware and some software and people viewed it as classic hardware tech, maybe a bit consumer discretionary tech. It really wasn't doing much enterprise business. Then all of a sudden, the iPod appears and boom, then here comes the iPhone and the evolution of Apple to a consumer staple began in earnest. Heck, the early iPods and iPhones were always at my kid's heads. To my kids, it wasn't even discretion, it was a utility. Sauerkraut and asparagus are discretionary to my children (laughs). So Apple's a great example I think of how tech has morphed, and next thing you know, Buffett has a multi-billion dollar position in Apple, you know, the guy who swore off technology.

I'm 59 now. I'm lucky that I got started at a pretty young age, but someone who's a portfolio manager today at a so-called value fund, if they want to call themselves that, and they're 35 or 40, I’m not sure they have any hesitancy to invest in tech, like my early generation did. It's been interesting to see how tech has evolved. In the very early days automobiles were ‘tech,’ look at say Progressive, what would Progressive’s business model look like today if they didn't whole heartily embrace tech – particularly telematics? Heck, advanced telematics is now table stakes in auto insurance.”

Evolution as an Investor

“Where we have evolved, and I think every investor has had to evolve is the Fed’s growing influence in financial markets, even back to the infamous Greenspan Put back in the late 1980’s. Back in the day the phrase ‘Don’t Fight the Fed’ was stamped on rookies’ foreheads on the first day in investing boot camp. We can thank Marty Zweig for those pearls of wisdom.  When one looks back on the DotCom boom/bust and the housing boom/bust and today with QE Infinity, it seems that the Fed has become both the arsonist and the fireman. Prior to say 2012, before central bankers barked ‘do whatever it takes’ to today’s yield control, when interest rates were allowed to find more free-market based levels, if a business was growing at say 12%, then the max P/E one might pay would be a high-teen multiple, certainly no more than say 22X unless it was a truly exceptional company. Fast forward today, 35 to 40X is the new 22X in the zero. It’s not the ‘Powell Put’ any longer, it’s become the ‘Powell Trampoline’.

And so what we've done over the last number of years is we have not been as steadfast to sell a stock outright because of valuations, we've been slower to trim it and conversely pay up a bit and build positions more slowly too. That said, we’ve maintained the discipline to sell even the best of businesses when valuations get absurd. Such was the case of our sale on NVIDIA last September.

When you look at the current valuation of our portfolio, if somebody were to have a crystal ball and they were to show me today the valuation, say, on a trailing or forward basis, if you would show me what the valuation is today, say, 10 years ago, certainly 15 years ago, I would have thought I’d gone mad.

But I think that's been a rational, intelligent adjustment to make. Let's face it, growth companies tend to be longer duration assets. Interest rates get lower, the valuation gets higher. We've learned or adjusted to the environment.  Of course, the catch is that we all know if Powell & Company announce on morning, ‘no more QE’ we all know what would happen to the stock market. It would be October 19th, 1987, The Sequel.”

Debt Levels

“If you look at a median or weighted average calculation of the debt of the companies that we own, it's never been higher than it is today over the past, since we’ve been doing this since 1992, but it hasn't been excessive. If debt capital is the cheapest capital, use it. If your equity is the cheapest, use it. Look at how successful Apple has been, borrowing super cheap money to buy back cheap enough stock to enhance their earnings per share. But Apple is the exception. Most C-Suites are terrible at capital allocation and dreadful at value-destroying share buybacks.” 

Holding Great Business Through Thick And Thin

“I need to have a page in our pitch book on the top 10 worst investment decisions at Wedgewood Partners in our 29-year history. And the one thing they all have in common, it's not necessarily valuation, it's we didn't understand how good and how resilient the business model was. We owned Home Depot for quite a while and we thought there were some problems, and there were for a few quarters or so, but we didn't get back in. Medtronic, same type of thing, Microsoft, Intuitive Surgical and United Healthcare and Amazon and Analog Devices and Apple Materials! I will admit to you, one of the hardest things when you're managing public money is on the one hand you have to take the long- term view, but you've got this quarterly score card, yearly scorecard, and I'd be less than honest if it hasn't affected us from time to time. When I think of the money that we left on the table in some of these stocks, it would have ... well, the numbers would have been even better.”

Banks As Growth Companies

“We've never invested in what I would call really deep cyclical companies like a Caterpillar or a John Deere, but in times past we have invested in more economically sensitive businesses like banks. That said, but only banks that are considerably superior to their peers. Years past we have owned the old Norwest, then Wells Fargo; the old Cherry Hill, New Jersey based Commerce Bancorp, U.S. Bancorp and MTB Bank. We own First Republic right now. If you look at their growth numbers, if you didn't know what they did, and you just looked at their numbers your jaw would be drop once you found out it’s a bank. They are incredible operators. An amazing franchise.”

New Ideas and Studying 13F’s

“Myself and our team, we're always digging up new names. Always looking for that emerging diamond in the rough. One of the areas that we are constantly on the lookout for are growing mid cap companies that are doing really well. On their way to becoming a large cap stock. The minimum market cap that we would consider is $10 to $15 billion. So part and parcel of our research bench are those smaller companies that are breaking into the large cap area that we can own.

Another area we're always looking at the competitors of the stocks we currently own. Years ago we owned Intel for a long time, from that we became familiar with Micron Technology. While that didn't work out for us that well, from that experience, we came across Linear Technology, which is probably one the greatest business models I've ever seen, particularly for a semiconductor company. Linear’s voodoo analog design engineers were the 1927 Yankees.

The last area we look at is that we study 13F’s. There's a lot of smart people in this business, very smart people and I keep a watch list of many investment firms that I respect and I'm always curious to see their 13F’s, It keeps you honest and humble. And so ideas can come from a lot of different areas, but those are the big ones.”

Position Sizing

“Over the last couple of years we haven’t had much chance to swing large on new portfolio positions. We usually initiate a position at two, two and a half, maybe three percent in the hopes that we can continue to build it. Typically, we're trying to buy companies when maybe the industry's out of favor or maybe the company has hiccuped a little bit and we want to get in at decent valuation and hope to own more. So in a 20 stock portfolio in our minds, a 5% weighting is average, 7%, 8%, 9% is large. We won't own anything over 10%. And then anything under 4% is considered on the smaller side.

Very key as a focus investor all of our stocks in the portfolio have a higher weighting than the weighting in a style benchmark or the S&P 500. It's high conviction focus, high active share so why waste time with tiny positions that are either benchmark weight or too small to move the performance needle. What's challenging for a lot of managers is the likes of Apple, Microsoft and Amazon are so gigantic, unless you run a focused portfolio, even if it's one of your top holdings, chances are it's just a benchmark weight. In the Russell 1000 growth, I think the top six stocks are 40% of the benchmark.”

Focused Investing - Diversify by Business Model

“We contend focused investing doesn't have to be risky if you stick with higher quality companies, however, we think a more intelligent way to diversify is to diversify by business model. So obviously Progressive has nothing to doing with Apple in terms of their business model. We're not going to own four or five semiconductor companies, we're not going to own four or five medical device companies. We've been a long-term investor in Visa. We've never owned MasterCard at the same time, because our thinking is those business models - there are some differences on the debit side of things - but they're alike enough that if something goes wrong with Mastercard it is unlikely that Visa escapes unharmed. So the last thing we want in our portfolio is when we make our inevitable mistakes, we don't want pin action in other parts of the portfolio.”

Stock Sell-Offs

“I've got plenty of scars too when we haven't gotten it right. I remember one of the early ones, when I joined Wedgewood, I guess it was Spring of 1993. ‘Marlboro Friday’, when Philip Morris came out on a Friday morning and said, ‘We've got to cut prices, we're losing market share to some of our competitors.’ It wasn't really an expensive stock at that time, but the next trade it's down 25%. Wall Street is pretty good of ripping the band-aid off. Rooting for a stock to go down runs against the grain, but some of those opportunities in hindsight have been wonderful. Again, it's going to hurt near term in a 20 stock portfolio, but when we can take a 5% holding that gets banged up someday, now it's a 3.5% weighting, and we can make it a 7% weighting and then we're right after that, when we look back on that difficulty that day or that week, when stocks blow up like that on a hiccup, it's not a fatal hiccup, but the valuation is pricey, the damage gets done pretty quick.”

Now, the ones that really hurt is where the business model has gone terribly wrong and oftentimes it could be fraud. Back in the day, we owned WorldCom, we got out when the cash flow statements started to look a little bit goofy, but we didn’t suspect fraud. Same thing with Lucent Technologies. If management wants to cook the books eventually it comes out. But those are episodes that you have to deal with. Fortunately, we've got scars, but they haven't put that dagger in our heart.

The thing that I probably admire the most are individuals who have been doing this for a long, long time, because without fail, they've all been hit by stock blow-ups and dusted themselves right off. Think of that book by Philip Carret, ‘A Money Mind at 90’, I mean, are you kidding me? I hope they pull me out of my office in a pine box when I'm 90, that's awesome. I don't care what profession you're in, if you can write a book on what you've done when you're at 90 years of age and you're still doing it, well, how cool is that?”

Berkshire Hathaway

“We sold our Berkshire Hathaway stock in 2019 after owning the stock in size since January 1999. We sold a third of our position in late May 2019 and the rest soon after in early August. All told, Berkshire stock gained about 370% over those +20 years.  The gain in the S&P 500 was about 235%. Investing in Berkshire and attending many annual meetings was a further education beyond reading and studying Mr. Buffett and Mr. Munger. A highlight of my career. The stock was terrific for our clients. 

On the first trim of Berkshire, we bought shares in Motorola Solutions (MSI). Since then (mid-May), Berkshire stock is slightly ahead of MSI, gaining about 44% versus 41% for MSI. After more buys of MSI, the stock today is our 3rd largest holding. The final sale of Berkshire really moved the needle for us. With those sale proceeds we increased our long-held position in Alphabet (GOOGL) by almost two-thirds to an 8% weighting and initiated a new position in NVIDIA (NVDA). Since then (as of mid-May again) GOOGL has gained about 90%, double that of Berkshire. GOOGL is currently our largest position at 9.6%. NVIDIA would turn out to be a moonshot. Over the course of the NVDA position we added to our original position once, trimmed twice and sold the stock in early September 2020. On the final sale of NVDA, the stock outperformed Berkshire over our holding period 215% versus 4%. Finally, we rolled the last NVDA sale proceeds into a new position in First Republic Bank (FRC). Since that purchase, FRC has gained about 67% and Berkshire Hathaway stock has gained about 39%.

Our sale thesis on Berkshire Hathaway was three-fold. First, too many capital allocation miscues. In a world of Fed-induced zero cost of capital, plus untold billions in private equity, Berkshire has long been at a competitive disadvantage in bagging gazelles and elephants. Compounding this problem, Mr. Buffett refuses to compete in investment banker-led buyout auctions and his disdain for leverage, typically a good thing, has all but rendered Mr. Buffett to, well, play solitaire while deal-making booms around he and Mr. Munger. Quite frankly, the phone rings more for the lonely Maytag repairman than it does in Omaha these days. Relatedly, we had long, long been an advocate for Buffett & Co. to cool the elephant hunting and bag the elephant in their backyard Omaha Zoo – Berkshire shares themselves (laughs). 

Capital allocation miscues, well, they've starting to add up - Precision Castparts, Kraft Heinz, Lubrizol, IBM and Wells Fargo.  On the equity portfolio let’s give credit where credit is due. Berkshire’s huge position in Apple was a terrific purchase and in elephant size as well. It really moved the needle. However, the lack of omission in the equity portfolio in large holdings of ‘Buffett-esque’ circle of competence stocks like Mastercard, Visa, Alphabet, Costco and Microsoft are head-scratchers. I understand Mr. Buffett’s reasoning on Miscrosoft that he didn’t want to take advantage of his friendship with Bill Gates, but that doesn’t square with his long friendship with Tom Murphy, key in delivering Mr. Buffett’s 1980’s-1990’s ABC/CapCities/Disney/GEICO masterstroke.  

The fact that Mr. Buffett looks like he has called off elephant hunting in lieu of buying back Berkshire stocks also reduces another related risk, that of complexity. At what point does a huge conglomerate become too big, too complex for Greg Abel to effectively manage? The supposed good news for shareholders after years of conglomeration are the seven or eight Fortune 500 sized companies within Berkshire. The bad news on this conglomeration is that Greg Abel is ultimately responsible that they are all managed well.  Tall order.  

I get the idea of ‘management by abdication’ long espoused by Mr. Buffett and Mr. Munger, but perhaps a little less abdication and a little more, what?, usurpation?, may have kept BNSF from underperforming Union Pacific, or GEICO underperforming Progressive. And speaking of GEICO, it’s been a year and a half since portfolio manager Todd Combs was named CEO of GEICO. I may be mistaken, but I thought Combs was to be a temporary CEO.  

The second part is the deteriorating quality of too many businesses within the Berkshire conglomerate, particularly in their MSR (Manufacturing, Service and Retailing) division. Outside of the recent addition of Clayton Homes in this segment, it is easy to conjecture that this group barely earns its cost of capital. We would know for sure if Mr. Buffett would provide a balance sheet for this segment. That said, the other key parts of the conglomerate are better than the average business. Again, BNSF is good, but under-performing Union Pacific. GEICO's is good, but underperforming Progressive. Berkshire Energy is fantastic, particularly on the tax credit side and their continued policy of reinvesting all of their earnings – quite unlike other large utilities. But here's the rub, you don't need Berkshire Hathaway or Mr. Buffett to get the ‘best of Berkshire.’ Who doesn’t own Apple these days? Instead of GEICO you can get Progressive on your own. Instead of Burlington Northern you can get Union Pacific on your own.  Replacing Berkshire Energy would be difficult because they're reinvesting in all their earnings, they don't pay a dividend and they have all of these tax credits. In a tax-exempt account, you can maybe buy a utility ETF and reinvest the dividends as a replacement proxy of Berkshire Energy.

The third, quite honestly, I think as the years go by now, there's significant management risk, succession risk. Mr. Buffett’s and Mr. Munger’s cognitive abilities and stamina continues to amaze, but unfortunately Father Time won’t be denied.  

Maybe one last thought on Mr. Buffett; I've have the greatest respect for Mr. Buffett.  I wouldn’t be in this business since 1986 without him as a guiding light. Mr. Buffett chooses his words carefully, both spoken and written. And I've certainly noticed, it's been remarked by many others too, it wasn't long ago, a few years ago, where he stated at annual meetings, essentially, ‘We think we have a collection of businesses that should do better against the S&P 500.’ Those words are gone. More recently the verbiage was ‘Maybe we'll keep pace with the S&P 500.’  Those words seem to be gone too. Even after the strong run of Berkshire stock versus the market since last June, the stock is still considerably behind the S&P 500 over the past three and five years. There's probably less downside in the stock relative to the S&P 500, maybe. But quite frankly, the people who hire us, want us to beat the S&P 500 and I don't think Berkshire, particularly at current valuations and its collection of businesses, will. The S&P 500, it's tough to beat, even for the best of us. I think it's going to be much tougher for an overdiversified conglomerate that isn't growing that much more than GDP. Mr. Buffett warned shareholders long ago the performance deadening perils of size. Shareholders will never again see examples of Mr. Munger’s ‘lollapalooza’ dynamism at Berkshire such as the brilliant transaction path of ABC/CapCities/Disney/GEICO/Coca-Cola.

After an incredible two decades in the stock for our clients, too many of the former competitive advantages of Buffett & Co. at Berkshire later, in our view, became disadvantages. That’s why we sold.”

Influential Books

“I finished school in late 1985 where I’d been fortunate to have a very influential investment professor, who was a stock market junkie. He dispensed with all of the textbook stuff and he just talked about the stock market. He was instrumental in pointing me to outside reading, outside of textbooks. And I was fortunate to get my hands on, in the early '80s, the classic 1980 book by John Train, The Money Masters. That was my first exposure to Buffett, Templeton, Graham, Carret, Rowe Price. It became an obsession literally overnight. I was hooked - hook, line and sinker. I got into the brokerage business in early 1986, that's when Peter Lynch's first book came out, and I didn’t want to be a salesman anymore. I wanted to be a stock picker, I wanted to be a portfolio manager, I wanted to be an analyst. 

Today we in the business are blessed with many classic, must read books. We get to sit on the broad shoulders of the greats. The Intelligent Investor; chapter 8 on margin of safety, chapter 20 introduces the concept of Mr. Market, those are must reads – every year too. But some of the early books, all of Train’s books obviously, Buffett's shareholder and his partnership letters. Even today, I'll go back and and I'll pull up say history 1981 shareholder letter, and though it’s a delightful trip down memory lane, it's still refreshing to read. It’s batting practice. Buffett’s such a great writer and it's like that old textbook ... It's like an old friend and you get to have that conversation again with that old friend.

Anything Charlie Ellis wrote. His Loser’s Game and The Paradox are among the pantheon of must reads.

But the one book that I have already mentioned that probably made the biggest impact on my career in those early formidable years back in the day was Peter Lynch's ‘One Up on Wall Street’. My two takeaways was when Peter Lynch went into some detail that even in his best years, his stock ideas, he batted just .500, one of the great investors of all time and he’s admitting that half of his stock picks don’t work out. What an eye opener. It was liberating, it really was. 

When I first got into this business, like many, I wanted perfection, I wanted every stock to work.  All the best have the proper ego and intelligence to take a loss and move on. So here's one of the greatest of all time saying, "Hey folks, half my ideas didn't work out." And then related to that, when he would say, "The worst thing that can happen is if the stock goes to zero." Now, if you're managing public money and you have too many of those, you're going to have to find another line of work, I get it. But then Lynch said, ‘The best thing that can happen is a stock may double or quadruple,’ his famous ten-bagger. 

Here comes some scars. Micron Technology, we bought that stock in March 1996, I think it was March 15, 1996. It never seemed to go up. The big demand for computer memory needed for Windows 95 and the new Pentium cpu was priced in. And DRAM surplus came on like Niagara Falls. Again, on any given day the stock wouldn't go up, and we bought some more, and more. At the same time, I'm looking at this company called Linear Technology, a completely different business model. So about six months later, we sucked it up, and we sold Micron Technology to buy Linear Technology and our clients were like, ‘Wait a minute, you're selling what technology to buy what technology, are you kidding me?’ But in the big scheme of things, I think we lost 40%, 45% on Micron and it stung, no doubt about it, but that 50% loss in one stock, hopefully we learned from it, pales in comparison to the money we made in Linear Technology. And so Peter Lynch's book, among other wonderful anecdotes he had in there, it took the pressure off me. I didn't have to be perfect and I stopped trying to be perfect, and if I stuck with the better businesses, even if I, in hindsight, I found out that I maybe paid a little bit too much for it, a growing, best of breed business often bails you out.”

Summary

You can see how Rolfe’s snowball has both first gathered and then continued to gather snow. His success has been earned over long years and it’s clear that his humility in admitting investment mistakes, his openness to the thoughts and opinions of others, and his willingness to challenge those opinions - even some of the greats - have all contributed to that investment success.

I’m incredibly grateful to David for both his time and his incredible insights and look forward to the next time we can speak. In the meantime, I hope some of the insights above can help your snowball grow.

Further Reading:
Wedgewood Partners Investor Letters.

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TERMS OF USE: DISCLAIMER

Master Series: Francois Rochon

Let’s face it, for most, achieving decent returns from investing can be remarkably difficult at times. Achieving consistent returns is even more so, and outperforming the markets over the long term is harder still. Few investors can do it. Francois Rochon is one of those who can and has; his Rochon Global portfolio¹ (that serves as a model for clients at Giverny Capital) has delivered a 15.3%² annual compound return for nearly three decades, outperforming the benchmark³ by more than five percent per annum. By 2020’s year end, the Rochon Global portfolio’s cumulative return since inception in 1993 stands at 4,969% versus the benchmark’s 1,103%.

While Francois carries a relaxed demeanor, it masks the emotional fortitude he possesses that is required to navigate challenging market conditions. No better example of his rational composure comes to mind than during the pandemic induced collapse of global financial markets last year. In the midst of the crisis, Francois penned a 2-page memo to his partners reminding them that their portfolio of companies had the capacity to weather the crisis and he implored them not to be influenced by stock market fluctuations. In the eye of the storm, it was a lighthouse guiding investors; the Giverny portfolio had been crafted to survive the most treacherous swells, provided investors could avoid the rocks of emotion. A recount of the most important market corrections of the last sixty years and their subsequent recoveries made clear that smooth sailing ahead was inevitable [see table below].

“It is only those who sell in panic in declines who become the real losers of the volatility inherent in financial markets.” Francois Rochon - March 16, 2020

Giverny Capital Letter - 16 March 2020.

Sage advice indeed.

Francois’ genuine humility is evident in everything he does. A few years back, after reaching out to him about content for the MastersInvest site, Francois invited us to meet with him in Omaha while we were attending Berkshire’s AGM. He willingly gave us his time while we were there, and we were able to discuss a wide range of topics and learn more about his thinking, his investment philosophy and the practical art of investing.

A few weeks ago we had the opportunity to chat with Francois once more, and gain his insights into how he sees the world, some opportunities he’s finding attractive and collect some timeless investment wisdom⁴.

Market Crises [Covid 19]

“When valuations are low and pessimism is high and you have a long term horizon I think you have to at least stay invested. If you have available capital you just have to have faith and invest.”

Current Valuations

“I always say, high valuations, most of the time, translate into lower returns. You have to accept that. You can justify paying 50 or 60 or 70 times earnings, as some stocks trade today, by expecting many years of high growth and discounting them with a very low interest rate. But that also means that you'll have lower returns if you discount them with a lower discount rate. I believe that there are many stocks that are expensive and many quality names are trading at pretty high ratios. You have to accept that if you want to own those names you'll probably have lower returns going forward. I’m not saying negative returns but for the S&P 500 in general, I think it's going to be hard to earn a total return in the next five years of more than let’s say 6% annually, which is okay but not as high as it's been in the last decade, that's for sure.”

Opportunity Set

“We still, as always, can find great companies that trade at reasonable valuations. If you build a portfolio of such securities, I think you can do better than the average. I take the example of Markel for instance. I think Markel is a great company and the market doesn't really see it that way. I think that's one example of a company I don't believe it's trading at high valuation at all.”

Financials

“In general, everything that is seen as interest rate sensitive or financial, has come back [up] a little bit but is still out of favor. Banks or insurance companies, they're not what young and dynamic investors want to own because that's not really exciting. But you know I always say, I'll favor stable, durable, competitive advantaged, great management, good return on equity, lower valuations and I will live with the ‘dull’ nature of the business.”

“We own two banks, Bank of American and JP Morgan. I think those two banks are very well managed, they have solid balance sheets. Their stocks have rebounded lately but I still think if you own them for the next five years you'll do okay.”

Tech Stocks

“I'm not against owning technology names. I mean I've owned some of them for many, many years. If I go back to the first years like 1994, I think back then I owned Intel and Sun Microsystems. One lesson I learned is that if you look at Sun Microsystems for instance, it was a great company in 1994, I bought it at very reasonable valuation and I had a very good return. While the company still exists, as part of Oracle now, it's not as dominant. It's far from as dominant as it was 20 years ago.”

Facebook & Google

“I think the situation with Facebook and Google is a little different. I don't really see them as technology companies, they offer a service and they've built this incredible network. I think they've got an extraordinary brand. I don't see them as sensitive to technology change as a company that sells hardware or software.”

“If you look at Facebook, it's trading at around 25 times this year’s earnings. It's still growing pretty fast. I think it can grow between 15 to 20% a year going forward for the next five years. It's a very reasonable valuation. These are clean earnings, meaning that everything that has to be expensed has been expensed - like stock options for instance. That's not the case with many companies that even trade at 40, 50 times earnings [non-GAAP, without stock options expensed earnings which I'm not a big fan of. I'll do my own calculation of earnings and adjust them for the stock option expenses]. If you look at Facebook, I think the valuation is very reasonable for such an outstanding company.”

Progressive

“If you look at Progressive, the auto insurance company, they've gained market share in the last 20 years and they're as strong, their model is as strong today as it was 20 years ago. There's many technology companies you can't say that at all. How durable is the competitive advantage is a key question you have to ask when you invest in any security.”

Apple

“I think Apple is more than just a hardware product. It's really an ecosystem where there's the phone, there's all these services and the fact is today, compared with 20 years ago, your cell phone is much more important to your daily life than it used to be. So many little things in your daily lives are built into your phone. It's a big thing to change your phone today. It wasn't a big thing 15 or 20 years ago to change a phone but today it is. I think Apple’s dominance is great. The thing you have to ask yourself, once you're so dominant, how are you going to come up with a lot of growth going forward. That's a question I think you have to ask with any already dominant businesses.”

Finding Opportunities

“I love baseball and so I watch, I don't know how many games a year. I don't do it because I want to learn about baseball or be a better baseball connoisseur, it's really because I enjoy watching the game. After a while you kind of know almost all the important players, the best players, the best pitchers, and the ones that have a better batting average. You know about those players because you're interested in this game. It's similar with an art collection. I'm interested in everything in the history of art, I try to go to every major show and visit the museums in Montreal, New York City, Chicago, Los Angeles. After a while I know a lot of artists and great artists. I think I can have a general view on which ones are the most important artists, the ones I believe are really the outstanding ones that will still be considered important in 50 years.

It's a similar process when you invest in companies. You look at almost every company, even private ones, but you're more interested in the public ones so you want to learn about every important public company in the world. When you find something, a company that looks exciting, that looks like they've got this great business, you want to understand why its so great, and what's the source of their greatness. You find CEOs that you admire like Mark Leonard at Constellation Software. When you've read a lot of annual reports I think you can find, you can see when there's something special about a company because you've seen so many of them; you can find one that really stands out. It's really a daily process for the last, in the case of investments, 28 years. Just looking daily at a lot of companies because I enjoy the process. I enjoy discovering companies and learning about the history of companies and I am always on the quest of finding new companies because finding a new company is exciting.”

“When I travel in the US, I'll go to a new restaurant chain I've never heard about and try it. If I like the food, if I like the experience, I'll say lets look at the stock. But sometimes just reading a friend’s annual letter and, "Oh, my friend bought this new company and I don't know about it so I'll read about it." I know how he thinks so since I share a similar investment philosophy as him, it might be at least worth reading. That's one source of ideas of course.”

Investment Edge

“I think a lot of opportunities in the stock market arise not because we have more insights into understanding businesses. I think a lot of people can pretty quickly identify the great businesses. I think our edge as investors is really our behaviour, it’s not to focus too much on the short term but really we're there for the next five to ten years. So even a great company can have some periods of uncertainties in their business or short term problem or if there is a recession and that makes the company growth rate be a little lower for a while; if we think the fundamentals over the long term are intact, it can be an opportunity for us. So our edge is really our behaviour and our long term horizon which is so rare today because people want good results in a very short time period. Of course, people can do whatever they want as an investment style; but we believe that the short term horizon of others is probably at the source of many of our investment opportunities because we have a longer term horizon than most people.”

Autohome

“There's some opportunity in the internet and technology sector, Facebook is one. We own a Chinese company called Autohome, which is by far the leader in China, a website where you can do some research about buying a new car or some car related products. It's a great company and I think Wall Street is a little worried about a Chinese company listed in the US so the stock has gone down at least 10 to 15% recently. If you look at Autohome’s valuation, I think it trades at something like 20 times this year's earnings. I think it can be a 15, 16, 17% grower going forward. It’s very well managed, the balance sheet is very good and the valuation is very reasonable. It's at a discount to the S&P valuation ratio.”

“Where did I find Autohome? I like to read annual letters from great managers. I think it was a top holding of a money management firm I admire in the US. I'd never heard about that company so I read the annual letter; I went to the website. I thought it was a good company and we talked to management and we did all the research and decided to buy shares.”

On Berkshire

“Warren Buffett is such a good steward of capital, he doesn't do anything risky. He doesn't use debt, he doesn't acquire companies by paying very high ratios. So of course in the last five years it's been hard for him to acquire companies because many other acquiring entities are using debt, are paying high ratios - the competition has been much less prudent than he is. Knowing Warren, that won't change his approach. Preservation of capital I think is still a cornerstone of his approach. He used to say that the first rule is don't lose money and rule number two rule is don't forget rule number one. He still is very prudent. This prudence has been probably one reason he has so much cash on the balance sheet, I think it's something like 140 billion dollars. That's a lot of capital because I don't know exactly the numbers but it would represent something, at least a quarter of the equity. So when a quarter of the equity is invested in something that yields close to 0%, it's hard for the whole thing to earn 10 to 12%. The rest has to compensate and it's very hard to compensate that much. That's been a drag on the return of Berkshire.”

“At some point I think until [company] valuations come back a little bit to more reasonable levels, I think the best thing he can do is buy back stock and return the excess capital to shareholders. If he continues to do that, and he's been doing that for the last two quarters very aggressively, I think it's nine billion per quarter in the last two quarters. From what the annual letter said he’s still doing this in the first quarter of 2021. That's $36 billion a year so that's about 7% of the market value of Berkshire. Well if you return 7% per year going forward, I think it's going to be a better stock than it was in the last few years, at least relative to the S&P 500 so I still think the whole thing can continue to grow at 5 or 6% annually at least. But if you add a 7% buyback, it's really a good return of capital to the shareholders. I think that Berkshire can do something like 12% going forward.”

Evolving

“The world is always changing and you have to evolve with it. If you don't evolve you'll probably stay behind, very slowly but surely. You have to accept that you have to always rethink everything and do postmortems on investments on what went well and what went wrong. We're doing that on at least a yearly basis with our yearly medals for the top three mistakes.”

Mistakes & Margin of Safety

“Year after year what I realise is most mistakes I've made is not paying perhaps a higher price than I should have for great companies. I think I probably have already evolved on that. I'm ready to pay 20 times earnings for good growth companies but sometimes there's not that much difference between 20 times and 25 times. There is between 20 and 60 but between 20 and 25, perhaps I'm trying to be a little too precise, or to prudent, and sometimes miss the big picture that if you find a great growth company and it doubles its earnings every five years, well perhaps valuation to some degree should be flexible a little bit. So I probably have evolved a little bit over the years with that.”

“You have to be careful because how much do you stretch? You can stretch to 25 and then 30 and then 40, I mean it never ends. You have to accept you still want a margin of safety and I think that's the key element in The Intelligent Investor and when you read Ben Graham’s writings. Seventy years later, I believe that the key lesson from Ben is still the importance of margin of safety.”

“The margin of safety is not just in the price you pay, it's also in the quality of the business, it's in the balance sheet of the business and the accounting and also in terms of the quality of top management. When we bought shares of Constellation Software, I don't remember how much we paid but we paid a reasonable valuation, I think 18 or 19 times earnings. To us the real margin of safety was Mark Leonard. We thought he was a great investor, a great manager and I mean to us it was not the valuation that was the key criteria it was really because of management.”

Portfolio Companies

“I think if you look at the portfolio, there's some differences in the style of the businesses but they all have similar themes. They are all great business, already profitable, already dominant in their industry, that have good growth prospects - not 40% a year - but between let's say 8 and 20% more or less. They have good balance sheets, we like the management and we think they're good capital allocators. All the companies we own, we believe share those characteristics. They're in different industries, they're different sizes. We own some small companies and some very large ones, but they have a similar style of businesses.

I know that I have some colleagues that would say, ‘Well, I invest in this young company that is not profitable yet but if everything goes well it can increase 10 times.’ Well to me that's a little risky. I've seen so many companies disappear over the years and I don't want to own a company that needs to go to the capital markets on a regular basis because either it has too much debt or is not profitable. You never know when there's going to be a financial crisis. I've seen a few of them in the last 28 years. I mean in 2000, 2001, and 2002 when the tech bubble burst it was very, very hard for those technology companies to get new financing. If you look at 2008 or 2009, there were some companies that had some debt and went to the financial markets and couldn't find capital at all. So I don't want to own companies that if there's a crisis or a recession, could be in the weak position of having to raise capital at very bad levels for shareholders or through expensive debt.

To avoid that I just avoid companies that are not profitable or have too much debt on the balance sheet. Even though I see that there is some upside potential, I see the downside in case of a recession or financial crisis because I've seen and I’ve lived through them. So I know they can happen and they will probably... I don't want to use the word conditional because it's not a conditional situation. There'll be recessions, there'll be crisis and I want the portfolio to survive them. We want the companies to be survivors not ones that will need to go to the capital markets at the worst possible time.”

Partner with Management

“There's all sorts of reason why some companies are not properly valued by the stock market. Sometimes it's just because it's non-exciting; a little dull business or a low profile manager. Some CEOs speak very well, they're good salesmen. That’s fine, that’s business. I like to see CEOs as partners because that's really what you are doing when you are buying shares; you're becoming a partner with the top management CEOs. I want partners that are low profile, are really focused on building something for the long run, ideally that are humble. They're not trying to pump up their stock. They want to build wealth over the long run, they're trying to build solid businesses and they know that in the end if the company does well the stock will eventually reflect that. They know that.”

Book Recommendations

“There's the classics of course like the books of Ben Graham, Peter Lynch and Philip Fisher. John Train wrote two good books in the 80’s, ‘The Money Masters’ and ‘The New Money Masters,’ which I liked. William Thorndike wrote the ‘Outsiders’ which was one of my favourite books over the last few years. Larry Cunningham wrote a few books on Warren Buffet and Berkshire Hathaway which I think are very interesting. My friend Guy Spier wrote the book, 'The Education of a Value Investor’.

There's older books such as John Paul Getty’s book, ‘How to be Rich’. It contains a chapter on stock market investing which I think is very good. You can read biographies or autobiographies by great business builders. Many years ago I read the book by David Packard which was very good and Ken Iverson’s, the guy that built Nucor. Bill Gates’ book from 1994 when the internet was just starting called ‘The Road Ahead’ was very good. I’d also recommend a book by S. Cathy Truett who started Chick-fil-A, the chicken burger chain. I thought that book, ‘How did you do it Truett?,’ was really good. I've been hoping that Chick-fil-A becomes a public company since then.”

Summary

Francois’ passion for investing is as obvious as his humility, and is mirrored in his deep interest in both baseball and art. His returns have been nothing short of outstanding over the years and are the envy of many. We’re very grateful to Francois once again for his insights and thoughts on matters. Truly he has painted a masterpiece of his own and we expect that his batting record will only continue to climb in the years to come.

Further Reading:
‘Investment Masterpieces - Francois Rochon’ - Investment Masters Class, 2017.
Giverny Capital Annual Letters

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TERMS OF USE: DISCLAIMER

The Beauty of Stock Markets

Step right up, step right up! Welcome to the Stock Market Circus, an unruly bazaar that is absolutely chock full of brazen salespeople, fortune tellers, sham wealth remedies, high-frequency pirates, fallen angels, pigs with lipstick and much, much more. This is a place where crazy things can happen; stocks can take exponential leaps only to then crash and burn, companies that are here today can be gone by tomorrow, and perceived good news that usually brings higher prices might actually trigger shock selling. Its not a place for the faint-hearted; this Circus abounds with metaphors like death spirals, squeezes, collapses and crashes, none of which engenders feelings of security. And if you want to leave, the exits aren’t always big enough. For the uninitiated, this can be a truly scary place.

If you take a step back however, there is beauty to be found in this madness. You just need the right perspective. A few home truths, a grasp of history and an ability to filter out the noise can go a long way to help investors in this respect. Let’s dive in…

Silly Prices

"The beauty of stocks is that they do sell at silly prices from time to time. That's how Charlie and I have gotten rich." Warren Buffett

Buffett likes to remind us that on occasion you will get silly prices in the stock market. That’s the beauty of it. Silly prices are often the result of emotionally charged behaviour rather than anything fundamental. The market’s ease of access and low cost of transacting encourages quick action, hence turning the psychological short cuts that saved our ancestors on the savannah into an impediment to investment success.

When we’re fearful, we look to other people for guidance. Yet, the truth of the matter is they’re just as likely to be acting on their own fears; reacting emotionally rather than rationally.

When you throw in the dominant quantitative and passive funds of today, who’ve no idea what they own and are triggered by price movements, you’ve got a recipe for significant mis-pricing - stock prices become untethered from business value. For those who are able to keep their cool during these situations, opportunity abounds.

"The stock market will offer you opportunities for profit, percentage-wise, that you’ll never see, in terms of negotiated purchase of business." Warren Buffett

“Research has shown that over the last century, U.S. stock prices have been three times more volatile than fundamentals.” Frank Martin

“We believe that shares spend relatively little time at ‘fair value’. Rather, lengthy periods of overvaluation are followed by lengthy periods of undervaluation… Extreme valuation spreads in the equity market aren’t necessarily rare or short-lived.” Marathon AM

Nick Sleep of Nomad Partners recognised that over time, all businesses can be meaningfully mis-priced.

“We can all observe that stock prices, set in an auction market, are more volatile than business values. Several studies and casual observation reveal that individual prices oscillate widely around a central price year in year out, and for no apparent reason. Certainly, business values don’t do this. Over time, this offers the prospect that any business, indeed all businesses, will be meaningfully mis-priced.” Nick Sleep

An analysis by John Huber at Saber Capital highlights this point. Mr Huber shows the average intra-year difference between the high and low of the ten largest stocks in the S&P500 in 2019 was a staggering 44%! [and people talk of an efficient market?]

“Stock prices move much more than true values do even in the largest stocks, which by definition causes mis-pricing at times. This isn’t due to a lack of information, it’s simply good old-fashioned human nature, and unlike the price of semiconductors or the value of information, human behaviour is not going to change. The biggest edge is in understanding this simple concept, and then being prepared to capitalise on it when it’s appropriate.” John Huber

Source: Saber Capital Letter Q3 2019.

The opportunity conferred by extreme price volatility isn’t lost on the Investment Masters. In many ways, the great investors are arbitrageurs of human nature.

Stock Markets Compound

The long-term history of the US stock market is one of rising prices. A key contributing factor to a rising stock market has been the earnings retained by corporates that are re-invested for the benefit of shareholders.

“Equities can compound in value in a way that investments in other asset classes, such as bonds and real estate, cannot. The reason for this is quite simple: companies retain a portion of the profits they generate to re-invest in the business.” Terry Smith

“To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker - John Maynard Keynes, who in 1925 reviewed the book, ‘Common Stocks for Long-Term Investment’, thereby putting it on the map. In his review, Keynes described ‘perhaps Mr. Smith's most important point ... and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus there is an element of compound interest operating in favour of a sound industrial investment.’ It was that simple. It wasn't even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn't thought through the implications of the point. Here, though, was this guy Smith saying, ‘Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings--and dividends, too.’" Warren Buffett

“In the 1920’s, a brilliant and important book by Edgar Smith, ‘Common Stocks for Long-Term Investment’, became a prime market influence. It was still popular in the fall of 1929, but most people read it too late. Mr. Smith advocated the benefit to corporate growth of the application of retained earnings and depreciation. Thus capital appreciates. The book may have been influential in changing accepted multiples of 10 x earnings to higher multiples of 20 to 30 x earnings.” Roy Neuberger

“Retained earnings have propelled American business throughout our country’s history. What worked for Carnegie and Rockefeller has, over the years, worked its magic for millions of shareholders as well.” Warren Buffett

While markets can be volatile, the returns achieved by corporate America have remained remarkably consistent. Free trade, an entrepreneurial spirit and continuous innovation have been the hallmarks of America’s success.

“Historically, US companies increase their profits by about 6-7% per year and pay a dividend of around 2%. This generates an annual return of 8-9% from simply owning a solid group of companies.” Francois Rochon

“Anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.” Warren Buffett

“The S&P 500 produces 12% or 13% returns on capital and it retains and reinvests about half of its earnings, and so that should generate 6% or 7% earnings growth over the long run. Then the rest of the earnings can be returned to you as dividends and share repurchases. If you can get 6% earnings growth in the long run, plus a couple percent from dividends and buybacks, then you're going to achieve a high single digit rate of return by owning that asset class in the long run. Obviously, it's going to be very lumpy, but if you have a long term, 10-year plus time horizon, that is the rate of internal compounding that I think American business will continue to achieve over time.” John Huber

Attractive Long Term Returns

Over the long haul the stock market has delivered attractive returns. While the Saber Capital table above makes clear the potential for short-term volatility, the potential for loss diminishes with time. Certainly that’s been the case in history.

The chart below highlights that over the last c150 years, investors who’ve taken a twenty year view have earned positive returns 100% of the time.

“The historical odds of making money in U.S. markets are c50/50 over one-day periods, 68% in one-year periods, 88% in 10-year periods, and (so far) 100% in 20 year periods.” Morgan Housel

Source: Collaborativefund.com - Morgan Housel.

Not only have investors been blessed with positive returns a good majority of the time, those returns have ordinarily been pretty solid. For context, in the last one hundred years the worst 25-year return in the market was four times capital. More generally, it’s been twelve times or more.

“You want to remind people that the worst 25-year period in the past 100 years was a 4-times return on their capital. Typically, a 25-year investor gets 12 times return or more. So, to me, being able to share that message with our younger analysts, with our shareholders and potential shareholders helps me keep it together when stocks are behaving differently than we anticipate they would.” Bill Nygren

Even stock market crashes fade over time. The worst percentage fall in stock market history, the 1987 crash, is a blip on the long term chart [see below]. What a wonderful friend compounding has been for the long term investor.

Dow Jones Industrial Average - 1987 Crash [Source; Bloomberg].

Asymmetric

It’s been found that humans find symmetrical patterns more attractive than asymmetrical ones. When it comes to the stock market however, it’s the asymmetry that beautiful. When you invest, the most you can lose is 100% of your capital yet the opportunity exists to make multiples of your investment.

“The asymmetric payoff structure (you can make far more if you’re right about a stock than you can lose if you’re wrong) is the fundamental attraction of investing in equity markets.” James Anderson

“One of the interesting dynamics of buying stock in a company is that our downside is known. In the worst case, we can lose 100% of our investment. In the best case, we can make many multiples of our original investment.” Scott Miller

Long Term Gains

To harness the market’s beauty you need to be invested. Sitting on the sidelines won’t earn returns. While short term market moves can be volatile, history has shown investing in high quality businesses has been a winning strategy over the long term.

“I think that this time would be as good as any other time or as bad as any other time. I have been at this business for 40 years now, so I have been through all kinds of times. That’s a long time to be at one trade, and I have done it every day. I couldn’t tell you that I knew any particular day, whether it was today or 10, 15, 20 or 40 years ago that actually would have been the right day for someone to invest. The right thing to do is to enter the investment scene, whether you are just an individual investor, someone who might be approaching it on a career basis, or a professional investor already working to hone your skill set.” David Polen

“All I can tell you as an increasingly experienced investor, is that I have never known a time when people weren’t worried about the sort of issues that you adduce and those people that spent too much time worrying about those issues, didn’t get invested and missed out on a opportunity to protect their wealth against inflation and indeed, to growth their wealth in real terms. So the rational way to deal with these sports of concerns, it may not be the correct thing, but the rational thing is to ignore them and be invested in fine businesses.” Nick Train

“The stock market goes up over time. Developed markets should increase by around 6% p.a. over long periods of time, implying a double every 12 years, a quadruple every 24 years, and so on. If you have a 40 year plus time horizon and an investment opportunity that will go up 8-fold, how much is there to think about? The smart money is invested, not on the side-lines fretting about what to do.” Robert Vinall

Get Rich Slowly

Compounding’s power reveals itself over time. While short term gains may look small, with time they mushroom. You don’t need to hit the ball out the park every year to build long term wealth. In fact, doing so, may increase the risk of losing capital. And losing capital is what impedes compounding. While everyone wants it all today, the world’s best recognise the beauty in getting rich slowly.

“At the beginning of the AGM of the Berkshire Hathaway Company they show this little video and each year Buffett is asked what’s the main difference between himself and the average investor, and he answers patience. And there is so little of it these days. Has anyone heard of getting rich slowly?” Nick Sleep

“The biggest thing about making money is time. You don’t have to be particularly smart you just have to be patient.” Warren Buffett

"The desire to get rich fast is pretty dangerous.” Charlie Munger

“People would rather be promised a (presumably) winning lottery ticket next week than an opportunity to get rich slowly.” Warren Buffett

“Ninety-nine percent of investors shouldn’t try to get rich too quickly; it’s too risky. Try to get rich slowly.” Sir John Templeton

“Small investors who get into trouble, I think, are those who try to get rich quick. They are in and out of the market in a flash and don’t take the time to learn. That’s a dangerous game.” Roy Neuberger

"In investing, time is your friend. The people who make a lot of money in investing are those that buy great businesses, in our case with expanding moats, and they give them time to work for them over 5, 10 and 15 year pulls. All the people that have created a lot of wealth for themselves didn't do it in a week, or 3 months or 6 months. They did it over a generation." Paul Black

“A good summary of investing history is that stocks pay a fortune in the long run but seek punitive damages when you try to be paid sooner. Virtually all investing mistakes are rooted in people looking at long-term market returns and saying, “That’s nice, but can I have it all faster?” Morgan Housel

Summary

On any given day it’s pretty much a coin toss what markets will do, and because of it you must be able to brace yourself for volatility. It’s a function of human nature and that’s not going to change anytime soon. Discard the received dogma that volatility is risk. While most business schools trumpet this notion, the great investors have recognised the beauty in volatile prices - they can present attractive entry points which ordinarily don’t surface in most markets. Little wonder these Investment Masters consider volatility as the friend of the long-term investor.

While there’s little sense to be made in the daily sound bites and market gyrations, as time expands, the markets longer term beauty reveals itself. Companies values compound and together cause markets to rise. You just have to lengthen your perspective to see it.

Whilst we’ve covered some of the attractive features of the stock market, I’m sure you can think of plenty of others; accessing the world’s best management teams, the ability to work from remote locations, not having a boss - there’s plenty more. Successful investing requires the right attitude, perspective and planning; manage your emotions, recognise and respect the power of compounding and exercise patience.

The market has a history of attractive long term returns; all you need to do is step back to see it’s beauty.

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Beyond Investing

In 2014, the Nomad Investment Partnership was it, and their last few years of returns were nothing short of astonishing. A 2012 return of 39.8% trumped the MSCI’s 15.8%, and a year later, Nomad clocked up a staggering 62.2% return, decimating the MSCI’s 26.7%. Indeed, in four of their last five years Nomad delivered returns of 40% or more. Without a doubt the partnership founders, Nick Sleep and Qais Zakaria were at the top of their game. Still young, in their mid-40’s, they possessed a magnet for capital via their track record of 20%+ annualised returns. The opportunity to raise billions of capital was there for the taking. Yet, after two decades of investing and fourteen years running Nomad, Sleep and Zakaria decided it was time to hang up their boots. They’d achieved their ‘X-amount’. For them, it was time to move beyond investing.

From the early days, Sleep and Zakaria had mused over a concept they referred to as the ‘X-amount’. This was an amount of money they deemed necessary to pay the bills and have a nice lifestyle. Beyond which, they felt the surplus funds could be an anchor, stripping meaning from their lives by distorting relationships with friends and family and encouraging an indulgent existence.

Like many of the Investment Masters, Sleep and Zakaria recognised the good fortune afforded to successful investors, and took it upon themselves to direct their excess gains towards charitable causes. Both established foundations which continue to benefit from their investing prowess; almost six years on from closing Nomad to external capital, the fund has achieved an average twenty percent return for twenty years.

There is certainly more to life than investing. Caring for the environment, supporting society and helping others less fortunate helps make the world a better place. The rewards of investing are often non-linear, rarely are they commensurate with the commitment, dedication and work required to achieve them. They are unique to the world of investing and with thoughtful application they can support the foundations of a better world.

“My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well. I’ve worked in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect the mis-pricing of securities with sums reaching into the billions. In short, fate’s distribution of long straws is wildly capricious.” Warren Buffett

“Investors can think their way to success without seeming to work in the traditional sense and the payoff in capitalism from stock picking can be extraordinary.” Nick Sleep

One of my favourite sayings is, ‘You can’t take a pin with you.’ Money won’t deliver happiness. Meaning will, however, and many of the world's greatest investors have recognised this. Below are some of the random musings I’ve collected over the years.

Giving Pledge

In 2010, Bill and Melinda Gates and Warren Buffett created the Giving Pledge, a movement of philanthropists who’ve committed to giving the majority of their wealth to philanthropy or charitable causes, either during their lifetimes or in their wills. In addition to Buffett, many of the Investment Masters have also signed the pledge, including Ray Dalio, Paul Singer, Paul Tudor Jones, Chris Hohn, Bill Ackman, Jim Simons, Mario Gabelli, Seth Klarman, Jeremy Grantham, Ken Langone, David Rubenstein, Tom Steyer, T. Boone Pickens and Julian Robertson.

It’s quite possible Warren Buffett will be remembered more by his philanthropic endeavours than his investing acumen.

“Gifting to Bill Gates his wealth to take on, that was the greatest achievement of Warren Buffett. He’s respected as an investor, but he should be more respected as a philanthropist.” Chris Hohn

Life Lessons

Studying the world’s greatest investors offers not just lessons in investment but lessons for living a successful and fulfilling life. While Buffett is beyond rich, he chooses to reside in a house purchased in 1958 for $31,500, whose value today reflects less than 0.001% of his wealth. Buffett’s favourite restaurant is the low-key local Omaha steak diner, Gorat’s, while his favorite meal remains a burger washed down with a can of Coke.

“I think it’s also probably surprising to people that the money doesn’t matter to him. He made the money sort of by accident because he was really good at doing what he loved, and when you do that particular thing really well, you end up with a whole bunch of money. But it’s really true that he does not care about having a bunch of money.” Susie Buffett [Warren’s daughter]

“When I look at a bunch of stock certificates in a safe deposit box that were put there 50 years ago or so, they have absolutely no utility to me; zero. They can’t do anything for me in life. I mean they can’t let me consume 7,000 calories a day instead of 3,000. There’s nothing they can do. I’ve got everything in the world I want, and I’ve had it for decades. If I wanted something additionally, I’d go buy it.” Warren Buffett

“I could have 10 houses, but, you know, I could buy a hotel to live in, you know. But would I be happier? It would be crazy. Charlie and I both like fairly simple lives.” Warren Buffett

Purpose

People need purpose and meaning in life. One of my favourite books, ‘Man’s Search For Meaning’ was written by Viktor Frankl, a survivor of the Nazi concentration camps. His experience at Auschwitz reinforced a key idea: life is not a quest for pleasure, but a quest for meaning. The greatest task for any person is to find meaning in his or her life.

Frankl’s insights are echoed in the empowering stories of James Stockdale and Eddie Jaku. Stockdale was a vice admiral in the US Navy who endured seven and a half years as a Prisoner of War - tortured, isolated in solitary confinement and restrained in leg irons - after being shot down above North Vietnam. Eddie Jaku, also a holocaust survivor, endured seven years of unimaginable horrors across Nazi concentration camps in World War II.

While each of their stories was forged in the extremes of terrible suffering, they highlight a common theme - mankind’s need of purpose.

Inheritance

Without purpose, one’s life lacks meaning. Most people cherish the idea of inheriting a fortune, yet there can be a ‘dark side of wealth’. Another favourite book is ‘Fortune’s Children - the Fall of the House of Vanderbilt.’ In 1877, Cornelius Vanderbilt was the richest man in the world. Fifty years after his death, one of his direct descendants died penniless, and no Vanderbilt was counted among the world’s richest people. The story recounts an extravagant lifestyle of spending by his heirs but also the misery, burden and loneliness that inherited wealth can inflict. By his early sixties, Vanderbilt’s son confessed to his family..

“The care of $200,000,000 is too great a load for my brain or back to bear. It is enough to kill a man. I have no son whom I am willing to afflict with the terrible burden. There is no pleasure to be got out of it as an offset - no good of any kind. I have no real gratification or enjoyments of any sort more than my neighbour on the next block who is worth only half a million. So when I lay down this heavy responsibility, I want my sons to divide it, and share the worry which it will cost to keep it.”

This hasn’t gone unrecognised by many of the world’s most successful investors and business owners.

“I think Kay Graham was quoting her father at the time but — some years back as saying, ‘If you’re quite rich, probably the idea of leaving your children enough so they can do anything, but not enough so they can do nothing, is not a bad formula.’” Warren Buffett

“If you have a lot of money, giving all your money to your kids is a mistake which will deprive them of self-achievement. I’ve given my kids a reasonable sum of money. One made it all on his own, one needed it because he’s a scientist, didn’t make a lot of money, but I wouldn’t give all my money to my kids, it’s just so damaging.” Leon Cooperman

“You can always give all your money to your children, but usually people who inherit great sums may not be as productive citizens as people who don’t inherit as much.” David Rubenstein

“I’m not a big fan of inherited wealth. It generally does more harm than good.” T. Boone Pickens

"My children are in a privileged position. I am willing to give them enough help to do something, but I am not willing to give them enough help to do nothing. Because it would destroy them." Terry Smith

“Do you really want your children to be like those who thought themselves your betters while you struggled? Letting them have too much money is really a lot worse than letting them have too little. I've watched family after family destroyed by excessive distributions to descendants, and by family patriarchs' and matriarchs' attempts to be able to control others' behavior from the grave. With wealth comes power. With power comes the ability to damage. Gifts and inheritances influence those you love most. Inheriting too much money at one time destroys initiative, distorts reality, and breeds arrogance. When the money runs out - as it always does - those left bereft of cash can't cope.” Michael Bloomberg

“We will make sure we’ve given most of our money away by the time we die, with the exception of what we leave to our kids. We want to pass along enough for them to live reasonably well, but not so much that they can do anything foolish with it. We want them to have a roof over their heads, but we also want them to have the meaning in their lives that comes from having to make their own way.” Ken Langone

“Why should men leave great fortunes to their children? If this is done from affection, is it not misguided affection? Observation teaches that, generally speaking, it is not well for the children that they should be so burdened.” Andrew Carnegie

“Inherited wealth is as certain a death to ambition as cocaine is to morality.” William Vanderbilt

Possessions

We live in a society that encourages consumption and materialism. Keeping up with the Jones’ has been a long held ambition of many. The sad truth of this matter is that it’s impossible to keep up; when everyone is striving for more, there is no finish line and the race is eternal. Personal possessions will only keep accumulating over time.

“Possession’s don’t bring anybody happiness and most people don’t believe it until you experience it. Your possessions in many ways can become burdens.” James Dinan 

“Money is a wonderful commodity to have, but the more one possesses, the more involved and complicated become his dealings and relationships with people.” John P Getty

“We should have guys like Sir John Templeton, Warren Buffett, Charlie Munger as examples to all of us. The legacy of these men should be the focal point of our lives because it doesn’t take long to realize that money buys nothing of value. Everything that is truly worthy is free. That lesson comes hard to some people, but the sooner it comes, the better.” Frank Martin

“Some material things make my life more enjoyable; many, however, would not… Too often, a vast collection of possessions ends up possessing its owner.” Warren Buffett

“The first thing you could do [with money] is you could pleasure yourself. You could buy a plane, you could buy cars, you could buy homes, you could buy art. If you’re an art collector you never have enough money because you can spend $100 million on one canvas. I don’t collect art and I happen to have a view that material possessions brings with it aggravation. I’m a less is more kind of guy.” Leon Cooperman

Health

This one speaks for itself. There’s no such thing as the richest man in a graveyard, so you better ensure you look after yourself while you’re alive.

“A healthy man wants a thousand things, a sick man only wants one.” Confucius

“Stay fit. You don’t want to get old and feel bad. You’ll also get a lot more accomplished and feel better about yourself if you stay fit. I didn’t make it to 91 by neglecting my health.” T Boone Pickens

"You get exactly one mind & body in this world & you can't start taking care of it when you're 50. By that time you'll have rusted out if you haven't done anything. You should really remember you've got just one mind & body to get through life with & do the most with it." Warren Buffett

Time is Money

Time is one of those rare finite resources. We only get so much of it, and regardless of how much money we have, we can’t buy more. So it becomes infinitely more valuable than any possession or trinket.

“If you asked me to trade away a very significant percentage of my net worth, either for some extra years in life, or being able to do, during those years, what I want to do, you know, I’d do it in a second.” Warren Buffett

“Many times over the years, I was fortunate enough to speak at student commencement ceremonies, and that gave me the chance to look out into a sea of the future and share some of these thoughts with young minds. My favourite of these speeches included my grandchildren in the audience. What I would tell them was this Depression-era baby from tiny Holdenville, Oklahoma — that wide expanse where the pavement ends, the West begins, and the Rock Island crosses the Frisco — lived a pretty good life. In those speeches, I’d always offer these future leaders a deal: I would trade them my wealth and success, my 68,000-acre ranch and private jet, in exchange for their seat in the audience. That way, I told them, I’d get the opportunity to start over, experience every opportunity America has to offer.” T. Boone Pickens

Last year, I was saddened by the loss of Jon Boorman, who died of cancer. I didn’t know Jon but I enjoyed his financial posts on twitter. He seemed to have his priorities right. He wrote this before he was diagnosed with cancer. He was a real stoic.

“When you’re young, you have so much time but never enough money. When you’re old you have money but never enough time. How you perceive and value time and money will change many times throughout your life, but at the end there’s only one you’ll want more of, would give anything for, but it won’t be available at any price. Cherish it while you can.” Jon Boorman

Pleasure

Many of the Investment Masters have chosen to give away their money while they are alive. Helping others gives pleasure and investors can direct the funds where they feel they’re most needed.

I enjoyed a recent Forbes article, ‘The Billionaire Who Wanted To Die Broke . . . Is Now Officially Broke’ which recounts the story of Chuck Feeney, the former billionaire co-founder of retail giant Duty Free Shoppers, who pioneered the ‘Giving While Living’ approach while donating over $8 billion to worthwhile causes.

“I see little reason to delay giving when so much good can be achieved through supporting worthwhile causes. Besides, it’s a lot more fun to give while you live than give while you're dead.” Chuck Feeney

Many of the Investment Masters have chosen a route similar to Chuck Feeney.

“You know, I get a lot of pleasure out of doing these things and if I didn’t do them and I died with more money, would I be a happier person? I don’t think so.” David Rubenstein

“Hopefully, we would live long enough to also see the consequences of our [charitable] actions; we would have to eat our own cooking, as it were. Previous generations that retired in old age and died soon after, have not always had that opportunity.” Nick Sleep

“Over the years, the emotional and psychological returns I have earned from charitable giving have been enormous. The more I do for others, the happier I am. The happiness and optimism I have obtained from helping others are a big part of what keeps me sane.. I get tremendous pleasure from helping others. It's what makes my life worth living.” Bill Ackman

“Philanthropy has had a huge role in my life. It’s brought me great joy. I give money away because I love the joy of watching lives change and being able to shape things. I don’t feel guilty about the money I made but I do think it’s strange that I’ve gotten the financial remuneration I have versus a doctor. If I can take that money and raise the the prospects for the American Dream in underserved neighbourhoods, provide scholarships or work on the environment it just brings great joy.” Stanley Druckenmiller

“When we make charitable gifts, we almost always feel richer, not poorer, for having been given the opportunity to help.” Seth Klarman

“We find the execution of our philanthropic work to be both challenging and deeply satisfying.” Jim Simons

“We think it is true that, once past X-amount, real meaning comes with reinvesting in society through charitable giving, which can also be a thoughtful, challenging, wonderful adventure, but with the added bonus that it feels like the world working properly.” Nick Sleep

A desire to donate through their lifetimes is the recognition that problems can sometimes compound faster than capital.

“Our current expectation is that within the constraints of the vagaries of fate, we will spend down most of our philanthropic assets in our lifetimes. One key observation is that society’s problems seem to be compounding as fast as or faster than wealth can compound, suggesting a greater urgency to current funding.” Seth Klarman

After Life

“I realised how rich I had become and I asked myself, ‘Do I really want to be the richest person in the cemetery?’” David Rubenstein

“There’s no Forbes 400, you know, in the graveyard.” Warren Buffett

Summary

The exponential pay-off unique to the investment industry can afford it’s most successful practitioners the capability to make a difference in the world. While every successful investor takes their own approach, there are lessons that can be drawn that relate to not just investing, but leading a more fulfilling life.

Investing is only a small piece of the pie.

Charlie Munger, with his 97 years of accumulated wisdom, teaches us in his characteristically shrewd way that a successful life requires stretching beyond investing.

“If all you succeed in doing in your life is to get early rich from passive holding of little bits of paper, and you get better and better at only that for all your life, it’s a failed life. Life is more than being shrewd at passive wealth accumulation.” Charlie Munger

“If you’re good at just investing your own money, I hope you’ll morph into doing something more.” Charlie Munger

Leon Cooperman encapsulated this nicely in his letter to the Giving pledge:

“I feel it is our moral imperative to give others the opportunity to pursue the American Dream by sharing our financial success. The case for philanthropy has been stated by others in a most articulate way and in words that have impressed me: In the early 1900's Andrew Carnegie said "He who dies rich, dies disgraced." In the 1930's, Sir Winston Churchill observed that "We make a living by what we get, but we make a life by what we give." In 1961, President John F. Kennedy in his inaugural address stated "Ask not what your country can do for you, ask what you can do for your country." Well before all these gentlemen expressed their thoughts, it was written in the Talmud that "A man's net worth is measured not by what he earns but rather what he gives away." Leon Cooperman

The idea of being able to answer the question of, ‘What’s enough?’ remains anathema to many. But not to these few altruistic investors who like Sleep and Zakaria, have determined their X-amount and chosen to pursue more meaningful lives beyond investing.

Sources/Further Reading:
‘X-Amount’ - The I.G.Y Foundation. Nick Sleep & Qais Zakaria. 2021.
‘The Giving Pledge - A Commitment to Philanthropy.’
‘The Billionaire Who Wanted To Die Broke . . . Is Now Officially Broke.’ Steven Bertoni, Forbes. 2020.
‘The Billionaire Who Wasn’t - How Chuck Feeney Made and Gave Away a Fortune Without Anyone Knowing,’ Conor O’Clery, 2007.

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Learning from Disney's Bob Iger

All industries face evolution and the inevitable change that comes with it. Its virtually unavoidable, and never more so than in recent times - technological advancements, competitive landscapes and the demands of consumers change almost daily, and only those businesses and industries that can adapt will survive. Even fewer will come out the other side stronger than when they went in, and only manage to do so because they have clarity of vision and purpose.

Intel’s Andy Grove noted that at the turn of this century, the entertainment industry was ‘facing the valley of death’; customers & distribution channels were fragmenting, customer choice was exploding, barriers to entry were collapsing, technology was filling old moats and niches were opening for new players to exploit. And the Disney Corporation was no exception.

The man tasked with navigating this new industry landscape for Disney was Bob Iger. Mr. Iger had started in the television industry in 1974 and joined Disney through their 1996 acquisition of ABC/Capital Cities, where he was CEO. Disney named Iger the president and COO in 2000, making him Disney's number two executive under chairman and CEO, Michael Eisner. He was appointed CEO of the Disney Corporation in 2005.

“Bob Iger is a home run hitter. I mean he is really, really good. And he’s a great guy on top of that.” Warren Buffett

In an industry confronting a strategic inflection point, clear and strategic direction are imperative. In his wonderful book, ‘Only the Paranoid Survive’, a journey into fundamental industry change and strategic inflection points, Intel’s Andy Grove observed:

‘It is very hard to lead an organisation out of the valley of death without a clear and strategic direction’.

Luckily for Disney, by the time he was CEO, Iger had identified some simple strategic priorities that would address the entertainment industry’s rapidly evolving landscape. Three clear priorities would guide the Disney Corporation for the next few decades; a focus on high-quality branded content; embracing technology; and becoming truly global. Combined, they would remain the cornerstone of Disney’s decision-making process throughout Iger’s tenure.

Iger wasn’t afraid to embrace change. He recognised the company’s inimitable history and scale meant Disney could leverage and monetise other high quality brands like no other. Iger sought out the pinnacle of the world’s entertainment assets; acquiring Pixar in 2006 for $7.4 billion, Marvel Entertainment in 2009 for $4 billion, Lucasfilm in 2012 for $4.06 billion, and 21st Century Fox in 2019 for $71.3 billion.

In making such bold acquisitions, once again, Andy Grove’s advice is telling: ‘when dealing with emerging trends, you may very well have to go against rational extrapolation of data and rely instead on anecdotal observations and your instincts.’ Battling internal dissent, it was Iger’s instinct that ultimately prevailed to conclude these acquisitions. And each alone was a home run.

‘Of all the changes in the forces of competition, the most difficult one to deal with is when one of the forces becomes so strong that it transforms the very essence of how business is conducted in an industry.’ Andy Grove, Ex CEO, Intel

Recognising the technological inflection point transforming the industry, Iger implemented the courageous step of disrupting his core distribution business. Despite significant upfront costs, the negative impact on near term earnings and the resultant backlash from Wall Street, Iger looked towards a future where Disney connected directly to customers and by-passed the middlemen that had exerted significant control over the industry.

‘Most managements will do too little too late and fritter away the protection that the bubble of their existing business would otherwise have provided them with.’ Andy Grove

The legendary Bob Iger’s story is told in his recent book, ‘Ride of a Lifetime - Lessons in Creative Leadership.’

I’ve included some of my favourite extracts below.

Universal Ideas

‘My experiences from day one have all been in the media and entertainment world, but these strike me as universal ideas: about fostering risk taking and creativity; about building a culture of trust; about fueling a deep and abiding curiosity in oneself and inspiring that in the people around you; about embracing change rather than living in denial of it; and about operating, always, with integrity and honesty in the world, even when that means facing things that are difficult to face.’

Education and Smarts

‘I got mostly B’s and a few A’s in high school, but academics was never my passion.’

Optimism

‘One of the most important qualities of a good leader is optimism, a pragmatic enthusiasm for what can be achieved. Even in the face of difficult choices and less than ideal outcomes, an optimistic leader does not yield to pessimism. Simply put, people are not motivated or energised by pessimists.’

‘Optimism in a leader, especially in challenging times, is so vital. Pessimism leads to paranoia, which leads to defensiveness, which leads to risk aversion. Optimism sets a different machine in motion. Especially in difficult moments, the people you lead need to feel confident in your ability to focus on what matters, and not to operate from a place of defensiveness and self-preservation.’

People

‘There’s nothing more important than the quality and integrity of your people and your product. Everything depends on upholding that principle.’

Creativity

‘However you find the time, it’s vital to create space in each day to let your thoughts wander beyond your immediate job responsibilities, to turn things over in your mind in a less pressured, more creative way than is possible once the daily triage kicks in.’

Bad News / Unexpected

‘I tend to approach bad news as a problem that can be worked through and solved, something I have control over rather than something happening to me.’

‘I sometimes chide [my team] that they don’t report bad news fast enough to me.’

‘There are always crises and failures for which you can never be fully prepared.’

Moat / Competitive Advantage

‘We manufacture fun.’

‘Shanghai Disneyland cost about $6 billion to build. It is 963 acres, about eleven times the size of Disneyland. At various stages of its construction, as many as fourteen thousand workers lived on the property. [It took] eighteen years to complete the park.’

‘It is impossible to overstate the creative and technical brilliance of Disney’s Imagineers. They are artists, engineers, architects, and technologists, and they occupy a place and fulfill a role that is unmatched anywhere else in the world.’

‘Rupert Murdoch was clearly worried about the future of 21st Century Fox. ‘We don’t have scale,’ he said several times. ‘The only company that has scale is you.’ Rupert’s decision to sell was a direct response to the same forces that led us to create an entirely new strategy for our company. It’s hard to overstate how sweeping the disruption is in our industry, but his decision - to break up a company he’d built from almost nothing - was as good a marker as any of its inevitability.’

Lollapalooza

‘[Michael Eisner] understood that ‘great’ is often a collection of very small things, and he helped me appreciate that even more deeply.’

Integrity

‘Nothing is more important than the quality and integrity of an organisation’s people and its product. A company’s success on setting high ethical standards for all things, big and small. Another way of saying this is: The way you do anything is the way you do everything.’

‘True integrity - a sense of knowing who you are and being guided by your own clear sense of right and wrong - is a kind of secret weapon.’

Strategy

‘A CEO must provide the company and its senior team with a road map… this kind of messaging is fairly simple: This is where we want to be. This is how we’re going to get there… I landed on three clear strategic priorities. They have guided the company since the moment I was named CEO:

1) We must devote most of our time and capital to the creation of high-quality branded content. In an age when more and more ‘content’ was being created and distributed, we needed to bet on the fact that quality will matter more and more. It wasn’t enough to create lots of content; and it wasn’t even enough to create lots of good content. With an explosion of choice, consumers needed an ability to make decisions about how to spend their time and money. Great brands would become even more powerful tools for guiding human behaviour.

2) We need to embrace technology to the fullest extent, first by using it to enable the creation of higher quality products, and then to reach more consumers in more modern, more relevant ways. From the earliest Disney years under Walt, technology was always viewed as a powerful storytelling tool; now it was time to double down on our commitment to doing the same.

3) We needed to become a truly global company. We were broad with our reach, doing business in numerous markets around the world, but we needed to better penetrate certain markets, particularly the world’s most populous countries, like China and India.’

‘Don’t be in the business of playing it safe. Be in the business of creating possibilities for greatness.’

Disney Corporation vs S&P500 - March 2005 to 2021 [Source: Bloomberg]

Innovate / Adapt

‘This job requires an ability to constantly adapt and re-adapt.’

‘If you want innovation, you need to grant permission to fail.’

‘I’ve thought every day about how technology is redefining the way we create, deliver, and experience media, and what it means to be both relevant to a modern audience and faithful to a nearly hundred-year-old brand.’

‘The foundation for risk-taking is courage, and in ever-changing, disrupted businesses, risk-taking is essential, innovation is vital, and true innovation occurs only when people have courage. This is true of acquisitions, investments, and capital allocations, and it applies to creative decisions. Fear of failure destroys creativity.’

‘A deep and abiding curiosity enables the discovery of new people, places, and ideas, as well as an awareness and understanding of the marketplace and its changing dynamics. The path to innovation begins with curiosity.’

‘[Roone Arledge at ABC sports] changed the way we experience televised sport. He knew, first and foremost, that we were telling stories and not just broadcasting events, and to tell great stories, you need great talent .. Athletes were characters in unfolding narratives .. He wanted to try every new gadget and break every stale format. He was always looking, always, for new ways to connect to viewers and grab their attention. Roone taught me the dictum that has guided me in every job I’ve held since: Innovate or die, and there’s no innovation if you operate out of the fear of the new or untested.’

‘I didn’t want to be in the business of playing it safe. I wanted to be in the business of creating possibilities for greatness. Of all the lessons I learned in that first year running prime time, the need to be comfortable with failure was the most profound. Not with lack of effort but with the unavoidable truth that if you want innovation - and you should, always - you need to give permission to fail.’

‘In early 2001, every media and entertainment company was feeling the ground shifting beneath it’s feet, but no-one was sure which way to run. Technology was changing so fast, and the disruptive effects were becoming more obvious and anxiety-provoking… It was an interesting time, and marked what I saw as the beginning of the end of the traditional media as we knew it. Of great interest to me was that almost every traditional media company, while trying to figure out its place in the changing world, was operating out of fear rather than courage, stubbornly trying to build a bulwark to protect old models that couldn’t possibly survive the sea change that was under way.’

‘I’ve been in the business long enough to have heard every old argument in the book, and I’ve learned that old arguments are just that: old, and out of step with where the world is and where it should be.’

‘After the dust settled on the last of our ‘big three’ acquisitions, we begun to focus even more on the dramatic changes we were experiencing in our media business and the profound disruption we were feeling. The future of those businesses had begun to seriously worry us, and we concluded it was time for us to start delivering our content in new and modern ways, and to do so without intermediaries, on our own technology platform.’

‘Did we have the stomach to start cannibalising our own still-profitable business in order to begin building a new model? Could we disrupt ourselves, and would Wall Street tolerate the losses that we would inevitably incur as we tried to modernise and transform the company?’

‘I know why companies fail to innovate. It’s tradition. Tradition generates so much friction, every step of the way. I talked about the investment community, which so often punishes established companies for reducing profits under any circumstances, which often leads businesses to play it safe and keep doing what they’ve been doing, rather than spend capital in order to generate long-term growth or adapt to change.’

‘Technological developments will eventually make older business models obsolete. You can either bemoan that and try with all your might to protect the status quo, or you can work hard to understand and embrace it with more enthusiasm and creativity than your competitors.’

Quality

‘If you’re in the business of making things, be in the business of making things great.’

‘[Roone’s] mantra was simple: ‘Do what you need to do to make it better’. Of all the things I learned from Roone, this is what shaped me the most. When I talk about this particular quality of leadership, I refer to it as ‘the relentless pursuit of perfection.’ It’s a mindset really, more than a set of rules. It’s not, at least as I have internalised it, about perfection at all costs. Instead, it’s about creating an environment in which you refuse to accept mediocrity.’

Culture

‘Strong leadership embodies the fair and decent treatment of people. Empathy is essential, as is accessibility. People committing honest mistakes deserve second chances, and judging people too harshly generates fear and anxiety, which discourage communication and innovation. Nothing is worse to an organisation than a culture of fear.’

‘A company’s culture is shaped by a lot of things, but this is one of the most important - you have to convey your priorities clearly and repeatedly. In my experience, it’s what separates great managers from the rest. If leaders don’t articulate their priorities clearly, then the people around them don’t know what their own priorities should be.’

‘‘Pixar needs to be Pixar’, I said [when acquiring the company]. ‘If we don’t protect the culture you’ve created, we’ll be destroying the thing that makes you valuable.’

‘If you trust your own instinct and treat people with respect, the company will come to represent the values you live by.’

Failure

‘I’ve never had too much fear about trying something and failing.’

Acquisitions

‘Disney had done due diligence about the assets [ABC Cities] they purchased, but there was no way they could understand all of the complexities of the company they were about to own.’

‘A little respect goes a long way, and the absence of it is often very costly. Over the next few years, as we made the major acquisitions that redefined and revitalised the company, this seemingly trite idea was as important as all of the data-crunching in the world; If you approach and engage people with respect and empathy, the seemingly impossible can become real.’

“You certainly can’t make a major acquisition without the necessary models to help you determine whether a deal is the right one, but you have to recognise that there is never 100 percent certainty. No matter how much data you’ve been given, it’s still, ultimately, a risk, and the decision to take the risk or not comes down to one person’s instinct.’

Disney acquisitions under Bob Iger

‘People sometimes shy away from taking big swings because they assess the odds and build a case against trying something before they even take the first step. One of the things I’ve always instinctively felt, is that long shots aren’t usually as long as they seem.’

‘.. a recurring theme in nearly every discussion I had about Pixar. I was told over and over it was too risky and ill-advised… It’s true on paper the deal didn’t make obvious sense. But I felt certain that this level of ingenuity was worth more than any of us understood or could calculate at the time. As with everything, the key is awareness, taking it all in and weighing every factor. Nothing is a sure thing, but you need at the very least to be willing to take big risks. You can’t have big wins without them.’

‘The buyer often destroys the culture of the company it’s buying, and that destroy value. A lot of companies acquire others without much sensitivity regarding what they’re really buying. They think they’re getting physical assets or manufacturing assets or intellectual property (in some industries, that’s more true than in others). In most cases, what they’re really acquiring is people. In a creative business, that’s where the value is.’

‘The Pixar acquisition served our urgent need to revitalise Disney Animation, but it was also the first step in our larger growth strategy: to increase the amount of high-quality branded content we created.’

‘The acquisition of Marvel has proved to be much more successful than even our most optimistic models accounted for.’

‘Looking back on the acquisitions of Pixar, Marvel and Lucasfilm, the thread that runs through all of them (other than that, taken together, they transformed Disney) is that each deal depended on building trust with a single controlling entity.’

Pricing Power

‘Michael’s [Eisner - ex CEO] biggest stroke of genius might have been his recognition that Disney was sitting on tremendously valuable assets that they hadn’t yet leveraged. One was the popularity of the parks. If they raised ticket prices even slightly, they would raise revenue significantly, without any noticeable impact on the number of visitors. Building new hotels at Walt Disney World was another untapped opportunity, and numerous hotels opened during Michael’s first decade as CEO… Then came the expansion of theme parks [Hollywood Studios & Euro Disney]. Even more promising was the trove of intellectual property - all those great classic Disney movies - just sitting there waiting to be monetised… It’s not an exaggeration to say that he taught me how to see in a way I hadn’t been able to before.’

Decentralised

‘[Tom Murphy & Dan Burke of Cap Cities/ABC] also believed in a decentralised corporate structure.. Other than a CFO and a general counsel, there was no corporate staff, no centralised bureaucracy, and very little interference with the business units.’

‘[Disney’s] centralised decision making had a demoralising effect on senior leaders of our businesses, who sensed that the power to run their divisions really resided at Strategic Planning… We had to start reconfiguring the apparatus and pushing strategic responsibility back to the businesses sooner rather than later… There were about sixty-five people in Strat Planning, and they’d taken over nearly all of the critical business decisions across the entire company. All of our senior business leaders knew that strategic decisions about the divisions they ran - Parks & Resorts, consumer products, Walt Disney Studios, and so on - weren’t actually theirs to make. Power was concentrated within this single entity at Burbank [and were] viewed more as an internal police force than our partner to our business… To my mind they were often too deliberate, pouring over every decision through their overly analytical sieve.. I wanted to drastically reduce the size of the group and begin streamlining our decision making by putting more of it in the hands of business leaders.’

Pain Today, Gain Tomorrow

‘It’s better to give up a release date and keep working to make a better movie, and we’ve always tried to put quality before everything else, even if it means taking a short-term hit to our bottom line.’

‘We were now fully committed to also becoming a distributor of our own content, straight to consumers, without intermediaries. In essence, we were now hastening the disruption of our own business, and the short term losses were going to be significant.’

‘The decision to disrupt businesses that are fundamentally working but whose future is in question - intentionally taking on short term losses in the hope of generating long-term growth - requires no small amount of courage. Routines and priorities get disrupted, jobs change, responsibility is reallocated. People can easily become unsettled as their traditional way of doing business begins to erode and a new model emerges.’

‘To often, we led from a place of fear rather than courage, stubbornly trying to build a bulwark to protect old models that can’t possibly survive the sea change that is under way. It is hard to look at your current models, sometimes even ones that are profitable in the moment, and make a decision to undermine them in order to face the change that’s coming.’

Worthwhile Markets

‘In one of our conversations about some initiative I was considering, Dan [Bourke] handed me a note that read: ‘Avoid getting into the business of manufacturing trombone oil. You may become the greatest trombone-oil manufacturer in the world, but in the end, the world only consumes a few quarts of trombone oil a year!’ He was telling me not to invest in projects that would sap the resources of my company and me and not give much back. It was such a positive way to impart that wisdom, though, and I still have that piece of paper in my desk, occasionally pulling it out when I talk to Disney executives about what projects to pursue and where to put their energy.’

Career Advice

‘Do the job you have well; be patient; look for opportunities to pitch in and expand and grow; and make yourself one of the people, through attitude and energy and focus, that your bosses feel they have to turn to when opportunity arises. Conversely, if you’re a boss, these are the people to nurture - not the ones who are clamouring for promotions and complaining about not being utilised enough but the ones who are proving themselves to be indispensable day in and day out.’

‘Surround yourself with people who are good in addition to being good at what they do.’

‘Take responsibility when you screw up. In work, in life, you’ll be more respected and trusted by people around you if you own up to your mistakes. It’s impossible to avoid them; but it is possible to acknowledge them, learn from them, and set an example that it’s okay to get things wrong sometimes.’

Humility

‘I can’t emphasise how much success is also dependent on luck, and I’ve been extraordinarily lucky along the way.’

‘To hold onto that awareness of yourself even as the world tells you how powerful and important you are. The moment you start to believe it all too much, the moment you look yourself in the mirror and see a title emblazoned on your forehead, you’ve lost your way.’

Summary

While Bob Iger stepped down from running the Disney Corporation last year, the business’ recent record share price is testament to the courage, creativity and resolve he showed in transforming this great company. For even the great Disney Corporation, with its cast of irreplaceable characters, wasn’t immune to the winds of change.

Iger fortified the business with the acquisition of Pixar, Marvel, Lucasfilm and 21st Century Fox which together provided an unprecedented stable of the world’s best entertainment product. In a bold move that was sure to hurt near term earnings, Iger developed the capability to deliver that content directly to consumers through the new Disney+, ensuring Disney controlled its destiny and longevity of success.

I hope you’ve recognised many of the characteristics common to the other great businesses we’ve studied; innovation and embracing change, tolerating mistakes, decentralisation, focus on quality, accepting pain today for gain tomorrow. Many of these are found in Tom Peter’s seminal classic, ‘In Search of Excellence,’ a book itself replete with Disney anecdotes of 40 years ago.

“A special attribute of the success-orientated, positive, and innovating environment is a substantial tolerance for failure.” Tom Peters

Every business book has its lessons, in Bob Iger’s case there’s a myriad of business, investing and life lessons. Collating the ideas into mental models to apply to investments can help identify potential opportunities and pitfalls. One mental model I particularly enjoyed was the ‘Trombone Oil Market.’ It’s a reminder to do things that are worthwhile, not to chase markets that are too small. As Linkedin’s founder Reed Hoffman noted, “If it’s the left-handed scissors market, it’s too narrow.” When it comes to investing we can seek out the same.

I’ll let Bob himself have the final say:

‘If you’re in the business of making things, be in the business of making things great.’

Source:
‘The Ride of a Lifetime’ - Bob Iger. Penguin Random House. 2019.

Further Reading:
‘Creativity - Learning from Pixar’ - Investment Masters Class. 2017.

Follow us on Twitter : @mastersinvest

TERMS OF USE: DISCLAIMER

Founders & Management Alignment

If you’ve ever founded your own business, you’ll know how important they become to you. For many business owners, their companies become like one of their own children; they nurture and guide them and then watch them grow, and feel every triumph and failure far more keenly than others who are not as emotionally invested within the business might. Some few decide to sell their businesses after a while, yet many others choose to stay with them, remaining with their ‘child’ over time to see it grow to maturity.

I’m sure you’ve heard the saying, ‘no one works as hard as the owner’, and this is largely true. No one does. Where other managers and employees might come and go over time, it’s the founder who is there, quite often seven days a week, plugging away at their enterprise, steering and guiding and leading it towards success. And its this commitment to the cause that often leads to remarkable levels of performance.

We’ve covered a lot of different successful businesses in the Investment Masters Class over the last few years: Aldi, Home Depot, Walmart, Copart, Charles Schwab and McDonald’s to name but a few. And interestingly, one of the most striking features of these businesses has been the fact that ninety percent of them have been run by Founders.

You may have also noticed yourself that many of the investors considered ‘Masters’ have quite literally filled their portfolios with companies run by either founders, families or major shareholders who act like such; Berkshire, Nomad, Giverny, Baillie Gifford, Marathon and Gardner Russo are some that come to mind.

“Nomad’s investments may be in publicly listed firms but these firms are also overwhelmingly run by proprietors who think and behave as if they ran private firms.” Nick Sleep

“Sixty-plus percent of my investments at the moment and most of the past decades have been invested in family-controlled companies, which is quite unusual, and it has given us a slightly interesting benefit that to most investors, family-controlled companies suggest more risk, not less risk.” Thomas Russo

“Almost ninety percent of the portfolio is invested in firms run by founders or the largest shareholder, and their average investment in the firms is just over twenty percent of shares outstanding.” Nick Sleep

“The attractions of [founding] shareholder structures explain why companies that enjoy them form nearly 60 per cent of the International Alpha portfolio.” Baillie Gifford

And the reason for this is quite simple. Over time, businesses with aligned management have tended to produce some of the best stock market returns. There’s a myriad of explanations for this. Let’s delve a little deeper.

Outperformance

Numerous studies have shown that companies with a long term founder at the helm have outperformed. A 2012 study by the Harvard Business Review titled, ‘What You Can Learn from Family Business’ highlighted, ‘when we looked across business cycles from 1997 to 2009, we found that the average long-term financial performance was higher for family businesses than for non-family businesses in every country we examined.’

“Studies such as the one from the Harvard Business Review conclude that founder-led businesses often outperform professionally managed firms. I would suggest that they do so because the founder's commitment runs far deeper and is often longer-term in nature than that of the professional manager. And commitment and focus is what drives performance." Ron Shaich, Founder, Panera Bread.

The Credit Suisse Research Institute have made similar findings. Using its proprietary ‘Family 1000’ database of more than 1000 publicly listed family or founder-owned companies, Credit Suisse has identified that since 2006, the overall universe of ‘Family-owned businesses’ have outperformed non-family-owned companies by an annual average of 370 basis points.

Research by Baillie Gifford concurs, “Our own research suggested that businesses where a family or founder owned more than 10 per cent outperformed by 3.4 per cent per annum over a fifteen-year period.”

Trust

Money managers effectively pass stewardship of their client’s capital to the management of the companies they invest in. And as it’s never possible to know everything going on inside a company, it’s paramount they trust management. A useful method to help ascertain management integrity is to study the course of a company’s history - reading every company announcement over the last five plus years until today - soon gives you an understanding of management’s achievements versus their goals. You’ll also get a sense of director behaviour through their buying and selling activity.

“When you choose to invest with us on behalf of your clients, you’re subcontracting their capital to us to look after. The reality of this process is we subcontract it to the management of companies. Therefore, seeing they think what we regard as sensible about things is a very important sign.” Terry Smith

“Our job is to pass custody of your investment over at the right price and to the right people.” Nick Sleep

“In effect, we subcontract our portfolio to the boards and managers of the companies in which we invest.” Andy Brown

If you don’t trust management, then don’t invest.

“If there is a serious question of the lack of a strong management sense of trusteeship for stockholders, the investor should never seriously consider participating in such an enterprise.” Phil Fisher

"We do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business." Warren Buffett

Incentives

In his 97 years, Charlie Munger has studied incentive-driven behaviour more than most. Yet, even he still feels he under-estimates it.

“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.” Charlie Munger

A company founder’s incentives are usually in stark contrast to those of a professional management team. A large ownership stake in the business means a founder’s wealth is far more influenced by longer term valuation improvements than a salary. In contrast, a CEO with little skin-in-the-game may be tempted to undertake accretive short term acquisitions or minimise capex & investments to achieve short term remuneration hurdles, even to the detriment of long term value creation.

"A CEO faced with 4 years at the helm with financial incentives is unlikely to act in the same way as an owner-manager with a multi-generational timescale." Marathon Asset Management

"All else being equal, favour companies in which management has a significant personal investment over companies run by people that benefit only from their salaries." Peter Lynch

"If the CEO owns $1 million worth of stock and gets paid $10 million per year, it’s pretty clear he’ll value his job more than the value of the stock. If he’s paid $1 million per year and owns $50 million in stock, we think that’s predictive of his making better long-term decisions for the company... Where the founder owns 20-30% of the business... they’ll work with Wall Street because they don’t completely control the company, but at the same time they can take a longer-term perspective. CEOs with tons of options rather than actual shares can be prone to adopt Wall Street’s short-term focus, which can cause value to be eroded more quickly than you’d think as one bad decision piles on top of another." Adam Weiss

“Many corporate CEOs have very low levels of genuine ownership in the firms they manage and are incentivised primarily on short-term earnings-per-share targets or share price movements. These sorts of incentive schemes do not engender long-term thinking.” Baillie Gifford

"A guy who rises to the top of a big corporation and owns none of it is much more interested in control than he is in economics. It is just the nature of humanity. A guy who owns his business is used to control. He never has to fight for control. What he has to fight for is economics. But a bunch of entrepreneurs find it much easier to collaborate and create economic value. They have something beyond control—they have economics.” John Malone

Principal-Agency Problem

The incentive misalignment is often referred to as the principal/agency problem; what’s in the best interest of the CEO may be detrimental to the shareholders. The presence of a founder can resolve this dilemma.

“As ownership increases agency costs fall. And like any cost, a sustained fall increases profitability and the value of firm. This effect is born out in our experience and numerous academic studies, dating as far back as the late 1980’s. This relationship between inside ownership and outcomes is not only positive but potentially meaningful. For example, Christoph Kaserer and Benjamin Moldenhauer correlated a 1 per cent increase in inside ownership with ~10 basis points per annum increase in share price performance.” Baillie Gifford

“Insider ownership has always seemed to us as the most direct way to deal with the principal-agent problem, which arises with the separation of corporate management from ownership. Our portfolios have tended to be skewed towards companies where successful entrepreneurs run their companies and retain sizeable shareholdings.” Marathon Asset Management

“The issue of alignment of interests is one of the great challenges of modern-day capitalism. Strong governance structures, well-devised remuneration schemes and large management shareholdings can help, but one of the best ways to overcome this challenge is simply to invest alongside the founders of a business or their descendants. When founders move on, substantial equity ownership by their descendants can still have significant beneficial effects." Baillie Gifford

Passion versus Pay

The most profitable businesses tend to be those focused on delivering a customer outcome, not the most profit-orientated. Founders often bring a passion to the business absent from that of professional managers. They are building a legacy, which requires long term thinking. Buffett himself is a good example; Berkshire pays him a salary of $100,000 a year; he resides in the same house he bought in 1958. Berkshire is his canvas. In the insightful book, Obliquity, John Kay observed, “Many of the businesspeople who talk obsessively about profit are ultimately less successful in creating profit than those who profess love for their business.”

“The best entrepreneurs we know don’t particularly care about the terms of their compensation packages, and some, such as Jeff Bezos and Warren Buffett have substantially and permanently waived their salaries, bonuses, or option packages. We would surmise that the founders of the firms Nomad has invested in are not particularly motivated by the incremental dollar of personal wealth… These people derive meaning from the challenge, identity, creativity, ethos (this list is not exhaustive) of their work, and not from the incentive packages their compensation committees have devised for them. The point is that financial incentives may be necessary, but they may also not be sufficient in themselves to bring out the best in people.” Nick Sleep

“One thing that Sam Walton and Mrs. B had in common is they had a passion for the business. It isn’t all about the money, at all. It was about winning. Passion counts enormously; you have to really be doing it because you love the results, rather than the money. When we buy businesses, we are looking for people that will not lose an ounce of passion for the business even after their business is sold.” Warren Buffett

“I always look to invest in a manager who has made the company his or her life’s work.” Robert Vinall

“A majority of our managers are financially independent, so that they don’t go to work because they are worried about putting kids through school or putting food on the table. So they have to have some reason to go to work aside from that.” Warren Buffett

“What matters most: passion or competence that was inborn. Berkshire is full of people who have a peculiar passion for their business. I would argue passion is more important than brain power.” Charlie Munger

“We’ve had terrific luck with the entrepreneurs who basically love their businesses the way I love Berkshire.” Warren Buffett

“I’ve spent a lot of time thinking about factors that influence the long-term success of a business, and I think firms (public or private) that are run by the founders often have a huge intangible quality to them - one that is crucial to the firm’s ultimate success. This intangible quality is that the founder is often motivated by much more than money. And that is a driving force that can be incredibly powerful, and incredibly valuable for the owners of those firms.” John Huber

Tone from the Top & Culture

This aspect is really quite simple, yet despite its simplicity, its often underestimated or even overlooked altogether. And it is vastly important to the success of any organisation. Higher management set the tone for any organisation. What this means is that when you think of a company’s culture, in its simplest form it is actually derived from the values and behaviour(s) of either the founder/owner or the combined personality of the management team.

And those behaviours of passion and commitment and love for the business are always going to be far more evident in a company that is run by a Founder, than that run by a professional manager or team.

“A company’s behaviour is an analog of its leadership’s behaviour, much as a marionette’s behaviour is an analog of the puppeteer’s hand motions.” Rajenda Sisodia

“Costco’s founder, Jim Sinegal owned a lot of shares but never made more than $300k a year. How different is that from other company's where the CEO is making $20, $30, $40m or gets fired and gets a $200m golden parachute? That doesn't usually bode well for the long term cultural success of the firm." Paul Black

“We’ve bought business after business because we admire the founders and what they’ve done with their lives. In almost all cases, they’ve stayed on, and our expectations have not been disappointed.” Charlie Munger

Lower Capital Requirements

Investors often give little consideration to the capital required to grow a business. One of the attractions of businesses owned by founders, or in an industry where a founder-led business thrives after decades, is the ability for a company to self-fund growth without calling upon external capital.

“We are the Groucho Marx of investment. Groucho Marx once said he would never join a club that would have him as a member. We would never invest in a company that needs our money. All the companies we invest in are quoted but the companies are not quoted on the stock market because they need our money. Why are they quoted? They are typically quoted because they were once family-owned, and when family’s become dispersed a realization has to happen. When we are looking at a sector and we are thinking of investing in it, we look for a big private company in that sector, that’s been around for many decades, if not longer and has never had to float. Which means we know in that sector companies can grow and prosper and create value without ever ringing up the shareholders and asking for more money. We can’t buy those companies but they give us comfort we are fishing in the right area.” Terry Smith

"We usually tend to be in bed with managements who don't really need the capital markets." Marty Whitman

Long Term Focus / Jam Tomorrow

All the way back in 1958, Phil Fisher understood the benefits of investing in businesses taking a long-term view.

“The investor wanting maximum results should favour companies with a truly long-range outlook concerning profits.” Phil Fisher

‘The Hunt for Europe’s Ten-Baggers’, Baillie Gifford 2019.

Often business decisions that promise long-term value, come at the cost of short-term performance. It might be investing in an overseas expansion which is dilutive to near term earnings, keeping margins low to deter competitors, increasing advertising spend to maximise long-term customer value or increasing R&D spending which has potential long-term benefits.

“Almost all good businesses engage in ‘pain today, gain tomorrow’ activities.” Charlie Munger

Professional CEO’s are often reluctant to disappoint Wall Street expectations over concerns of long-term job stability, short-term earnings implications and concern for short term stock price performance.

“If you owned a business all by yourself, you wouldn’t care at all about maximising reported numbers.”  Tom Russo

“Our favourite and most frequent acquisitions are the businesses that we buy from founders. When a founder invests the better part of a lifetime building a business, a long-term orientation tends to permeate all aspects of the enterprise: employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated product suites.” Mark Leonard

“At best, family control can be an elegant solution to the agency problem. Families are better able to withstand short-term profit fluctuations and to invest for the long term benefit of themselves and outside shareholders.” Marathon Asset Management

“Often family controlled companies have the ability to look out beyond quarters and that's valuable.” Thomas Russo

“Our experience suggests founder-led companies show greater propensity to focus on long-term value creation, even when it comes at the expense of short-term pain.” Baillie Gifford

“Family owners typically want their firms to last for generations, so they can make long-term investments without worrying about shareholders looking for short term-profits.” Vicki Tenhaken

A founder is less likely to be seduced by the demands of Wall Street.

“I admire Amazon founder, Jeff Bezos. He has revolutionized the retail industry and has two great qualities: He is patient and persistent, and he doesn’t care to please Wall Street’s quarterly expectations. This last quality is often overlooked but it is seldom found and represents, in my opinion, a true competitive advantage.” Francois Rochon

Summary

Warren Buffett has long espoused the more attractive opportunities in the equities market than the private market. Notwithstanding, he has continued to seek out founder-led businesses for acquisition. In fact, if he had his way, he’d own more.

‘In the stock market, you get a chance to buy businesses at foolish prices, and that is why we end up with a lot of money in marketable securities. If we absolutely had our choice, we would own three times the number of businesses we own outright.’ Warren Buffett

Many of the world’s best investors have applied the benefits of his approach to public equities investing.

“An owner-operator culture is the central idea expressed in our portfolio. Boiled down to our essential raison d'être, that’s it. We invest with talented people who have skin the game. In other words, we invest in businesses where management and/or the board own a significant amount of stock.” Chris Mayer

“We seek companies with owner-oriented management.” Fred Liu

“I follow the philosophy, have your money where the owners are.” Mario Gabelli

“We look for managers who are owners.” Chuck Akre

"I invest almost exclusively in companies with active and engaged owners. Very occasionally, you find managers who think and act like owners even if no owner is present but this is the exception rather than the rule. If a restaurant has an absentee owner, over time the service quality will slip and the waiters will have their hand in the till. With large companies, it is no different.” Robert Vinall

"We love owner-operators.” Mason Hawkins

"We want to invest with management teams 'that think and act like owners.’" David Herro

“If we recognise that portfolio performance is usually driven by a relatively small number of long-term winners, and that these winners most often are run by passionate managers, often founders or a second-generation with a deep-rooted interest in the success of their offspring, we must then redouble our efforts to find more of this type of company.” David Poppe

"I want to invest with people who have at-risk skin in the game, ideally founder capital. I like knowing that I and the person calling the shots are in parity in terms of risk." Frank Martin

“I try to stuff our portfolio with management teams that ‘get it’. Founders run 45% of our companies; the average tenure of management is fifteen years.” Ryan Krafft

One of my favourite quotes from Charlie Munger is ‘Fish where the fish are.’ The starting point is finding the right pond. And ultimately, this is profound advice. It’s clear that a great starting place in your search for great investments might be the pond of companies run by Founders.

Sources:
‘The Hunt For Europe’s Ten Baggers’, Baillie Gifford. 2019
‘Owner Operators’, Horizon Kinetics, 2014.
‘What You Can Learn from Family Business,’ Kachaner, Stalk, Bloch. Harvard Business Review. 2012.
‘Family-owned businesses show resilience through pandemic,’ Credit Suisse Research. 2020.
‘Founder-Led Companies Outperform the Rest — Here’s Why,’ Chris Zook, Harvard Business Review, 2016.
‘Business In The Blood - Companies controlled by Founding Families remain surprisingly important and look set to stay so.’ The Economist, 2014.

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Learning from Nick Sleep

True investment success is rare, and even more so is the prospect of long term success; an investor’s returns that outperform the index year on year. Rarer still is the prospect of gaining insights into how the most successful in the investing world have achieved that success. And let’s be honest; we’re all looking for information that will give us an edge; those pearls of wisdom that allow us to intimately understand the thoughts and mental models of the great investors. But this information is sometimes so hard to find, it’s almost like searching for the Dead Sea Scrolls - We know it exists but we’re not quite sure where to look.

If the Dead Sea Scrolls had an investing equivalent, Nick Sleep’s letters would be it. For a long time these letters have been as rare as hen’s teeth, and because of this, and the gems contained within, they have been coveted by investors the world over. Only in the last few months have they surfaced publicly. Having spent the better part of the last few decades studying the world’s best investors, businesses and CEO’s, I’ve read hundreds of letters, interviews and books. And what I have found is that Mr Sleep’s remarkable insights and creativity in investing are almost without peer.

In 2001, after a decade in the industry, Sleep and his partner Qais Zakaria launched the Nomad Investment Partnership under the tutelage of Jeremy Hosking at Marathon Asset Management. The fund was spun out in 2006. After trouncing the index for thirteen years [20.8%pa vs index 6.5%pa], Nomad was closed in 2014 as Sleep & Zakaria sought more ‘caring pursuits’.

Like many of the world’s great investors, Nick Sleep came to investing from unorthodox beginnings. He didn’t study business or finance, but geography, a multi-disciplinary subject that nurtured a love of asking questions.

“Geography is a subject with an identity crisis – it is the confluence of geology, physics, chemistry, oceanography, climatology, biology and that is just physical geography. Human geography deals with sociology, psychology, statistics, economics – so it is the ultimate polymath course. Geography just reached in to other subjects and grabbed what it thought it had to have. Indeed, the reason I studied Geography at all was because of this polymathic quality.”

“But because Geography is so broad, it claims little territory of its own.. Because Geography is seen as an academic gate-crasher, practitioners have had to ask themselves questions that other more homogenous subjects such as physics or chemistry have not.”

And it was Geography combined with Robert Pirsig’s seminal book, one occasionally referenced by the great investors, that reshaped his perspective on the world.

“I was reading ‘Zen and the Art of Motorcycle Maintenance’ by Robert Pirsig at the time, and the two just combined to change how I viewed the world. So I have this tendency to return to the basic questions.”

Mirroring the journey of many of the Investment Masters, Nick Sleep evolved as an investor. In Nomad’s early years the fund had almost half its assets in typical ‘value’ plays - discounted asset based businesses and deep value workouts - the ‘cigar butts’ that characterise Benjamin Graham’s investing style. Notwithstanding, Sleep could see that Nomad’s destination was in owning ‘honestly run compounding machines’. Nomad’s 2004 letter set out ‘the likely evolution of Partnership Investments’ which he referred to as the ‘terminal portfolio’ - where he wanted to go. By the time the partnership wound down the fund was characterised by a portfolio of these compounding machines; businesses deploying ‘scale-economic-shared’ models largely run by their founders.

Charlie Munger has often said ‘take a simple idea and take it seriously’. Sleep embraced this philosophy, grasping the market’s perennial undervaluation of ‘scale-economics-shared’ businesses. He formulated creative investment theses that he fortified through the mental models he collected from disparate disciplines; many not ordinarily applied to investing. When combined with a deep understanding of psychology, the application of relentless patience and a steadfast focus on each company’s destination, Nomad achieved an astonishing track record of performance.

There are so many lessons to draw from this incredible collection of investment letters it’s almost difficult to know where to begin. Sleep’s prescient views on Amazon are laid out in a roadmap in the early letters. A contrarian view on Costco from Nomad’s formative years is now conventional wisdom. I’ve included some of my favourite learnings below.

Think Long Term

“We own the only permanent capital in a company’s capital structure – everything else in the company, management, assets, board, employees can change but our equity can still be there! Institutional investors have never really reconciled their ability to trade daily with the permanence of equity.”

“There is a lot to be said for gentle contemplation. And of course, a long investment holding period allows one time between decisions to ‘retreat and simmer a little.”

“We are genuinely investing for the long term (few are!), in modestly valued firms run by management teams who may be making decisions, the fruit of which may not be apparent for several years to come.”

Focus on the Destination

“Destination analysis is consciously central to how we analyse businesses these days. It helps us ask better questions and get to a firm’s DNA.”

"The only real, long term risk, is the risk of mis-analysing a company's destination."

Compounding Machines

“We can do better with the compounding businesses these days- and they are much less stressful.”

“If we had out time again, we would hope not to be seduced by some firms (apparent) economic cheapness but weigh more heavily their DNA, if you like. One of the things we have learnt over the last few years is our most profitable insights have come from recognising the deep reality of some businesses, not from being more contrarian than everyone else. Old habits die hard but, even so, I am finally attending classes at CBA, Cigar Butts Anonymous!”

“We estimate that around three quarters of the portfolio is invested in growth businesses, which have the potential to compound for many years, and the balance in more cigar butt like investments (we just could not help it!).”

“Investors know that in time average companies fail, and so stocks are discounted for that risk. However this discount is applied to all stocks even those that, in the end, do not fail. The shares of great companies can therefore be cheap, in some cases, for decades.”

Ignore the Noise

“At its heart, investing is simple, and to make it seem anything but, with the frequent repartition of short-lived facts and data points, may be a conceit. Indeed, it could be argued that a running commentary obfuscates a discussion of the things that really matter.”

“Information is like food has a sell by date - after all, next quarter's earnings are worthless after next quarter. And it is for this reason the information Zak and I weigh most heavily in thinking about a firm is that which has the longest shelf life, with the highest weighting going to information that is almost axiomatic: it is, in our opinion, the most valuable information.”

“The investment industry, as well as many economic commentators, spend so much time shouting. So much commentary espouses certainty on a multitude of issues, and so little of what is said is, at least in our opinion, knowable. The absolute certainty in the voice of the proponent so often seeks to mask the weakness of the argument. If I spot this, I metaphorically tune out. In our opinion, just a few big things in life are knowable. And it is because just a few things are knowable that Nomad has just a few investments.”

Psychological Advantages

“Charlie Munger’s ‘Psychology of Human Misjudgment’ speech given at the Harvard Law School in the mid 1990’s is the finest investment speech ever given. Not that he talked directly about investments. And that tells you something. But the most enduring advantages are psychological. And the trick here is to first understand them. And then train yourself out of them!”

Focus on the Business

“We own shares for multi-year periods and so our continued investment success has far more to do with the economics of the underlying businesses than it has to do with their last share price quote.”

"The trick, it seems to us, if one is to be a successful long-term investor, is to recognise the sources of enduring business success, get in early and own enough to make a difference."

“We can all observe that stock prices, set in an auction market, are more volatile than business values. Several studies and casual observation reveal that individual prices oscillate widely around a central price year in year out, and for no apparent reason. Certainly, business values don’t do this. Over time, this offers the prospect that any business, indeed all businesses, will be meaningfully mis-priced.”

Customer Relationships

“[Nomad’s firms’] cultures are focused on the customer experience, not on the competition or the profit and loss statement. Our firms tend to chase the vision, not the money.”

"To be precise, the wealth you receive as partners came from the relationship our companies' employees (using the company as a conduit) have with their customers. It is this relationship that is the source of aggregate wealth created in capitalism."

“One trick that Zak and I use when sieving the data that passes over our desks is to ask the question: does any of this make a meaningful difference to the relationship our businesses have with their customers? This bond (or not!) between customers and companies is one of the most important factors in determining long-term business success. Recognising this can be very helpful to the long-term investor.”

Business Models

“Zak and I observe several business models that work in the long run, and scale economics shared is one of these... that is why companies that share scale with the customer make up around sixty percent of the portfolio.”

“The basic business models that lead to success don’t change that much and there aren’t that many of them.”

“We have little more than a handful of distinct investment models, which overlap to some extent.”

Management

“Our job is to pass custody of your investment over at the right price and to the right people.”

Founders & Management

“Almost ninety percent of the portfolio is invested in firms run by founders or the largest shareholder, and their average investment in the firms they run is just over twenty percent of the shares outstanding.”

“The best entrepreneurs we know don’t particularly care about the terms of their compensation packages, and some, such as Jeff Bezos and Warren Buffett have substantially and permanently waived their salaries, bonuses, or option packages. We would surmise that the founders of the firms Nomad has invested in are not particularly motivated by the incremental dollar of personal wealth… These people derive meaning from the challenge, identity, creativity, ethos (this list is not exhaustive) of their work, and not from the incentive packages their compensation committees have devised for them. The point is that financial incentives may be necessary, but they may also not be sufficient in themselves to bring out the best in people.”

“Nomad’s investments may be in publicly listed firms but these firms are also overwhelmingly run by proprietors who think and behave as if they ran private firms.”

Scale Economics Shared

“Nomad’s firms are, on average, so cost advantaged compared to many of their competitors that the worse it gets for the economy, the better it gets for our firms from a competitive position.”

“The simple deep reality for many of our firms is the virtuous spiral established when companies keep costs down, margins low and in doing so share their growing scale with their customers. In the long run this will be more important in determining the destination for our firms that the distractions of the day.”

“Scale Economics Shared operations are quite different. As the firm grows in size, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods., which provides greater scale for the retailer who passes on the new savings as well. Yippee. This is why firms such as Costco enjoy sales per foot of retailing space four times greater than run-of-the-mill supermarkets. ‘Scale economics shared’ incentivises customer reciprocation, and customer reciprocation is a super-factor in business performance.”

"In the office we have a white board on which we have listed the (very few) investment models that work & we can understand. Costco is the best example we can find of one of them: scale efficiencies shared. Most companies pursue scale efficiencies, but few share them."

Price Give-Back

“We would suggest that investment in price-giveback, so favoured by Nomad's firms, is the most long-lived of the investment spending items if it engenders consumer habit. It may, therefore, be the most valuable to long-term investors.”

Risks of Pricing Power

“Early in a firm’s development it makes sense to reward customers disproportionately as customer referrals and repeat business are so essential to the development of a valuable franchise. With maturity this bias can be reduced and shareholders can reasonably take a greater slice of the pie. Too much, however, and the moat is drained with negative consequences for longevity. The temptations are enormous because capital markets will reward profiteering. There are many examples of companies which ‘harvest’ excessively, when perhaps they should focus on longevity. This may have been what happened at Coca Cola which has leant excessively on bottlers, or Gillette where advertising has been cut, or even at Home Depot which has boosted gross margin in recent years. Shareholders often suffer a double whammy as highly rated companies enter ‘growth purgatory’, because growth slows just at the time when shareholders spot the mis-analysis of reported profitability.”

Risk with High Margins

"The risk with super-normal profitability is that profits are an incentive for a new competitor, far better to earn less, but for a much longer time.”

Lollapalooza Moat

“There is not a prior reason why a comparative advantage should be one big thing, any more than many smaller things. Indeed an interlocking, self-reinforcing network of small actions may be more successful than one big thing… Firms that have a process to do many things a little better than their rivals may be less risky than firms that do one thing right [e.g. develop/own a patent] because their future success is more predictable. They are simply harder to beat. And if they’re harder to beat then they may be very valuable businesses indeed.”

Misunderstood

“[We] invest in firms that are misunderstood by many. For example, we invest in firms that pay their employees 80% more than rival companies (Costco); firms that lower prices as an article of faith (Amazon.com); firms that force an equitable distribution of commissions in an industry dominated by an eat-what-you-kill culture (Michael Page); a low cost airline for the masses in a region served by airlines for the rich (Air Asia); and a company that thinks table top figurine games are cool, really, (Games Workshop). Isn’t it wonderful that these firms are behaving in this way despite being misunderstood by the outside world? All the social pressure will be to conform with industry norm but these companies have a deep keel that keeps them upright.”

Recognising & Weighing the Right Information

“What investors needed to understand, and attribute sufficient weight to, in order to hold Colgate-Palmolive shares for the last thirty years, and so enjoy the fifty-fold uplift in share price, was the economics of incremental products (often referred to as “line extensions”, from the first “Winterfresh” blue minty gel in 1981 to “Total Advanced Whitening” today) and the psychology of advertising. Other items were important too, discipline in capital spending in particular, and there were lots of other things that seemed important along the way (stock market crises, country crises, management crises and so on) but it was the success and economics of line extensions and advertising that, in our opinion, was what the long-term investor really needed to embrace. A similar story can be told at Nike and Coca-Cola (manufacturing savings funneled into dominant advertising) or Wal-Mart and Costco (scale savings shared with the customer). Recognising and correctly weighing this information in-spite of the latest news flow is a matter of discipline, and it is that discipline that is so richly rewarded in the end.”

Inaction - SOYA

“One common psychological trap that agents may fall into is that clients expect action, or to be more accurate, fund managers expect their clients to expect action! The investor Seth Klarman was once challenged on whether Buffett’s track record was statistically significant as he traded so little? To which Klarman answered that each day Buffett chose not to do anything was a decision, too. It is quite possible that we may not change the companies we have invested very much over the next few years.”

“There are, broadly two ways to behave as an investor. First buy something cheap in anticipation of a price rise, sell at a profit, and repeat. Almost everybody does this to some extent. And for some fund managers it requires, depending on the number of shares in a portfolio and the time they are held, perhaps many hundred decisions a year. Alternatively, the second way to invest is to buy shares in great businesses at a reasonable price and let the business grow. This appears to require just one decision (to buy the shares) but, in reality, it requires daily decisions not to sell the shares as well! Almost no one does this, in part because it requires patience.”

“The decision not to do something is still an active decision; it is just that the accountants don’t capture it. We have broadly, the businesses we want in Nomad and see little advantage to fiddling.”

“The runway ahead for our businesses may be very long indeed. Inaction on our part is counter-cultural and deliberate, and is easier said than done. Really… As Berkshire Hathaway Vice-Chairman, Charlie Munger says, you make your real money sitting on your assets!”

“Our portfolio inaction continues and we are delighted to report that purchase and sale transactions have all but ground to a halt. Our expectation is that this is a considerable source of value add!”

The Real Mistakes

“The biggest error an investor can make is the sale of a Walmart or a Microsoft in the early stages of the company’s growth. Mathematically, this error is far greater than the equivalent sum invested in a firm that goes bankrupt. The industry tends to gloss over this fact, perhaps because opportunity costs go unrecorded in performance records.”

The Value in Mistakes

"In investment terms, once lessons have been learnt, mistakes can be put on a price earnings ratio of one and the resultant, good behaviour on a ratio of more than one. In other words, mistakes become net present value positive."

Position Sizing

“It is common-place for overall portfolio construction to be as a result of stock weighting built up from one to two to three percent of a portfolio and so on up to a target holding. This means that weightings are anchored at a small number with only outliers reaching double digits. There is another way to construct a portfolio, which is to invert and start at a hundred percent and work down! If fund managers did this, I am sure they would end up with completely different portfolios. Now we are not advocating all the fund in Amazon (well, not just yet at least), but in allowing past habits to anchor portfolio construction we have probably made the mistake of a starting holding that was almost certainly too low.”

Diversification

“The church of diversification, in whose pews the professional fund management industry sits, proposes many holdings. They do this not because managers have so many insights, but so few! Diversity, in this context, is seen as insurance against any one idea being wrong. Like Darwin, we find ourselves disagreeing with the theocracy. We would propose that if knowledge is a source of value added, and few things can be known for sure, then it logically follows that owning more stocks, does not lower risk but raises it!”

“In our opinion, just a few big things in life are knowable. And it is because just a few things are knowable that Nomad has just a few investments.”

“Sam Walton did not make his money through diversifying his holdings. Nor did Gates, Carnegie, McMurtry, Rockefeller, Slim, Li Ka-shing or Buffett. Great businesses are not built that way. Indeed the portfolios of these men were, more or less, one hundred percent in one company and they did not consider it risky! Suggest that to your average fund manager.”

Learning

“We still have much to learn.”

“As a young(ish) man there is something slightly depressing about thinking things through for a while, arriving at a somewhat reasoned conclusion only to find that others have been there before, and years earlier. In some respects we are fifty years behind Buffett, but that’s ok, so long as the average investor is at least fifty-one years behind!”

“Discovery is one of the joys of life, and in our opinion, is one of the real thrills of the investment process; the cumulative learning that leads to what Berkshire Hathaway Vice-Chairman Charlie Munger calls ‘Worldy Wisdom’. Worldly wisdom is a good phrase for the intellectual capital with which investment decisions are made and, at the end of the day, it is the source of any superior investment results we may enjoy.”

Patience

“At the beginning of the AGM of the Berkshire Hathaway Company they show this little video and each year Buffett is asked what’s the main difference between himself and the average investor, and he answers patience. And there is so little of it these days. Has anyone heard of getting rich slowly?”

“Good investing is a minority sport, which means that in order to earn returns better than everyone else we need to be doing things different to the crowd. And one of the things the crowd is not, is patient.”

Summary

These observations are but a fraction of the insights espoused in Nomad’s letters. Discourses on investment edges, the ‘robustness ratio’, business models, ‘value vs growth’, the ‘equity yield curve’, fee structures and behavioural finance more generally, while not included here, are worthy of their own posts. Sleep’s observations on habit change and the implications for internet retailing are imminently relevant in light of today’s Covid-19 inflicted consumer landscape.

Nick Sleep didn’t rely on complex models, non-public information or business relationships to deliver his returns. Like Munger, he reached into other disciplines for mental models he could apply to his thinking. Asking questions, thinking things through, turning ideas upside down and challenging conventional wisdom led to insights other investors couldn’t see. Sticking within his core competency, keeping it simple, and recognising the basic nature of the businesses he owned accorded him the patience to remain invested in compounding machines. Despite Nomad’s closure, Sleep remains invested in Amazon and Costco to this day.

Like Buffett’s missives, Nomad’s wonderfully articulate letters are likely to prove a rewarding resource that can enhance investment success. I implore you to read them. And then, re-read them. These are an absolute rarity that have recently come into the public domain, and offer as much relevant wisdom in today’s landscape as they did when they were first written. The Dead Sea Scrolls, indeed.

Further Reading:

The NOMAD Investment Partnership Letters - 2001-2013 are available on Mr. Sleep’s charitable foundation website here .. I.G.Y Foundation

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Learning From the Santa Fe Institute

If only we had perfect foresight and understanding. It certainly would make investing easy, but unfortunately, the infinite complexity of the world makes it impossible for us to make sense of it all. To help us cope with the complexity we develop mental models - short cuts or maps - that simplify what’s in front of us. These mental models become the tools we use to interpret the world, and while useful, they’re often but a crude guide to reality. Through curiosity, exploration and study we can upgrade our toolkit of mental models providing us a better window into the future. We can develop what Charlie Munger refers to as ‘worldly wisdom.’

“As Thoreau said, ‘It's not what you look at that matters, it's what you see.’" Warren Buffett

"Visionaries are not people who see things that are not there, but who see things that others do not. As Einstein quipped, ‘Why do some people see the unseen?’" Bennett Goodspeed

"The real voyage of discovery consists, not in seeking new landscapes, but in having new eyes." Marcel Proust

“Theory shapes the observation.” Albert Einstein

When it comes to investing and businesses, the mental models in our head help us answer the question, ‘what does the future hold?’ Ordinarily such models deal with businesses, industry structure, markets, politics, history, economics, etc. Ultimately, they manifest themselves in the numbers that fill an analyst’s or investor’s spreadsheet model. Devoid of the right mental models, or applying the wrong ones, is likely to result in failure. By way of example, applying the mental model of ‘mean reversion’ for a ‘fade-defying’ business model will lead to an erroneous conclusion. If the mental models are wrong, the spreadsheet model will be wrong. Period.

“I would argue rationality, which is seeing the world the way it is, instead of the way you hope it is. I’d say that’s the most important thing. If you don’t see the world the way it is, it’s like judging something through a distorted lens, you think the world is one way and it’s different. And of course, that leads to terrible mistakes. You want to think correctly.” Charlie Munger

It’s for this reason that developing a broad ensemble of mental models can provide an investment edge; offering insights others can’t see. A striking example is Nick Sleep’s prescient analysis of Amazon some fifteen years ago. The recent FT article, “Cult figure of investing one of few to grasp early promise of internet stocks,” picked up on this: ‘what remains remarkable about [Nick Sleep’s] observations made more than 15 years ago is that many are only now starting to be accepted by mainstream financial analysis, while some remain controversial to this day’.

Nick Sleep is undoubtedly one of the best investors nobody’s heard of. His fund, Nomad Partners, delivered returns of more than 20 percent a year for thirteen years before he closed up shop to pursue more ‘caring pursuits.’ What differentiates Sleep are the diversity of the mental models he internalised and crafted into unique investment theses. Many of these mental models were drawn from a think-tank nestled in the Sangre de Cristo Mountains in New Mexico known as the ‘Santa Fe Institute’ [SFI].

Source: Nomad Letter 2007

If Charlie Munger, the epitome of a multi-disciplinary mindset, were to design a ‘think-tank’, the ‘Santa Fe Institute’ would be it. Drawing on fields as diverse as physics, chemistry, biology, information processing, economics, political science and every other aspect of human affairs, the Institute endeavours to see the world as it is, a complex non-linear web of incentives and constraints and connections.

In 2007, Nick Sleep discussed the Santa Fe Institute professor Geoffrey West’s work on ‘Scaling’ and the universal laws of growth, innovation and sustainability. Sleep proposed the simple elemental structure of scaling found in organisms might apply to companies, with specific reference to internet retailing and Amazon.

Source: Nomad Letter 2007

In 2010, SFI professor Ole Peter’s work on decision trees was utilised to clarify the risk a company poses as it moves down the various branches of future possible realities. Sleep concluded the stock market mistakenly prices all possible future outcomes concurrently, yet the range of future scenarios lessen as a company moves down each consecutive branch, leaving long-term success under-valued.

Source: Nomad Letter 2010

Nick Sleep is not alone in drawing on the learnings of the Santa Fe Institute. James Anderson, Bill Gurley, Josh Wolfe, Bill Miller, Michael Mauboussin and Chris Davis are passionate adherents.

“It is my personal opinion that the thinking presented by Zeckhauser, and at the Santa Fe Institute should be thought of as the new economics in waiting, but it will likely only become mainstream consensus once the old guard has died off. The fact that these courses are still considered Moonie conventions and are rejected by the Harvard economics department shows how far away establishment, consensus thinking is.” Nick Sleep

“For a long time I’ve thought that the Santa Fe Institute was the best academic link that we have. ‘Best’ in almost every sense: highest intellectual calibre (as partially evidenced by how little I grasp), interdisciplinary devotion, collegiate atmosphere and obliquity. Yet Santa Fe has turned out to be directly relevant to how I, at least, invest. Indeed I can scarcely think of any significant investment I’ve made that hasn’t been fundamentally driven by ideas emanating from Santa Fe. From Brian Arthur’s views on the economics of increasing returns to Geoffrey West’s work on scaling, to Jessika Trancik’s tracking of innovation rates (especially in energy), to the basic notion of complexity itself, their thoughts have altered my mind a lot. In fact it’s simply been the most important material I’ve come across.” James Anderson

"You don't come [to the Santa Fe Institute] to get an answer to something, you come here to understand things in a different way." Bill Miller

“My favourite book of all time is a book called “Complexity,” about the rise of the Santa Fe Institute where I’m now fortunate enough to serve on the board. It’s really an analysis of multi-variable nonlinear systems & how they behave. And that includes things like stock markets or weather, the pandemics. A lot of the tools that we think are scientific like linear interpolation actually don’t work very well in these chaotic systems. One of the early people there was Brian Arthur [who was] the first to write about network effects back in the early 90’s, and that had a big impact [on me].” Bill Gurley

Summary

Developing a diverse toolkit of mental models for investing is a proven path to success. Nick Sleep, Charlie Munger and James Anderson, mavericks when it comes to investment thinking, are evidence of such. The learnings these Masters have extracted from nature, biology, physics, psychology, economics, politics and complexity science have lead to investment insights and success others couldn’t see.

'Wordly wisdom is a good phrase for the intellectual capital in which investment decisions are made, and at the end of the day, it is the source of any superior investment results we may enjoy." Nick Sleep

The Financial Times article concluded, “the story of Mr Sleep is a reminder that a small number of investors who possess genuinely differentiated insights about the world can generate vastly superior results to the herd.”

Every single human being on earth is blessed with the power of thought. And every single one of us utilises our capacity for thinking every single day. Some of us are very good at it, yet others are not, and most of us will tend to hang onto the thoughts that have been presented to us during our education or working lives, and never question their veracity, accuracy or even relevance in today’s world. Even more, very few of us can attain the idea of an original thought; that is, an idea or opinion that has never been previously imagined in the past. But don’t be discouraged, even a genius like Nick Sleep has identified there is a body that can. So, if you’re looking for differentiated insights and vastly superior results, the Santa Fe Institute might be a rabbit hole worth venturing down.

Further Reading:

‘Complexity - The Emerging Science at the Edge of Order and Chaos,’ Mitchell Waldrop, 1992.
Santa Fe Institute - Website.
‘Multi-Disciplinary Mindset’ - Investment Masters Class Tutorial.
‘How to Build a Better Investing Mind’ - Investment Masters Class, 2017.

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Fight the Fade - Round 2

Businesses Fade; its a fact. Market saturation, new competitors, management complacency and poor capital allocation all conspire against business growth. Today, corporate moats are being filled faster than ever as new technologies disrupt and challenge the prospects of what were once unassailable businesses. This process isn’t new. If you look back at the leading stocks of the S&P500 twenty years ago, few companies still hold those positions today. Given enough time, capitalism guarantees the demise of virtually all businesses.

Most analysts and investors understand this, correctly assuming a business’ growth will FADE.

“Investors tend not to believe in “longevity of compound.” Conventional thinking has it that good things do not last, and indeed, on average that’s right! Empirical Research Partners, an investment research boutique, discovered that the chance of a growth stock keeping its status as a growth stock for five years is one in five, and for ten years just one in ten. On average, companies fail.” Nick Sleep

However, when the ‘mental model’ of mean reversion is applied to those rare FADE-defying companies, the estimate of value can not only be incorrect, but in the wrong ballpark. Both Nick Sleep and Terry Smith have drawn on examples to make this point. Nomad’s 2009 letter contained the following chart:

Sleep observed, “If, in 1972, upon reading that year’s twelve page annual report (!) an investor chose to make a purchase of shares, he could have paid over one hundred and fifty times the prevailing share price (a price to earnings ratio of over fifteen-hundred times, a ratio far in excess of what professional fund managers would consider prudent. They would be mistaken, as it turns out) and he would have still earned a ten percent return on his investment through to today. If, instead, the investor thought about it for a while and decided to purchase shares ten years later he could still have paid over two hundred times earnings for his shares (beware heuristics) and still earned ten percent on his investment. And ten years after that could also have paid a premium over the prevailing Wal-Mart share price and done well subsequently. The market struggled to appreciate the magnitude and longevity of the business’ success.”

Terry Smith makes the following point in his new book, ‘Investing For Growth,’ “.. the level of valuation which may represent good value at which to buy shares in a high-quality company may surprise you. The following chart shows the “justified” PEs (price-to-earnings ratios) of a group of stocks of the sort we invest in. What does that mean? It looks at the period 1973 to 2019 when the MSCI World Index produced an annual return of 6.2% and works out what PE an investor could have paid at the outset for those stocks and still returned 7% p.a. over the period, so beating the index. You could have paid 281 times earnings for L’Oréal in 1973 and beaten the index return. Or a PE of 126 for Colgate. A PE of 63 for Coca-Cola. Clearly this approach would not fit the mutation of value investing in which the rating must simply be low. Yet it is hard to argue with the fact that these stocks would have been good value even on some eye-watering valuation metrics.”

While neither Smith nor Sleep advocate paying such extreme multiples for a business, their analysis highlights both the value that accrues to a business able to compound for extended periods of time and the disservice a simple price earnings multiple can afford great businesses.

Holding a variant perception on the sustainability of growth and resultant business worth can equip an investor with the fortitude to remain invested in these ‘compounding machines’. The unique characteristics misunderstood by the investing community often come in the form of business models, industry structures or the individual culture of the business. While by no means exhaustive, below we review four of these: ‘Scale Economics Shared’, ‘Increasing Returns’, ‘Market Dynamics’ and ‘Culture’.

Scale Economics Shared

‘Scale Economics Shared,’ a term coined by Nick Sleep, describes a business which shares the benefits of scale with it’s customers; ‘increased revenues begets scale savings begets lower costs begets lower prices begets increased revenues’.

These businesses optimise for longevity - not short term profitability. Persistent low prices attract customers, leading to increased turnover that drives scale benefits which are then returned to the customer in the form of even lower prices; a virtuous feedback loop. As the business grows, the moat gets wider.

“There are very few business models where growth begets growth. Scale economics turns size into an asset. Companies that follow this path are at a huge advantage.” Nick Sleep

It’s not new. Cornelius Vanderbilt, America’s first tycoon, built the greatest fortune America had ever seen employing this business model over two centuries ago. Buffett too, recognised this model decades ago. Berkshire’s 1993 letter touched on Nebraska Furniture Mart.

“They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business - one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners."

Berkshire’s 1996 letter discussed Geico:

“There's nothing esoteric about GEICO's success: The company's competitive strength flows directly from its position as a low-cost operator. Low costs permit low prices, and low prices attract and retain good policyholders. The final segment of a virtuous circle is drawn when policyholders recommend us to their friends… the economies of scale we enjoy should allow us to maintain or even widen the protective moat surrounding our economic castle. We do best on costs in geographical areas in which we enjoy high market penetration. As our policy count grows, concurrently delivering gains in penetration, we expect to drive costs materially lower.”

Companies across diverse industries, Ford, Costco, Walmart, Southwest Airlines, Aldi, Amazon and Geico, have all delivered exponential wealth to their shareholders employing this business model.

“The business model that built the Ford empire a hundred years ago is the same that built Sam Walton’s (Wal-Mart) in the 1970’s, Herb Kelleher’s (Southwest Airlines) in the 1990’s or Jeff Bezos’s (Amazon.com) today. And it will build empires in the future, too.” Nick Sleep

Increasing Returns

Over the last decade, many tech giants have defied the fade. They’ve grown stronger and more profitable as they have evolved; first mover advantages have morphed into huge network effects. The Santa Fe Institute’s theoretical economist, W. Brian Arthur, recognised this potential in a groundbreaking paper published almost 25 years ago. ‘Increasing Returns and the New World of Business,’ presented a roadmap for what would become today’s tech titans.

“Increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage. They are mechanisms of positive feedback that operate—within markets, businesses, and industries—to reinforce that which gains success or aggravate that which suffers loss. Increasing returns generate not equilibrium but instability: If a product or a company or a technology—one of many competing in a market—gets ahead by chance or clever strategy, increasing returns can magnify this advantage, and the product or company or technology can go on to lock in the market.” W. Brian Arthur

Arthur recognised the capital-light nature of technology businesses meant they could become entrenched in a winner-take-most scenario. High upfront costs (‘The first disk of Windows to go out the door cost Microsoft $50 million; the second and subsequent disks cost $3. Unit costs fall as sales increase’), network effects and customer lock-in all serve to increase business sustainability over time.

“Western economies have undergone a transformation from bulk-material manufacturing to design and use of technology—from processing of resources to processing of information, from application of raw energy to application of ideas. As this shift has occurred, the underlying mechanisms that determine economic behaviour have shifted from ones of diminishing to ones of increasing returns.” W. Brian Arthur

Charlie Songhurst, a Microsoft alumni and prolific investor, recognised the limitation of applying typical fade metrics to ‘increasing returns’-type businesses.

“I think one thing that's very interesting is the way you model companies in Excel with a DCF, there's this sort of set of cultural norms, like trending down the growth rate to a terminal value over time that obviously we collect for industrial era companies. It's obviously the right concept [for industrial era companies]. Maybe that's just not right for network effects businesses because instead, literally, how do you model in Excel the concept of in year six, something becomes a standard and therefore gets sustained to accelerating growth? There was some sort of joke in the eighties that you'd never get fired for buying IBM. Well maybe in 2006, it suddenly became you never got fired for buying salesforce.com. How do you model in that as a concept? Suddenly kicking into revenue growth, maybe what you should actually be doing is writing a 3,000 word essay on revenue growth drivers, as opposed to sort of trending down over time as an automatic default.” Charlie Songhurst

Addressable Market / Market Opportunity

It’s obvious that a business starting from a smaller base has a much bigger runway for growth; the law of large numbers makes it hard for businesses to grow at high rates for long periods. Even with this understanding, investors and analysts often misjudge a potential market opportunity. When Southwest Airlines enters a new market they liberate a new class of customers by dramatically cutting fares and increasing frequency; market size can rise by a factor of eight.

“When evaluating market size, it’s also critical to try to account for how lower costs and product improvements can expand markets by appealing to new customers, in addition to seizing market share from existing players.” Reid Hoffman

“When you materially improve an offering, and create new features, functions, experiences, price points, and even enable new use cases, you can materially expand the market in the process. The past can be a poor guide for the future if the future offering is materially different than the past.” Bill Gurley

Often an adjacent market can be tapped by an enterprising business. The obvious example is Amazon’s move beyond books. Uber and food delivery, Airbnb and hotels, Nike and casual wear are further examples.

“When Amazon listed at the height of the dot.com boom in the late 1990’s, even the most bullish analysts thought that the total addressable market for Amazon was $26 billion, which equated to the total size of the book market in the US.” Helen Xiong

“We didn't really foresee back 20 years ago that the sport shoe business could get so big.” Phil Knight

“We should ban all talk of TAMs – the total addressable market – these are spot numbers in any other guise and useless in my view. Ten years ago, did anyone imagine the success of Amazon Web Services or YouTube? The supposed experts had no conception of how large cloud computing might become or how many smartphones would be sold. Tesla’s potential in the mass market today looks rather different than when the company produced the first Roadsters, etc. The point here is not to constrain ourselves to a point in time – great companies innovate to create new areas of opportunity and by doing so help to prolong their corporate life.” Mark Urquhart

“In the tech space, investors repeatedly made the mistake of assuming that the size of the market opportunity for growing companies was capped by the size of the market they were disrupting. Many examples spring to mind where this was the case. For example, Google’s and Facebook’s market opportunity was thought to be capped by the size of the advertising market (the largest part of which historically was TV advertising in which only the largest 100 or so companies in any country could participate). Facebook today has over ten million advertisers.” Robert Vinall

“Newer companies are opening up new markets and it’s easy to undersize size the TAM. Is Uber or Lyft replacing taxis or reinventing car ownership?” Philippe Laffonte

Deriving the scope for a market from an incumbent can seriously under-estimate the addressable market. I recall when realtor ads first moved on-line, analysts dampened their growth expectations for a listed company which achieved winner-take-all status. The analysts failed to appreciate the opportunity to take a greater share of the customer’s wallet by monetising on-line video tours, which weren’t possible with newsprint.

“Sizing the market for a disruptor based on an incumbent’s market size is like sizing a car industry off how many horses there were in 1910.” Aaron Levie

Management & Culture

Everyday businesses face competitive challenges, threats and opportunities; capitalism is a brutal force and change is constant. If a business is to survive and prosper it must adapt and evolve. It’s the company’s management and people that ultimately determine the long term success of a business.

Businesses sustainability is enhanced in the presence of a culture of continuous learning, trial and error, accepting of mistakes, innovation, quality and customer focus. Respect and care for a business’ ecosystem - employees, customers, shareholders, suppliers, the community and environment - is critical to long term success. The management team must set the right example, be aligned with shareholders and focus on the long term.

“A business’s product differentiation is not an enduring moat. If the differentiation has any merit, it will eventually be copied and advantages will soon be frittered away. Xerox, Kodak, BlackBerry and countless other businesses once held product dominance and fell to this fate. The only moat that is not fleeting, and conversely the only moat that is truly enduring, is culture.” Christopher Begg

“Culture trumps everything else in the long term. What do I mean by culture? Simplistically, it’s where companies are genuinely run for the long term.” Helen Xiong

Summary

When it come’s to long term business success, sharing scale benefits with the customer, grasping increased returns, optimising your market and ensuring an enduring culture can go a long way to fight the FADE that inflicts typical businesses. The companies that benefit from a few of these are likely to be long-term success stories. Those that utilise all may become tomorrow’s titans. Amazon is a case in point.

And for those investors who recognise and incorporate these characteristics in their investment process, the rewards can be lucrative. It’s time to search out those businesses where the ‘mental model’ of mean reversion is unbefitting - then all you have to do is simply sit on your ass.

“It’s a simple statement of fact that there have been great growth companies that have defied the skepticism of Graham and the mantra of mean reversion. They have endured for decades even at massive scale. I don’t see this as a contention but as an observation. Ironically they’ve altered the patterns of stock market return sufficiently that the very utility of the ‘mean’ has been undermined. The mean is now so far above the median stock that our entire notion of the distribution of returns has to be reviewed. The first chance to reassess came with Microsoft over 30 years ago. The investment community has been slow indeed. We can react to economic data or quarterly earnings in seconds but adjusting our world view has proven far harder.” James Anderson

Further Suggested Reading:
“What Goes Up Must Come Down: Must It Not?” - Nick Train, Lindsell Train 2012
“Graham or Growth - Concluding Thoughts.” - James Anderson, Baillie Gifford, 2020
“Increasing Returns and the New World of Business.” - Brian Arthur, HBR, 1996.
“How to Miss By a Mile: An Alternative Look at Uber’s Potential Market Size.” - Bill Gurley, Above the Crowd. 2014.

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Fight The Fade - Round 1

Every great investor has an edge. Jim Simons employs a code cracking team, Ray Dalio demands radical transparency while Paul Singer deploys no-holds-barred activist attacks. One of the most common and lucrative edges I’ve seen exploited in markets is ‘Fighting the Fade’. It’s in this niche many of the world’s most successful investors have cemented their track records; Munger & Buffett, Akre, Sleep, Smith, Polen, Lone Pine, Lindsell Train, WCM and Baillie Gifford.

At the heart of all successful investing is compounding and when it comes to this exponential function, two things matter - high rates of return and longevity. Over the long run just a few percentage points differential in annual returns translate to staggering differences in financial outcomes. It’s right here you find the edge in ‘Fighting the Fade’.

Let me explain.

It’s a well known fact that few businesses can defy capitalism’s onslaught. Business success attracts attention, copycats emerge and so called ‘super-returns’ and high growth get competed away - they FADE. And while most businesses FADE, not all do. A few rare companies have defied competition’s mean reverting forces to sustain growth over the longer term. They possess some unique or idiosyncratic features that help them fight the FADE, delivering and maintaining those extra percentage points that drive the huge return differentials we discussed above.

Investors and analysts who misjudge the longevity of a company’s success will do so at the detriment of valuation. The typical discounted cash flow [DCF] model will specify financial outputs for a company over five or ten years. In the early years investors often apply high growth rates, after which forecasts assume capitalism’s brutality forces returns to a lower perpetual growth rate; usually a rate consistent with GDP (2-3%). This is the FADE and in a general sense, it’s appropriate. Just as no trees grow to the sky, no business can be larger than the economy they’re in. Compound at a rate much faster than the economy over a very long period of time and you eventually end up bigger than the economy.

The non-linear effect of compounding means those businesses that can sustain success over decades, who ‘Fight the Fade,’ are worth substantially more than a typical DCF model would suggest. These businesses deliver those extra percentage points of return that get neglected in the valuation and can render companies on ‘optically high’ price-earning ratios as actually under-valued.

“Investors presume regression to the mean starts at the time of their analysis or, as CFA students may recognize, in year three or five of a DCF analysis! Investors use valuation heuristics rather than assess the real value of the business.” Nick Sleep

“It would seem that the unwillingness of many analysts to forecast strong growth out beyond 18 months to two years in the future is a significant factor in the valuation differences. The durability and longevity of extraordinary growth drastically changes what one might be willing to pay for a company. It can mean that we are willing to pay for growth at what seems like ‘an unreasonable price’ based on near term price multiples etc.” James Anderson

“Our ability to identify businesses that have the market opportunity, product distinction, competitive advantage and management skill to grow earnings and cash flow for longer than is factored into consensus expectations has distinguished our investment effort over the years.” Steve Mandel

“Since stock markets typically value companies on the not unreasonable assumption that their returns will regress to the mean, businesses whose returns do not do this can become undervalued. Therein lies our opportunity as investors.” Terry Smith

“From what is misleadingly labelled the ‘growth’ universe, we search for businesses whose returns are believed to be more sustainable than most investors expect.” Marathon Asset Management

“We are explicitly hunting the 3% of securities that do not mean revert, and the absence of mean reversion is our variant perception. Typically our expectations over the first year for these companies isn’t much different from consensus. What can be vastly different is what happens over two, five or ten years. The market in general will fade growth rates, earnings power and the multiple. We try to underwrite businesses we think can maintain growth and high returns for long periods of time.” Yen Liow

“We do not spend a lot of time building discounted cash flow models, but many people do. In these models, after five or ten years, the idea is to take the growth rate down to GDP. But we believe that doesn’t happen with great companies. Great companies can compound at over GDP growth rates for decades usually. So, the ‘market’ has a hard time pricing that. Essentially, we seek to buy companies at a discount to their intrinsic value. It may not appear that way when you pay 20-30X earnings. But the strength of earnings growth and length of time that a company compounds that growth is how we achieve our results.” Dan Davidowitz

“Most sell-side models go out a couple of years and then assume some sort of step-function down in growth or a terminal growth rate of some kind. Doing that might overly discount growth prospects that are more than a couple years out.” Rajiv Jain

“In out-year estimates, market participants tend to apply a generic fade rate to growth that is in line with industry base rates. If that assumption is wrong, it can create an investment opportunity.” Scott Management LLC

“Structurally with the market, it’s very rare that even the third year of earnings is priced into these business [compounders] let alone the fifth, seventh or tenth year. When you find these companies with real durability that can compound for long periods of time, the optically high multiple, when in hindsight that was a smoking deal five years ago.” Jeff Mueller

“One of the hallmarks of the unique, competitively-advantaged businesses that comprise our portfolios is that we think they all possess the ability to grow their earnings base at a much greater rate, and for much longer, than the market typically expects.” Dan Davidowitz

“It’s rational to assume that the good times won’t last forever. As such, prudent analysts will assume some amount of ROIC decay in their terminal assumptions. But, again, the billion-dollar question is, ‘How long will it take for ROIC to decay to WACC?’ Assume the decay is too rapid and you’re undervaluing the business; assume it’s too slow and you’re overvaluing the business.” Ensemble Capital

“The businesses we seek to invest in do something very unusual: they break the rule of mean reversion that states returns must revert to the average as new capital is attracted to business activities earning super-normal returns.” Terry Smith

The investor’s quoted above have all exploited this wrinkle in accepted financial theory. They’ve done so by identifying and seeking the unique characteristics that allows a business to ‘Fight the Fade’; maybe it’s an exceptional business model, a special culture, adaptability, or capital allocation prowess. These rare great businesses not only don’t succumb to capitalism’s mean reverting forces, but in many cases become stronger as they grow. The key is where can they be found? Freshen up for Round 2.

“Marathon’s experience suggests that the stock market is often poor at pricing superior fade characteristics. Mis-pricing stems from a number of sources. One is the under-estimation of the durability of barriers to entry. Another is the under-appreciation of the scale and scope of the addressable market. Management’s capital allocation skills are also often overlooked.” Marathon Asset Management

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Learning From Cornelius Vanderbilt

“In 1850, a decade before the Civil War, the United States’ economy was small—it wasn’t much bigger than Italy’s. Forty years later, it was the largest economy in the world. What happened in-between was the railroads. They linked the east of the country to the west, and the interior to both. They gave access to the east’s industrial goods; they made possible economies of scale; they stimulated steel and manufacturing—and the economy was never the same.” W. Brian Arthur

Vanderbilt rode this wave like no other. He was rich. Filthy rich. At the peak of his wealth he owned the equivalent of one in every nine dollars in the United States. His heirs would build the largest mansions Americans had ever seen. Mansions that spanned New York’s city blocks and extravagant country estates like ‘Biltmore’, a gilded-age 250-room French Renaissance chateau that holds the title of America’s largest house to this very day.

Biltmore Estate, North Carolina

The ‘First Tycoon - The Epic Life of Cornelius Vanderbilt’ tells the fascinating story of Cornelius Vanderbilt, the business magnate who built an empire in shipping and then, at the ripe old age of seventy, in US railroads. Nicknamed ‘The Commodore’, Vanderbilt’s endeavours fighting brutal short-squeezes, double-crossing business partners, a race to provide passage across the Panama, personally saving the US stock market and the gifting of his largest ship to the Union Navy to fight the Civil War are relayed in vivid detail.

The book’s most useful learnings might relate to the insights into Vanderbilt’s business acumen. While they say history doesn’t repeat, it does rhyme, and despite two centuries passing since Vanderbilt first plied his trade ferrying cargo on New York’s harbour, the lessons in his business success remain as relevant today as they were then. I’ve included a collection of ‘Business Lessons’ extracted from this truly exceptional tome.

Grow the Market

Vanderbilt understood the benefits of increasing patronage by lowering prices; a strategy exploited in more recent times by SouthWest Airlines whose ex-CEO Herb Kelleher explains, ‘Charge low fares, get more people to fly, get them to fly more often, and you will produce the best return to shareholders.’

“Soon afterward he launched the Bellona on a new season of high-speed competition, powered by another cut in the fare to Philadelphia. The repeated price reductions were a stark departure from the past. They delivered a competitive advantage, of course, but also showed that Gibsons and Vanderbilt believed in a growing market – that more and more people wanted to travel between two cities, and would do so by steamboat if rates were cheap enough. This notion of an expanding economy was surprisingly new. The Livingstons’ North River Steam Boat Company had kept the same number of boats running to Albany at the same fare for years, and saw ridership steadily drop. They believed there was a natural number of passengers, and that competition was destructive, robbing them of their due.”

Increased Efficiency

“How do I make a profit? Vanderbilt would rhetorically ask in court in 1869. “I make it by a saving of the expenditures. If I cannot use the capital of that road for pretty nigh $2,000,000 per year better than anyone that has ever been in it, then I do not want to be in the road.” He would elaborate at length on his approach. “That has been my principle with steamships. I never had any advantage of anybody in running steamships; but if I could not run a steamship alongside another man and do it as well as he for twenty percent less than it cost him I would leave the ship.”

Lowest Costs

“Vanderbilt carried on the business war, the one he knew best. His and Mills’ ships continued to connect via Panama, rather than Mexico, but the Commodore’s prowess at cutting costs would allow him to slash fares until he had cut open the very arteries of the Accessory Transit Company.”

The Selfish Revolutionary

Fifth Avenue Mansion - Vanderbilt II

“For all his contradictions over the years, he remained the master competitor, the individual who did more to drive down costs and open new lines in steam navigatiuon than any other. More than that, he had helped shape America’s striving, productive society. Waging war with his business, he had wrought change at the point of the sword. He was the selfish revolutionary, the millionaire radical.”

Scale Advantages

“What he did not realise was that the world he had made himself – the world that gave rise to these individualistic, laissez-faire values – was beginning to disappear, thanks in part to his own success. He helped create enterprises on a scale never seen before in the United States. Small proprietors could not compete against him.”

Culture - Tone at the Top

“What Vanderbilt did was set general policies, as well as the overall tone of management. Any corporation has an internal culture shaped by the demands, directives, and expectations that rain down from above. The Commodore created an atmosphere of efficiency, frugality, and diligence, as well as swift retribution for dishonesty or sloth. Every employee knew he was watching.”

Customer Focus

“The testimony of Vanderbilt and his men produced ‘a decided change in public sentiment, which had previously run altogether in favour of the Central management,’ the Times reported. For one thing, Vanderbilt had a chance to present himself in his own terms. ‘I have always served the public to the best of my ability’, he remarked. ‘Why?, Because, like every other man, it is in my interest to do so, and to put them to as little inconvenience as possible.’”

Integrity, Shareholder Alignment

“His honesty attracted great admiration, for this was an era when even the best corporate officials routinely engaged in self-dealing, as they had since the first appearance of railroads in the 1830’s.”

“Thomas A. Scott, demanded kickbacks in the form of stock from outside contractors, such as sleeping-car and express companies. In the Central, Corning and other directors had ordered the company to purchase iron, goods, and services from their own firms. ‘The peculiarity of Mr. Vanderbilt’s railroad management,’ Putnam’s Monthly Magazine wrote, ‘is that instead of seeking to make money out of the road in contracts and side speculations, he invests largely in stock, and then endeavours to make the road pay the stockholders.’ The only compensation he accepted as president of his roads was in dividends on his own shares. ‘I manage it [a railroad corporation] just as I would manage my individual property. That is my notion, and the way I think a railroad ought to be managed,’ he told the assembly committee in February.”

Debt

“When I have some money I buy railroad stock or something else, but I don’t buy on credit. People who live too much on credit generally get brought up with a round turn in the long run. The Wall Street averages ruin many a man there, and is like faro.”

The Capital Cycle

“The Panic of 1873 started one of the longest depressions in American history - five straight months of economic contraction. In the next year, half of America’s iron mills would close; by 1876, more than half of the railroads would go bankrupt. Unemploynient, hunger, and homelessness blighted the nation. "In the winter of 1873-74, cities from Boston to Chicago witnessed massive demonstrations demanding that authorities ease the economic crisis," Eric Foner writes. The irony is that the fall was far more severe because of the rapid rise of the previous decade. The expanding, increasingly efficient railroad network had created a truly national market. The fates of farmers, workers, merchants, and industrialists across the landscape were tied together as never before. New York had cast its financial net across the country, which meant that credit flowed to remote regions far more easily than before but also that financial panics -affected the entire nation. As Vanderbilt pointed out, railroad overbuilding was an underlying economic problem, and it was exacerbated by Wall Street's craze for railway securities. When the bubble burst, the consequences were felt across the country with devastating suddenness and severity.”

New Business Enterprises, Lowered Prices, Dislocation

“And yet, even before the Commodore's death it was clear that the forces he had helped to put in motion were remaking the economic, political, social, and cultural landscape of the United States. There was the transparently obvious: the dramatically improved transportation facilities that allowed Americans to fill in the continent; the creation of enormous wealth in new business enterprises; and the railroads’ economic integration of the nation, bringing distant farms, ranches, mines, workshops, and factories into a single market, one that both lowered prices and dislocated older communities. (The new availability of western foodstuffs, for example uprooted New England farmers.) And there was the less obvious, such as the emergence of a new political matrix in which Americans struggled to balance the wealth, productivity, and mobility wrought by the railroads and other industries with their anxiety over the concentration of vast economic power in the hands of a few gigantic corporations. Though government regulation would emerge slowly and fitfully—fiercely opposed by many - it would take its place at the center of politics in the decades ahead.”

Engine of Social Revolution

“The importance of the railroad in the nineteenth century is a historical cliché; a cliché can be true, of course, but will have lost its force, its original meaning. Garrison's letter, on the other hand, speaks to the railroad's dramatic impact at the time of the Civil War. It was, one contemporary writer argued, "the most tremendous and far reaching engine of social revolution which has ever either blessed or cursed the earth." It magnified the steamboat’s impact, instilling a mobility in society that unraveled traditions, uprooted communities, and under-cut old elites. It integrated markets, creating a truly national economy.”

Evolve and Adapt

“The Commodore’s character played a role as well. Over the decades, his personality had evolved in parallel with his changing material interests. He had earned his reputation as a ferocious competitor in steamboats, a business notoriously prone to warfare, due to the low start-up costs and the inherent mobility of the physical capital - the steamers—which allowed a proprietor to fight on one route after another. It was also a time in his life when New York's merchant aristocrats derided him as a boorish outsider. After devoting himself to railroads, however, he had consistently pursued peace, seeking industry-wide agreements (though he remained ready to fight when attacked). The transformation reflected the nature of the railroad business, but it also suited his late-life status. The elite now thought of him as an "honorable & high toned" gentleman, precisely the sort of man who sought dignified arrangements, not economic bloodletting.”

Sacrifice Short Term Profits

“Time and again, Vanderbilt showed  himself to be patient and diplomatic in dealings with Corning and Richmond, as he sacrificed short-term proficts for long-term stability.”

Decisive Strategic Advantages

“What did he see in it that no one else did? From the very beginning of Vanderbilt's career, he had focused on transportation routes that had decisive strategic advantages over competitors. The Stonington railroad for example, ran from a convenient port inside Point Judith over a direct line to Boston with easy grades that he made into the fastest and cheapest to operate at the time of his presidency. Likewise, the Nicaragua route to California had possessed a permanent superiority in coal consumption over Panama, thanks to shorter steamship voyages.”

Fixed Cost Leverage

“Vanderbilt sorely wanted the long-distance passengers and through freight that came from the West via the Central, no matter how little revenue he received. Unlike a steamboat and steamship line, a railroad suffered from high fixed costs. It was an immovable piece of infrastructure. Whether trains ran or not, the tracks, bridges, buildings, locomotives, and cars had to be maintained; conductors, engineers, firemen, and laborers had to be paid. At least two-thirds of a railroad's expenses remained constant no matter how much or how little traffic it carried.  If the Commodore could get additional business, even at losing rates, it would improve the Harlem's outlook. To gain access to that rich flow of freight from the West, Vanderbilt decided to pursue diplomacy with the Central.”

Vanderbilt Residences - Fifth Avenue

Net Worth

“On the other hand, these figures do provide some context for the scale of Vanderbilt's fortune. If he had been able to liquidate his $1oo million estate to American purchasers at full market value (an impossible task, of course), he would have received about $1 out of every $9 in existence. If demand deposits at banks are included in the calculation, he still would have taken possession of $1 out of every $2o. By contrast, Forbes magazine calculated in September 2008 that William Henry Gates III—better known as Bill Gates—was the richest man in the world, with a net worth of $57 billion. If Gates had liquidated his entire estate (to American buyers) at full market value at that time, he would have taken $1 out of every $138 circulating in the American economy. Even this comparison under-states the disparity between the scale of Vanderbilt's wealth and that of any individual in the early twenty-first century, let alone his own time.”

Summary

Vanderbilt’s legacy provides timeless and universal lessons in business success. He thrived in an era of enormous technological change as railways revolutionised the American economy. Yet his approach to business is evident in many of the successful businesses we see today; tapping new markets through lower prices, respecting shareholders, sharing scale advantages and sacrificing short term profits for long term gains.

Vanderbilt was a legend. He held himself to a higher morale compass than his ruthless competitors. A lifetime spent in shipping proved no impediment to grasping the opportunity the nascent railway industry presented. Striving always for competitive advantages, Vanderbilt once again leveraged the benefits of scale to deliver his customers lower fares. For this he was amply rewarded. Incredibly so.

Reference:
‘The First Tycoon: The Epic Life of Cornelius Vanderbilt’ T.J Stiles, 2010.

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Business is People

When we invest, we invest in companies. Either we buy small portions or large stakes but whichever size you take, we’re inevitably staking a position in an organisation. And the concept for successful investing in businesses is quite simple: Find a quality business, buy it at a reasonable price, watch it grow, and then succeed as an investor.

Of course, whilst the steps are simple in principle, its not always that easy. First you have to find the great business. But what makes a quality business? To answer that, let’s get back to first principles.

Can you touch a business? Can you feel it? Can you see it?

These are some of the critical questions posed by Dee Hock, the founder of Visa. Hock’s book, ‘One from Many - VISA and the Rise of Chaordic Organization,’ considers businesses in a different light; not tangible, physical realities such as buildings or machines, but people. He un-peels the onion so to speak, creating a mental exercise to emphasise the point.

“Fix the company you work for, or any other organisation of which you are part, firmly in your mind. Not its physical manifestations such as its name, employees, or offices, but the company itself. Put all thoughts aside and fix the organisation itself firmly in mind.

Surely you have seen it. What colour is it? No? Well, then you must have smelled it from time to time. Describe its odour. No? Then surely you’ve tasted it. Is it sweet, tart or bland? You don’t know? Well, you must have touched it often. Is it hot or cold, hard or soft? No? Then, without a doubt you have heard it. Make its sound. No? Can you perceive the company you work for, or any other organisation, whether political, social, or commercial, with any of your senses? Obviously not. If you can’t perceive an organisation with any of your senses, does it have any reality at all? Perhaps it’s a fiction. Perhaps it doesn’t exist. But you’re not going to accept that explanation.

The truth is that a corporation, or for that matter, any organisation, has no reality save in the mind. It is nothing but a mental construct to which people are drawn in pursuit of common purpose; a conceptual embodiment of a very old, very powerful idea called ‘community’.

All organisations can be no more or less than the moving force of the mind, heart, and spirit of people, without which all assets are just so much inert mineral, chemical, or vegetable matter, by the law of entropy, steadily decaying to a stable state.”

Yuval Harari, author of the wonderful book, ‘Sapiens’ makes a similar point. He uses the Peugeot Lion, the icon adorning the cars made by one of the oldest and largest of Europe’s car makers, as an example. Harari explains, ‘Today Peugeot SA employs about 200,000 people worldwide, most of whom are complete strangers to each other. These strangers co-operate so effectively that in 2008 Peugeot produced more than 1.5m automobiles, earning revenues of about 55 billion euros.’

Peugeot Lion

‘In what sense can we say Peugeot SA (the company’s official name) exists?, Harari asks. ‘There are many Peugeot vehicles, but these are obviously not the company. Even if every Peugeot in the world were simultaneously junked and sold for scrap metal, Peugeot SA would not disappear. It would continue to manufacture new cars and issue its annual report. The company owns factories, machines and showrooms.' Peugeot is ‘a figment of our collective imagination.’

Harari concludes, ‘Any large scale co-operation is rooted in common myths that exist only in people’s collective imagination’. Companies fit that bill. Veteran Fortune 500 leader, James Autrey agrees, “There is no business, there are only people. Business exists only among people and for people.” And that applies to all businesses.

“Whoever you are, reader, your organisation is not different. You may have a different product or a different mission, a different organisational structure, or a different management style. You may have a unique manufacturing process or distribution system, or, if you're a non-profit, a special way of fund-raising or delivering services. You may have a lot of things that are different. But fundamentally, your organisation is not different, because it depends on people, and it is that dependence on people that makes you and your organisation far more similar to, than dissimilar from, your counterparts and their organisations elsewhere.” James Autry

Two of the foremost business experts in the world, Thomas Peters and Jim Collins, both recognised that the foundations for all great businesses is people.

‘The starting point for everything is the people.’’ Jim Collins

“Treating people – not money, machines or minds - as the natural resource may be the key to it all.” Thomas Peters

When you delve behind a company’s assets, whether it be brands, factories, mines or services, you’ll find people. People that are coming together for a common purpose to achieve a goal. The glue that keeps these people together is the culture.

“Healthy organisations are a mental concept of relationship to which people are drawn by hope, vision, values and meaning, along with liberty to cooperatively pursue them. Healthy organisations educe behaviour.” Dee Hock

“Since the strength and reality of every organisation lies in the sense of community of the people who have been attracted to it, its success has enormously more to do with clarity of a shared purpose, common principles, and a strength of belief in them, than with money, material assets, or management practices, important as they may be.” Dee Hock

Even a business with product differentiation, valuable intellectual property or patents must evolve; competitors innovate, patents expire and technological advantages become redundant. The necessary process of constant evolution is ultimately driven by people.

“Businesses evolve, people matter.” Scott Miller

“The only moat that is not fleeting, and conversely the only moat that is truly enduring, is culture.” Chris Begg

“Culture trumps everything else in the long term.” Helen Xiong

Successful businesses have strong management teams which value and empower their people, they promote innovation and risk taking, encourage ownership, and adopt appropriate incentives through the full rank and file of the organisation. It’s little wonder the world’s top CEO’s and the investment industry’s sharpest minds focus on people and culture.

“The force that creates one company in an industry that is an outstanding investment vehicle and another that is average, mediocre, or worse, is essentially people.” Phil Fisher 1958

“As one goes longer and longer in this business you spend more and more time thinking about people. Thinking about the characteristics of the people running the business; how smart they are, what their ethics are, how they set a culture at the company. Obviously we spend time on companies competitive positioning, what their financials look like, what sustainable moat they have, but more and more we spend a lot of time really trying to understand the people, how they think, what culture they’ve created, how they motivate their people, what kind of people that work there. Over time we’ve spent more time thinking about the people.” Steven Mandel

“Businesses are people not excel spreadsheets. It’s easier to sit in an office and crunch numbers than it is to get on a phone or plane and talk to people. If you aren’t willing to do so, then don’t complain about being average. Do what others aren’t willing to do.” Ian Cassel

“Isn’t it true in your life that you associate with people of similar values and spiritual beliefs and mindfulness and so on? Businesses are just collections of people who are organized around an idea.” Peter Keefe

“Many analysts are naturally a bit nerdy, focusing on numbers rather than personalities, character and vision. It's important to establish and field a team that can appropriately weigh both. The numbers are important. They often tell a compelling story of their own. But, like many other things in life, successful long-term investing is still largely about people.” Bill Stewart

“What I'm interested in is investing in people. And I look for people who, you know, everything you could think of. They're honest. They have fire in their belly. They're intellectually honest meaning that they see things as they are, not the way they want them to be and, and have priorities and know where they're going and know how they're going to get there. So I spent a lot of time with people just trying to figure [that] out.” Arthur Rock

“Entrepreneurs place far more importance on people than investors do. I have never met an entrepreneur who does not believe that the success of any commercial venture is mainly down to the people running it. Investors, on the other hand, rarely base their investment case on people and sometimes skip the topic altogether. This is why “people” is my first investment criterion (though not the sole one). It is partly because it is important, but also because it is more likely to be a source of market inefficiency to the extent other investors are paying less attention to it.” Robert Vinall

“Business is people.” B C Helzberg, Sr

“Business don’t succeed or fail. People do.” S Truett Cathy, Chick-fil-A

“HEICO is simply the name on a facility wall, it's the team members that make HEICO special.” Larry Mendelson

“You can have an outstanding location in our business and have an average store. But reverse of that, you can have an average location and have an outstanding store. Our business is about people. It's about that that top-notch customer service that we always talk about. It's about going the extra mile.” Brad Beckham, O’Reilly Automotive

"Don't be misled, the Tractor Supply story isn't really about catalogs or stores. It's a people story. It's a story about the power of vision and enthusiasm and hard work and people." Joe Scarlett, Tractor Supply

"Success in business is all about people, both your employees and your customers." George Jenkins, founder Publix

“Your main mistake in business is people. Your main triumphs and successes are because of people. So getting the people right, getting the judgment of the people and making sure you have the right people on the team is really, really critical.” Brad Jacobs

“The restaurant business is the people business, and people are our investment.” Peggy Cherng, founder Panda Express

“A common theme is that people are crucial to an organization. They are the organization. The organization is its people. I will say this over and over again because it is essential, because it really is so.” Robert Pritzker, Marmon

"The success of any company is in direct proportion to the ability and motivation of its people, and that fits anything." Les Schwab

“Every business is a people business.” Henry Bloch, H&R Block

“The key to success is not information. It’s people.” Lee Iacocca

"Henry Singleton believed, and often said, that the key to his success was people." George Roberts, Teledyne

“Everybody talks about the bottom line, but as I’ve seen time and time again, you ignore the human element of business at your peril.” Ken Langone

“In business, people must come first – and your team is made up of the most important people who will determine the success of your company.” Jim Haslam

“People are the only sustainable competitive advantage.” Rich Teerlink

“One thing we found repeatedly over 50 yrs of experience is that ultimately people run and build businesses. If you're with the right people, the right teams and the right cultures, the surprises, the inevitable surprises, tend to be good ones. And if you're with the wrong people they tend to be bad ones.” John Harris

"Unfortunately, the business is not run by a spreadsheet. The business is run by people.” Brian Niccol

"I’ve always said the two most important assets in an organisation don’t appear on the balance sheet. They are people & brands. I do believe a company’s true value is in people and brands, not the buildings or processes.” Greg Creed, Yum Brands

“One company will be successful making pots; others won't. They all use basically the same equipment or variations of it. Who decided which equipment it will be? People. Who alters it to improve output or quality? People. Who makes the pots? People. Who sells them? People. Who decides to whom and how they will be marketed? People. Intelligent, imaginative, dedicated people who can't be expressed as numbers.” Robert Pritzker

"It's all about the people. The key to a successful business lies in managing and motivating the workforce so that they give their best to the job." Julian Richer, Richer Sounds

“A lot of people think it is all in the numbers, we think it’s all in the people.” Kurt Winrich

“The two most important things in any company do not appear in its balance sheet: it’s reputation and its people.” Henry Ford

“People make all the difference in the world.” Dianne Hendricks, ABC Supply

“Many companies have buildings and machines and a lot of real estate, but it’s only people that have a chance to make any difference.” Eiten Werthheimer, Iscar

"The greatest achievement of good executives is to get things done through other people, not themselves." Warren Buffett

“It is chiefly to my confidence in men and my ability to inspire their confidence in me that I owe my success in life.” John D Rockefeller

Finding the historical financial numbers to fill a spreadsheet isn’t hard. Discovering the qualitative aspects of the business which will determine the future numbers is a little more challenging. In large part, these numbers will be determined by the people.

Insights can be gleaned through studying annual reports, management interviews and result transcripts; studying employee and management alignment, incentives, ownership and turnover. When it comes to understanding a company’s culture, employee empowerment, empathy, time horizons, philosophy and motivation nothing beats channel checks. Getting out and talking to ex-management, current and former employees, customers, suppliers, vendors, competitors and anyone else who might affect the company.

Berkshire Hathaway is a powerful example of people making a difference. Prior to Buffett’s acquisition, Berkshire was a failing textile manufacturer. Absent Buffett, there’s zero chance it would be the company we know today. Buffett himself succeeded not only by deploying his investment acumen, but by identifying quality people to oversee the business units. He attracted and assimilated the high quality people from the dozens of acquisitions to continue their role within Berkshire.

“We tend to overestimate our ability to forecast financials and underestimate the role of people and our ability to spot them. When the new CEO took the reins at Berkshire Hathaway, it was not the economics of the textile industry that determined the outcome. In many of the investments I can think of, it was the people that were crucial. And I would suggest we should be a little bit more skeptical about our ability to build excel models and valuations and calculate margins of safety and this type of quantitative stuff, and give ourselves a little more credit on our ability to think about people." Robert Vinall

“I think partly we look smart because we pick such wonderful people to be our partners and our associates, even our employees.” Warren Buffett

“We are doing something that’s quite difficult. We are judging people because we don’t understand what the people do. And that’s what Andrew Carnegie did. He didn’t know anything about making steel, but he knew a lot about judging whether the people he was trusting making steel were any good at it. And of course that’s what Berkshire’s done, if you stop to think about it. We have a lot of businesses in Berkshire that neither Warren or I could tell you much about, but we’ve been pretty good at judging which people are capable of running those businesses.” Charlie Munger

“Our job is not so much to select great managers, because we do have this proven record that they come with. Our job is to retain them. And a majority of the managers that work at Berkshire — are independently wealthy. We hand them checks, sometimes, in the billions, often in the hundreds of millions. So they do not have a monetary reason to work, in many cases. We are dependent on them, incidentally. I mean, we have 19 or so people at headquarters, and we have 250,000 working for Berkshire around the world, and we can’t run their businesses. Our job is to make sure that they have the same enthusiasm, excitement, passion, for their job after the stock certificate changes hands, than they had before.” Warren Buffett

Ask yourself this: What is the one thing, in the absence of all else, that makes a business successful? That is to say, if nothing else was available to ensure you had a business and that it ran effectively, what would it be? Is it the products? The brand? The corporate structure? The pricing? The quality of the supply chain and warehouse? The business model? The value of the stock? In the end, it’s none of these things. While each is important, if you don’t have capable, engaged and empowered people, none of the other things matter.

The really important mental model to take away from this is, that when you’re investigating an organisation as a potential investor, the computer screen ain’t gonna provide all the answers. Study the people! Only then can you determine the culture of the organisation. Only then can you understand the value of the people within. Because until you do, the business you’re looking at, remains a figment of your imagination…

Further Reading:
‘Culture - Tutorial’ - Investment Masters Class.
‘The IMportance of Culture’ - Investment Masters Class 2017.
‘Widening Moats and Culture’ - Investment Masters Class 2018.

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Charlie Munger’s ‘Bag of Tricks’

Who hasn’t heard of Charlie Munger? If you work in, or even merely have a passing interest in Investing, you are sure to have come across his name, I’m guessing. The name Munger is seen as synonymous with investment smarts, which is no mean feat in itself. Its not surprising, however; Charlie will clock up his 97th birthday on the 1st day of 2021, which means he’s been doing what he does for a very long time. And doing it well.

The more years I spend learning the investment game and taking in all Charlie has to offer, the more I realise that there isn’t a lot he hasn’t worked out. From a lifetime spent reading and thinking, Charlie has extracted all the really big ideas out of every other discipline and applied those to investing. It’s his bag of tricks so to speak. And while Charlie won’t acknowledge his genius, he says it allowed a non-prodigious man to achieve prodigious results.

“I have benefited over the years from closely studying Mr. Munger's own words and actions. As such, I have come to a deep appreciation for his profound thoughts.” Li Lu

"The truth is there is not that much to say, at least, not much that hasn't been said before. That's the curse of being two thousand years younger that Saint Paul, forty-four years younger than Charlie Munger and twenty-nine years younger than my father." Nick Sleep

I recently enjoyed watching a conversation with Charlie at the University of Redlands from earlier this year. Charlie discussed how and why his philosophical foundation was laid, he touched on his love of reading, Berkshire’s investment philosophy and a plethora of life lessons.

Charlie also revealed how he created near a billion dollars in value for the University of California, Santa Barbara when a friend was struggling to sell her family’s 1,800 acre ocean front ranch. Despite two miles of frontage to the ocean, a perfect climate and great views, draconian planning laws significantly inhibited the use to which the land could be put. Recognising an opportunity to realise value, Charlie donated $70m to the University of California, Santa Barbara to buy the land. Charlie knew the University wasn’t subject to the Santa Barbara zoning laws and could therefore develop needed student accommodation on the site. This outside-the-box thinking effectively created a billion dollars of value for the University and a once unattainable sale price for the friend.

And there’s plenty more lessons. I’ve included some of my favourite Munger-isms from the interview below…

Fun

“Warren and I have fun in business. We like our business, and we like the people we work with.”

Problem Solving

“We like the problem solving. That's a huge advantage in life. If you really love problem solving, that is worth about 20 IQ.”

"I have made my way in life with a pencil and a pen, and a calculating machine, and a compound interest table, and I haven't looked at a calculus question since I was 19 years old. So I'm totally a creature of old fashioned horse sense and a little arithmetic."

Take Care of Customers

“I'm also a total nut on the subject that the best way to get what you want in life is to deserve what you want. Of course, if you apply that to business, that means you really take care of the customers.”

Morality

“My life is organised so that just time after time what works for my pocket book works for every moral teaching that I've been taught.”

“Warren always says, ‘You should always take the high road because it's less crowded.’"

Investment Philosophy

“We have a very peculiar way of looking at things. We want to buy something that's intrinsically a very good business, meaning that an idiot could run it and it would do all right. Then we want that business which an idiot could run successfully to have a wonderful person in it running it. If we have a wonderful business with a wonderful person running it, that really turns us on, and it works very well. Now, we do make exceptions, but not many. It's a pretty simple philosophy. Warren sometimes says you have to choose good person or good business. You know what he says? This is not politically correct. He says good business. I had a friend when I practiced law and he said, ’If it won't stand a little mismanagement, it's not much of a business.’ We like businesses that stand a lot of mismanagement but don't get it. That's our formula. We can't make it work perfectly, but it certainly worked better than most peoples.”

Redlands Forum 2020

Tough Businesses

“As Warren says, ‘When a business with a reputation for being tough, and a manager with an opportunity for being brilliant get together, it's the reputation of the business that remains.’ If they start tough they stay tough. It's really hard to change a whole business, or a person.”

Pretend

“I've known a lot of roguish people that made a fair amount of money. They started giving [away] a little money to show off. And, 20 years later, they're actually real philanthropists. You become what you pretend to be, to some considerable extent. Having observed this so much, I think there's something to be said for hypocrisy, but that's not a common observation, but I've seen it do so much good in life that I don't think it's all bad, the hypocrisy. I always try and pretend to be a little better than I am. Not too much.”

Reading

“It's just God's gift. If you're into self-education, there's nothing like reading. Of course, people who do a lot of it have an enormous advantage.”

“I don't think you can take every bookish little boy and turn him into a billionaire by patting him on the head and saying, ‘Read all you want, Johnny.’ If it were that easy, there'd be more billionaires. It enormously helped me, and I think reading, once you've learned it, reading and arithmetic, you can take in so much, and you can take it in on your own time schedule.”

Language and Maths

“Of course, if you learn your own language, that's a very useful gift. Of course learning the basic math of life is another tremendous gift. And if you're really good at picking up language and doing just basic arithmetic, you can take enormous territory. You don't need much else.”

Learn to Learn

“Something that's more important than what they teach you in college -  learn the method of learning.”

“Now, when I want to know something, I just learn about it. The habit of figuring something out for yourself is an important thing to develop.”

Keep Learning

“We all start out stupid, and we all have a hard time staying sensible. You have to keep working at it. Berkshire would be a wreck today if it were run by the Warren I knew when we started. We kept learning. I don't think we'd have all the billions of stock of Coca-Cola we now have if we hadn't bought See’s. Now, you know how we were smart enough to buy See’s. Barely. The answer is barely.”

Resentment and Hatred

“There are two things I have noticed in a long life, that really do enormous damage to the bearer. One of them is resentment, and the other is hatred. What good is it going to do you to have this vast resentment of the way the world is?”

Own Equities

“I am continuously invested in American equities. But I've had my Berkshire stock decline by 50% three times. It doesn't bother me that much. That's just a natural consequence of an adult life, properly lived. If you have my attitude, it doesn't really matter. I always liked Kipling's expression in that poem called “If”. He said, success and failure, treat those two imposters just the same. Just roll with it.”

Warren and Charlie

“I think Warren and I are very much the way we were born. We were both a bit nerdish, and not huge successes as young boys. But we both had this love of humor, and we both loved understanding how things worked. We both have been lucky enough to attract marvellous associates and partners.”

Bag of Tricks

“I just got a bag of tricks, and I got the right bag of tricks early, and of course it’s been an enormous help to me.”

“I have a good mind, but I'm way short of prodigy. I've had results in life that are prodigious. That came from tricks. I just learned a few basic tricks from people like my grandfather.”

“[Using mental tricks,] it's so habitual with me. I revolve possibilities, and I rag problems hard. If they don't yield, I come back. And so, this is just a bag of tricks. It enables a non-prodigious man to get prodigious results.”

Inverting

“There are all kinds of tricks that I just got into by accident in life. One is, I invert all the time. I was a weather forecaster when I was in the Air Corp. How did I handle my new assignment? Being a weather forecaster in the Air Corp is a lot like being a doctor that reads x-rays. It's a pretty solitary. You're in the hangar in the middle of the night and drawing weather maps and calling pilots, but you're not interfacing with a bunch of your fellow men very much. So I figured out the men that I was actually making weather forecasts for: real pilots. I said, "How can I kill these pilots?" That's not the question that most people would ask, but I wanted to know what the easiest way to kill them would be, so I could avoid it. And so, I thought it through in reverse that way, and I finally figured out. I said, “There are only two ways I'm ever going to kill a pilot." I said, "I'm going to get him into ‘icing’ his plane can't handle, and that will kill him. Or I'm going to get him someplace where he's going to run out of gas before he can land." I just was fanatic about avoiding those two hazards.”

Back to Basics

“If you just have the mental trick of constantly going back to the basics, it's pretty basic insight.”

Destroy Best Loved Ideas

“One of the great tricks in life is to destroy your own best loved ideas. That I worked at. I actually go through my best loved ideas occasionally, see if I can weed one out.”

No Perfection

“You don't need to be perfect, if you're 96% sure that's all you're entitled to in many cases. I see these people doing this due diligence and the weaker they are as thinkers, the more due diligence they do. Of course it's just a way of allaying an inner insecurity. Of course it doesn't work. I don't think people who are that insecure mentally ought to be in positions of decision making power.”

Easy Problems

“My grandfather would say, he basically thought it was sinful to be dumber than you had to be. I share some of that. What you can't remove I think is forgivable, but to have an easily removable ignorance in your own head is really stupid.”

“I seek out easy problems. I've tried hard problems. It makes it a lot more difficult.”

Ask Questions

“One thing I’ve learned is to always inquire. Always ask questions, and look at the vulnerabilities of a situation in order to figure out how to solve it.”

Summary

One of my key take aways, beyond the incredible amount of invaluable lessons he can provide, is that the man is inadvertently humble. And that’s a conscious choice. With his track record, anyone could choose to be arrogant; “I’m obviously one of the greatest investors of all time!” But he doesn’t. He acknowledges the people he has learnt from over his long life, and even goes so far as to reward them. Generously. I like that in the man. And he has so many lessons to teach us. I understand that he won’t be around for ever - none of us will - but I expect his lessons for life and his bag of tricks will be.

Source:
University of Redlands - Redlands Forum: Charlie Munger. January 2000.

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Learning from Patagonia’s Yvon Chouinard

When you think about business planning for the future, most CEO’s talk about anything from the next quarter to a five year plan. Its certainly important to think ahead, and successful companies often plan their way forward using these time scales to determine both the growth and profitability goals they wish to achieve, and the strategies and plans for them to get there. Its rare to look much further ahead than these timescales however, and I can’t think of many businesses that do, which is why I was struck by Yvon Chouinard’s oft-quoted reference to the next ‘hundred years’.

Patagonia is the brainchild of Yvon Chouinard, who not only wanted to build a business with the highest possible quality products, but also wanted his company to do the right thing by the environment along the way. Profitability was an oblique goal and indeed, was seen as nothing more than a byproduct of success; Chouinard recognised early on that there was no business to be done on a dead planet. That’s a different mindset altogether.

Patagonia does things differently. Not only does it look well beyond the standard timescales for its business and plan for the next 100 years, in a world of fast fashion, where people will prefer to discard worn clothing rather than retain, Patagonia builds its clothing products for the long term as well. It offers an iron-clad guarantee that provides free repairs; if its worn out, or broken, then return it to the store and Patagonia will repair it at no cost. Forever.

‘Let My People Go Surfing’ is the extraordinary story of an unlikely businessman and his journey to create the highest quality outdoor products while doing good for the world. It’s one of the most enjoyable business books I’ve ever read. And I’m not alone. His staff view the book as an almost sacred text, and all strive to live by the values contained within. Recently I stepped into a Patagonia store to find that not only had all the employees read the book, but they also mentioned that many customers had studied the text in business management classes. It’s no surprise.

Flip through the pages of a Patagonia catalog and you’ll see why it’s amassed a cult following.

Yvon started out with the eponymous climbing gear company, Chouinard Equipment, which made high quality climbing gear for his customers. It wasn’t long afterwards that he identified that his ‘pitons’ were detrimentally affecting the cliff faces, so he abandoned them for a more environmentally friendly alternative. And it didn’t stop there. Since then, Chouinard moved into clothing and has developed his business into one of the most socially responsible corporations on the planet.

“The cumulative effects of Chouinard's original product began to hammer at the company's environmental conscience, the result of numbers of the pitons being left behind in the rock. Consequently, Chouinard became an advocate of "clean" climbing that made use of such products as its Hexentrics and Stoppers nuts. The company introduced the first tubular ice screw in the late 1970s.”

As can be expected with an innovative business such as this, it shares many of its characteristics for success with other great companies. The same recurring themes are highlighted: Family Culture, Innovation, Empowering Staff, Embracing Change, Focus on the Long Term, a Win-Win Mentality, No Compromise on Quality, Maintaining Smallness; just to name a few. Patagonia has established an ecosystem that espouses strong relationships with suppliers and customers alike. And this was purposeful - Yvon studied and then extracted these universal characteristics from other great businesses. But he didn’t stop there. He also drew inspiration from other ideologies he embraced; from the environment and the management structures of ant colonies to Darwinian evolution at the edge of chaos.

These are some of the markers I use on my own quest to find great companies. They form the basis of the mental models I search for that when combined, can produce winning corporate DNA.

Below are fascinating excerpts from Chouinard’s sacred text, ‘Let My People Go Surfing.’

Profit is Not Primacy

“Financial Philosophy: We are a product-driven company. That means the product comes first and the company exists to create and support our products.”

“At Patagonia, making a profit is not the goal, because the Zen master would say profits happen ‘when you do everything else right.’”

“Our mission statement says nothing about making a profit. In fact, our family considers our bottom line to be the amount of good the business has accomplished over the year. However, a company needs to be profitable in order to stay in business and to accomplish all its other goals, and we do consider profit to be a vote of confidence, that our customers approve of what we are doing.”

“Without giving its achievement primacy, we seek to profit on our activities. However, growth and expansion are values not basic to this corporation.”

Borrow Ideas

“Borrow ideas from other disciplines. We beg, borrow, and steal ideas from other companies and culture.”

“We should borrow and adapt ideas even from unlikely sources. McDonald’s is as far from Patagonia as you can get in its image and many of its values. No one at McDonald’s ever tells a customer, ‘Sorry, we’re all out of iceberg lettuce today.’ It successfully organises on-time delivery every day of the week, and I think Patagonia could learn a lesson from McDonald’s and the symbiotic relationship it enjoys with its suppliers.”

Empower Employees

“[Our] philosophies must be communicated to every one working in every part of the company, so that each of us becomes empowered with the knowledge of the right course to take without having to follow a rigid plan or wait for orders from the boss.”

Simplicity

“I believe the way toward mastery of any endeavour is to work toward simplicity; replace complex technology with knowledge.

“The best performing firms make a narrow range of products very well. The best firms’ products also use up to 50 percent fewer parts than those made by their less successful rivals. Fewer parts means a faster, simpler (and usually cheaper) manufacturing process.”

Unconventional

“I had always avoided thinking of myself as a businessman. I was a climber, a surfer, a kayaker, a skier, and a blacksmith.”

“I knew I would never be happy playing by the normal rules of business. If I had to be a businessman, I was going to do it on my terms.”

“I read every book on business, searching for a philosophy that would work for us. I didn’t find any American company we could use as a role model.”

Fun

“One things I did not want to change, even if we got serious: work had to be enjoyable on a daily basis.”

“Having fun should be part of the culture at Patagonia.”

Innovation

“We learned an important lesson in business. [Our new innovative] fabric would never have been developed if we had not actively shaped the research and development process. From that point forward, we began to make significant investments in our own research and design departments. Our fabric lab and our fabric development departments became the envy of the industry.”

Source: Patagonia catalogue

Testing

“You can minimise risk by doing your research and, most of all, by testing. Testing is an integral part of the Patagonia industrial design process, and it needs to be included in every part of the process. It involves testing competitors’ products; ‘quick and dirty’ testing of new ideas to see if they are worth pursuing; fabric testing; ‘living' with a new product to judge how hot the sales may be; testing production samples for function and durability, and so on; and test marketing to see if people will buy it.”

Change

“[We] begin with an attitude of embracing change rather than resisting it - not just changing without reflection and weighing the relative merits of the new ideas, but nonetheless assuming that if we only look hard enough, there may be a better way of doing things.”

“The owners and managers of a business that they want to be around for the next hundred years had better love change. The most important mandate for a manager in a dynamic company is to instigate change.”

“Evolution [change] doesn’t happen without stress, and it can happen quickly. Our company has always done its best work whenever we’ve had a crisis. When there is no crisis, the wise leader or CEO will invent one. Not by crying wolf but by challenging the employees with change.”

“Every organisation, business, government, or religion must be adaptive and resilient and constantly embrace new ideas and methods of operation.”

“When I look at my business today I realise one of the biggest challenges I have is combating complacency. I always say we’re running Patagonia as if it’s going to be here a hundred years from now, but that doesn’t mean we have a hundred years to get there! Our success and longevity lie in our ability to change quickly. Continuous change and innovation require maintaining a sense of urgency - a tall order, especially in Patagonia’s seemingly laid back corporate culture. In fact, one of the biggest mandates I have for managers at the company is to instigate change. It’s the only way we’re going to survive in the long run.”

Source: Patagonia Catalogue

“It’s the same in nature. Nature is constantly evolving, and ecosystems support species that adapt either through catastrophic events or through natural selection. A healthy environment operates with the same need for diversity and variety evident in a successful business, and that diversity evolves out of a commitment to constant change.”

“Only on the fringes of an ecosystem, those outer rings, do evolution and adaption occur at a furious pace; the inner centre of the system is doomed to failure by maintaining the status quo. Businesses go through the same cycles.”

“Only those business operating with a sense of urgency, dancing on the fringe, constantly evolving, open to diversity and new ways of doing things, are going to be here one hundred years from now.”

Diversity

“A clothing company of the size of Patagonia, if it is not diversified in its product line and operations, is as much at risk as a farming operation growing a mono-crop. Only the ‘diseases’ are different.”

“At Patagonia, we sell our product at a wholesale level to dealers, sell through our own retail stores, through mail order, and through e-commerce, and do it all worldwide. The diversity of distribution has been a tremendous advantage to us. In a recession, when our wholesale sales are down, our direct sales channels do well because there is no lessened demand for our goods from our loyal customers."

“Doing business in Japan, Europe, Asia and Latin America, and Canada also buffers us against downturns in the economy in any one of those areas.”

“Few businesses have the confidence to try to master all four business styles, but when you do master them, the four means of distribution work very powerfully in concert. We consider each to be essential to Patagonia’s relationship with the customer.”

Learn By Doing

“There are scientific ways to address a new idea or project. If you take the conservative scientific route, you study the problem in your head or on paper until you are sure there is no chance of failure. However, you have taken so long that the competition has already beaten you to market. The entrepreneurial way is to immediately take a forward step and if that feels good, take another, if not, step back. Learn by doing, it is a faster process.”

First Mover Advantage

“You can’t wait until you have all the answers before you act. It’s often a greater risk to phase in products because you lose the advantage of being first with a new idea.”

“Being first offers tremendous marketing advantages, not the least of which is you have no competition. Coming in second, even with a superior product, is often no substitute for just plain being first.”

Culture

"In every long-lasting business, the methods of conducting business may constantly change, but the values, the culture, and the philosophies remain constant.”

“Despite our own growth at Patagonia, we were able, in many ways to keep alive our cultural values as we grew.”

“We never had to make a break from the traditional corporate culture that makes businesses hidebound and inhibits creativity.”

“We built a new administration building that had no private offices, even for executives. The architectural arrangement sometimes created distraction but helped keep communication open.”

Family

“Not only was the company like an extended family, but for many it was family, because we always hired friends, friends of friends, and their relatives.”

Selling

“My first principle of mail order argues that ‘selling’ ourselves and our philosophy is equally important to selling product. Telling the Patagonia story and educating the Patagonia customer on layering systems, on environmental issues, and on the business itself are as much the catalog’s mission as is selling the product.”

“Over the years we have come upon a balance between the product content and the message - essays, stories, and image photos. Whenever we have edged that content towards increased product presentation, we have actually experienced a decrease in sales.”

Source: Patagonia catalogue

“In owning our retail stores, we’ve learned that it is far more profitable to turn that inventory more quickly than to have high margins or raise prices.”

“Part of Patagonia’s authenticity lies in not being concerned about having an image in the first place. Without a formula, the only way to sustain an image is to live up to it. Our image is a direct reflection of who we are and what we believe.”

“The catalog is our bible for each selling season. Every other medium we use to tell our story - from the website, to hangtags, to retail displays, to press releases to videos.”

“If we come out with a product that is difficult to promote, it’s probably because it’s no different than anyone else’s and we probably shouldn’t be making it.”

“We have three general guidelines for all promotional efforts: 1) Our charter is to inspire and educate rather than to promote, 2) We would rather earn credibility than buy it. The best resources for us are the word-of-mouth recommendation from a friend or favourable comment in the press, 3) We advertise only as a last resort and usually in sport-specific magazines.”

“Advertising rates dead last as a credible source of information. Overall, we do far less advertising (usually less than 1 percent of sales) than most outdoor companies, let alone clothing companies.”

Value Employees

“We provided a cafeteria that served healthy food where employees could gather throughout the day. And we opened an on-site childcare centre. At the time it was one of only 120 in the country; today there are more than 8,000.”

“If you care about having a company where employees treat work as play and regard themselves as ultimate customers for the products they produce, then you have to be careful whom you hire, treat them right, and train them to treat other people right.”

“Our benefits package is generous but strategic. Each benefit makes good business sense for us. We offer comprehensive health insurance, even to part time employees, in order to attract serious athletes to work in our retail stores.”

“Patagonia’s internship program allows employees to leave their jobs for up to two months to work for an environmental group and still receive their Patagonia paychecks and benefits.”

Hiring

“It’s our first principle of hiring, that as many Patagonia employees as possible also be true Patagonia customers.”

“We also seek core Patagonia product users, people who love to spend as much time as possible in the mountains or the wild.”

“We’ll often take a risk on an itinerant rock climber that we wouldn’t on a run-of-the-mill MBA.”

“Hiring people with diverse backgrounds brings in flexibility of thought and openness to new ways of doing things, as opposed to hiring clones from business schools who have been taught a codified way of doing business. A business that thrives on being different requires different types of people.”

“As much as possible we hire from within, to keep the company culture strong. And then we train, and take the time to train, as though our future depended on it.”

“We don’t want drones who will simply follow directions. We want the kind of employees who will question the wisdom of something they regard as a bad decision.”

“In a company as complex as ours, no one person has the answer to our problems, but each has a part of the solution.”

Walk The Floor

“In this information age it’s tempting for managers to manage from their desks, staring at their computer screens and sending out instructions, instead of managing by walking about and talking to people. The best managers are never at their desks yet can be easily found and approached by everyone reporting to them.”

Tone at the Top

“The best leadership is by example. Malinda’s and my office space and the CEO’s is open to anyone, and we always try to be available. We don’t have special parking spaces for ourselves or any upper management; the best spaces are reserved for fuel efficient cars, no matter who owns them. Malinda and I pay for our own lunches in our cafeteria; otherwise it would send a message to the employees that its’s okay to take from the company.”

Decentralised & Smallness

“Systems in nature appear to us to be chaotic but in reality are very structured, just not in a top down decentralised way. Deborah Gordon, a professor at Stanford University who studies ant colonies, says that there is no specific ant in charge of a colony, no central control. Yet each ant knows what its job is, and ants communicate with one another by way of very simple interactions; altogether they produce a social network. A top down central system like a dictatorship takes an enormous amount of force and work to keep the hierarchy in power. Of course, all top-down systems eventually collapse, leaving the system in chaos.”

“I believe that for the best communication and to avoid bureaucracy, you should ideally have no more than a hundred people working in one location. This is an extension of the fact that a democracy seems to work best in small societies, where people have a sense of personal responsibility.”

“Hundreds of studies in factories and workplaces confirm that workers divided into small groups enjoy lower absenteeism, less sickness, higher productivity, greater social interaction, higher morale - most likely because the conditions allow them to engage what is best in being human, to share the meaning and fruits of their labour.”

Respect Customers

“We treat customers with respect, too. We don’t farm out phone calls to a service bureau in Delhi.”

“We have an ‘ironclad’ guarantee, and we honour it - even if we have to go to great lengths. We do know that the extra steps we take are worth it. Our catalog re-order rate from customers, season after season, far exceeds the mail-industry standard. In fact, it’s off the charts.”

Source: Patagonia catalogue

“We don’t speak to what is perceived as the lowest common denominator. We speak to each customer as we want to be treated, as an engaged, intelligent, trusted individual.”

“We recognise that we make most profit by selling to our loyal customers. A loyal customer will buy new products with little sales effort and will tell all his friends. A sale to a loyal customer is worth six to eight times more to our bottom line than a sale to another customer.”

Listen To Customers

“To stay ahead of the competition, our ideas have to come from as close to the source as possible. With technical products, our ‘source’ is the dirtbag core customer. He or she is the one using the products and finding out what works, what doesn’t, and what is needed.”

Win-Win / Ecosystem

“In 1986, we committed ourselves to donate 10% of profits each year to small groups working to save or restore natural habitats. We later upped the ante to 1% of sales, or 10% of pretax profits, whichever was greater. We have kept that commitment every year, boom or bust.”

“We consider ourselves to be an integral part of communities that also include our employees, the communities in which we live, our suppliers and customers. We recognise our responsibilities to all these relationships and make our decisions with their general benefit in mind.”

“Develop long term relationships with suppliers and contractors. Patagonia has never owned a fabric mill or sewing shop. To work on a single endeavour with so many other companies, with no compromise in product quality, requires a mutual commitment much deeper than the traditional business relationship.”

“We do as much business as we can with as few suppliers and contractors as possible. The downside is the risk of becoming highly dependent on another company’s performance. But that’s exactly the position we want to be in, because those companies are also dependent on us. Our potential success is linked. We become like friends, family; mutually selfish business partners; what’s good for them, is good for us.”

“We put a lot of effort into choosing factories that have healthy relationships with their employees.”

“If you want to get things right the first time, rigorous specs aren’t enough. You have to be a full partner. You have to make sure your supplier and contractors have the necessary knowledge and tools to get the job done to your design standards.”

“I think of Patagonia as an ecosystem, with its vendors and customers as an integral part of that system. A problem anywhere in the system eventually affects the whole, and this gives everyone an overriding responsibility to the health of the whole organisation. It also means that anyone, low on the totem pole or high, inside the company or out, can contribute significantly to the health of the company and to the integrity and value of our products.”

Source: Patagonia catalogue

“A successful, long-lived, and productive company like Patagonia could be compared, on the most basic level, with a healthy environment, simply in the fact that both are composed of various elements that must function together in some kind of balance in order for the whole system to work.”

Quality

“Maximum attention is given to product quality, as defined by durability, minimum use of natural resources, multi-functionalism, non-obsolescence, and the kind of beauty that emerges from absolute suitability to task. Concern over transitory fashion trends is specifically not a corporate value.”

“The first part of our mission statement, ‘Make the best product’, is the raison d'être of Patagonia and the cornerstone of our business philosophy.”

Source: Patagonia Catalogue

“‘Make the best’ is a difficult goal. It doesn’t mean ‘among the best’ or the ‘best at a particular price point.’ It means ‘make the best’ period.”

“The challenge for Patagonia, or for any company serious about making the best product of its kind, is to re-create on an industrial scale the hand knitters devotion to quality. You cannot hand off your pattern or blueprint or model to the lowest-bid contractor and expect to get anything close to what you had in mind.”

“We believe that quality is no longer a luxury. It is sought out by the consumer, and it is expected. For example, the Strategic-Planning Institute has been collecting data for years on the performance of thousands of companies. [Their] report has begun to show quite clearly that quality, not price, has the highest correlation with business success. In fact, the institute has found, overall, companies with high-product and service-quality reputations have on average return-on-investment rates twelve times higher than their low-quality and lower-priced competitors.”

“Whenever we are faced with a serious business decision, the answer almost always is to increase quality. When we make a decision because it’s the right thing to do for the planet, it ends up also being good for business.”

Stick to Knitting & Recessions

“You have to know your strengths and limitations and live within your means. The same is true for business. The sooner a company tries to be what it is not, the sooner it tries to ‘have it all’, the sooner it will die.”

“We don’t force our growth by stepping out of the specialty outdoor market and trying to be who we aren’t. We let our customers tell us how much we should grow each year. Some years it could be 5% growth or 25%, which happened during the middle of the Great Recession. Consumers become very conservative during recessions. They stop buying fashionable silly things. They will pay more for a product that is practical, multi-functional, and will last a long time. We thrive during recessions.”

Not Fashion

“Our design and product development calendar is usually eighteen months long, too long to be a contender in any new fads. We rarely buy off-the-shelf fabrics or existing prints, so we have to work with artists and design studios in producing original art.”

“When you give in to fashion trends, you doom used clothes to the trash heap.”

Long Term

“I did know we had become unsustainable and that we had to look to the Iroquois and their seven-generation planning, and not to corporate America, as models of stewardship and sustainability. As part of their decision process, the Iroquois had a person who represented the seventh generation in the future. If Patagonia could survive this crisis [an earlier sales and cash-flow crisis], we had to begin to make all our decisions as though we would be in business for a hundred years. We would grow only at a rate we could sustain for that long.”

“Long-term capital investments in employee training, on-site child care, pollution controls, and pleasant working facilities all are negatives on the short-term ledger. When the company becomes the fatted calf, it’s sold for profit, and its resources and holdings are often ravaged and broken apart, leading to the disruption of family ties and the long-term health of local economies. The notion of businesses as disposable entities carries over to all other elements of society.”

“When you get away from the idea that a company is a product to be sold to the highest bidder in the shortest amount of time, all future decisions in the company are affected. The owners and the officers see that since the company will outlive them, they have responsibilities beyond the bottom line. Perhaps they will even see themselves as stewards, protectors of the corporate culture, the assets, and of course the employees.”

Private Ownership

“Being a publicly held corporation or even a partnership would put shackles on how we operate, restrict what we do with our profits, and put us on a growth/suicide track. Our intent is to remain a closely held private company, so we can continue to focus on our bottom line: doing good.”

Debt

“We are a privately owned company, and we have no desire to sell the company or to sell stock to outside investors, and we don’t want to be financially leveraged.”

“Not only don’t we want to be financially leveraged, but our goal is to have no debt, which we have achieved.”

“A company with little debt or with cash in the kitty can take advantage of opportunities as they come up or invest in a start-up without having to go further in debt or find outside investors.”

Scenario Analysis

“A company should always be playing ‘what if’ scenarios, e.g what if all our top management goes down in an airplane crash, our warehouse burns down, our main computer melts down or gets a virus? Or what if there is a 25% downturn in business or sales in Japan suddenly explode beyond our wildest planning?”

Consultants

“When a problem comes up, the effective CEO does not immediately hire a consultant. Outsiders don’t know your business the way you do, and anyway, I’ve found that most consultants come from a failed business.”

Environment

“Repair is a radical act. As individual consumers, the single best thing we can do for the planet is to keep our stuff in use longer. This simple act of extending the life of our garments through proper care and repair reduces the need to buy more over time - thereby avoiding the carbon dioxide emissions, waste output, and water usage required to build new products.”

Source: Patagonia catalogue

“We strive to balance the funding of environmental activities with the desire to continue in business for the next hundred years.”

“Patagonia’s environmental efforts began in the 1970s by trying to prevent the destruction of our surf breaks and by trying to stop the physical damage to the rock walls of Yosemite. Later we started looking at minimising the environmental hurt with manufacturing our products.”

“One of the hardest things for a business to do is to investigate the environmental effects of its most successful product and, if it’s bad, to change it or pull it off the shelves.”

“When we act positively on solving problems instead of ignoring them or trying to find a way around them, we are further along the path to sustainability. Every time we’ve elected to do the right thing, it turned out to be more profitable.”

“Worldwide we are using the resources of several planets. We can no longer afford to use a natural resource only one time. Today, our Repair Centre in Reno Nevada, is the largest garment repair facility in North America. It employs more than fifty people who complete more than forty thousand repairs per year.”

“Each time we tried to do the right thing for the environment, regardless of the cost to us, we ended us saving money.”

Summary

Many of us grow up wanting to climb a mountain and Yvon Chouinard did exactly that. Not only did he achieve that goal, he also established a global business that helps others achieve their vision all while offering environmentally sound business practices along the way. And its the envy of the industry.

Patagonia really does do things differently. From 100-year plans to investing in the planet’s health, the business is once again, another example of how one person’s extraordinary vision has led to not only corporate success, but also to providing a healthy ecosystem that allows suppliers, staff and customers to exist harmoniously. Forever.

Source: ‘Let My People Go Surfing’, Yvon Chouinard, Penguin Books.

Video: ‘Let My People Go Surfing, 10 More Years of Business Unusual’, Trailer. Patagonia.

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