Review – The Acquirer’s Multiple

The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market (buy on Amazon.com)

by Tobias Carlisle, published 2017

I received a free copy of this book from the author.

I spend a lot more time thinking about the best way to introduce people to the world of value investing than I actually get requests for such information, though I do receive occasional requests for advice. The reason is not just because I am a pedantic thinker but because I spent a very long time acquiring my own knowledge on this subject, with many wrong turns and wasted efforts and I have always wondered, “Is there a better way?”

Toby Carlisle’s “The Acquirer’s Multiple” may just be that better way.

But first, let me explain the most up-to-date advice I have been vending, and keep in mind, this advice is not intended as “how to be a good investor/make good investments” because I am not a registered investment adviser nor would I attempt to impersonate one– this is just my opinion of “how best to learn about investing”. I think I can dispense that advice as an opinion without running afoul of the authorities because I am just talking about ways to acquire certain knowledge. At least I hope so!

My suggestion is to read the following titles, in this order:

  1. The Richest Man in Babylon: Now Revised and Updated for the 21st Century (Paperback) – Common
  2. The Millionaire Next Door: The Surprising Secrets of America’s Wealthy
  3. Buffett: The Making of an American Capitalist
  4. The Accounting Game: Basic Accounting Fresh from the Lemonade Stand
  5. The Essays of Warren Buffett: Lessons for Corporate America, Fourth Edition (or more specifically, Buffett’s Shareholder Letters from Berkshire Hathaway, and his private partnerships, available on the Berkshire website)

Perhaps at a later date I will spend some time writing a post explaining in greater detail why I recommend these resources in this order to an aspiring student of (value) investing, but for now I will simply say that the first two explain how to save and how to develop the psychological discipline and personal habits that permit one to save money, and you must have savings if you want to fuel an investment program. The second lesson is in inspiration, to study the life of the greatest master of investing in the modern era to understand both what is possible, and what it takes, to be great at investing. The third lesson is a rudimentary knowledge of accounting, “the language of business” because if you’re going to be investing in businesses you ought to have a clue what is going on.

Only then, young grasshopper, are you ready for your fourth (but not final) lesson, which is to learn the methods and principles of (value) investing itself. And I can think of no greater expositor of these principles than the great master himself once again, Warren Buffett, especially because you can read along as his company develops and see the wondrous workings of these principles in “real time”.

But even this can be an overwhelming introduction for a noobie who doesn’t realize what a deep pool they’re wading into in asking the question. For the action-oriented, then, I offer a 3-Point Plan of Investment Attack which includes:

  1. The Richest Man in Babylon
  2. The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Books. Big Profits)
  3. The 2013 Berkshire Hathaway Shareholder Letter, “Some Thoughts About Investing”

This short list will teach you how to save money so you have fuel for your investment machine, and then it provides the basic knowledge needed to decide if you want to be a humble Sunday-driver investor and do passive index investing, or if you want to be a more racy investor and pick your own businesses to invest in the way a true value investor would.

Pedantic as I am, where the heck does Toby’s book fit into all of this?! Well, I think now I can whittle my 3-Point Plan down to 2-Points: The Richest Man in Babylon, and The Acquirer’s Multiple. And I might be able to turn my original 5 item foundations into a 3 item list, using Richest Man, Accounting Game and The Acquirer’s Multiple as the set of texts. Here’s why.

Toby has done something incredible with this book. He has boiled a deeply studied, highly opinionated, multi-trillion dollar field of human endeavor down to its most essential, best researched and expertly practitioned concepts and he’s done it all in simple language that I am convinced even a complete neophyte would find approachable. He has included a number of delightful graphics that help to illustrate these simple concepts about how typical market participants behave and where investment value comes from that, for the first time in my life, I actually found increased my understanding of what I already knew rather than confused me (note: charts, data tables, etc., usually just distract me and I skip them, I am a mostly verbal knowledge acquirer). You really can’t go wrong jumping in this way.

The best part, however, is that he has curated some dramatic and action-packed biographical stories demonstrating how successful billionaire investors have put these ideas into practice. This checks the “inspiration” box I mentioned earlier because it helps the reader see how these ideas were translated into action and it gives confidence that you, too, could stand to benefit in this way.

And finally, he repeats (yes, the book is repetitious) all the neatly summarized concepts into one final summary list at the end of the book that involves 9 rules for a value investor to live by. I am confident that if a new investor referred to this list again and again at each point in his investment research and portfolio management process and asked himself, “Am I living true to this list?” he would be very satisfied with himself over a long period of time if his answer was “Yes”. And if the answer were “No”, then he’d understand exactly what he needed to do to get back on course.

I know Toby personally. He is a highly intelligent fellow, his passion for these ideas and the subject are intense and, if you ask me, he lands firmly in the “Graham” side of the “Graham-Fisher” spectrum of value investing (discussed a bit in the text) that all value investors and followers of Warren Buffett debate endlessly. And that is why I was so pleased that the conclusion of the book included an admonition to “check yourself before you wreck yourself”, so-to-speak. The Acquirer’s Multiple principle itself couldn’t be simpler, but Toby knows, as do all great investors in the Grahamian-tradition, that true risk lies in the behavior and biases of the investor himself, particularly an investor who can’t follow simple principles he knows to be true because he insists on trying to outsmart them.

Don’t try to outsmart what can be simple (though never easy!)… like reading 5 books on the art of investing when you could maybe get away with just two or three. And I am now convinced that Toby’s book should be one of them.

4/5







Notes – What Is Jobs To Be Done (JTBD) Theory?

Several months ago, a friend of mine introduced me to “Jobs To Be Done Theory” (JTBD) via the free work of an entrepreneur named Alan Klement called When Coffee and Kale Compete. The JTBD framework is part of a growing base of entrepreneurial knowledge in the innovation space with key similarities to things like disruptive innovation (The Innovator’s Dilemma by Christensen) and Design Thinking practice. These approaches to entrepreneurship focus on empathy as a methodology for understanding the psychological motivations and needs of a potential customer rather than on their demographic characteristics or profile data. Solutions are designed to help the customer make progress rather than being built around features or functions; in this way business people might be surprised to find out that “coffee” and “kale” can be competitors in helping a person make progress on “get my morning started right”, whereas in the traditional product design space an entrepreneur might be more focused on “how to build a better cup of coffee for 18-35 year old women.”

As Klement says in the introduction,

I want to help my customers evolve themselves. I shouldn’t study what customers want in a product. I need to study why customers want.

He describes a JTBD as consisting of three elements:

  1. job is your struggle to make a change for the better
  2. The to be part denotes that overcoming that struggle is an evolutionary process; it happens over time
  3. The change is done when you overcome that struggle and have changed for the better; there are things you can do now, that you couldn’t do before

These jobs originate inside people, not inside things. They have to do with motivations or states of mind, that is, they are psychic not material in nature. And there are many potential strategies for helping a person to accomplish that transition from one state to another, which is why it is possible to envision disruptive solutions that redefine the categories by which product or service competition occur.

Klement helpfully summarizes some principles of JTBD theory:

  • Customers don’t want your product or what it does; they want help making their lives better
  • People have Jobs; things don’t
  • Competition is defined in the minds of customers, and they use progress as their criteria
  • When customers start using a solution for a JTBD, they stop using something else
  • Innovation opportunities exist when customers exhibit compensatory behaviors
  • Solutions come and go, while Jobs stay largely the same
  • Favor progress over outcomes or goals
  • Progress defines value; contrast reveals value
  • Solutions for Jobs deliver value beyond the moment of use
  • Producers, consumers, solutions and Jobs, should be thought of as parts of a system that work together to evolve markets

He works through a number of case studies to illustrate these principles. The methodology in each case study focuses on interviewing customers to get verbatims about how they reason about what problem they’re trying to solve and what solutions they’ve tried in the past and present. The emphasis is on revealed preference, determined by actions, rather than stated preference, determined by marketing surveys or hypothetical scenarios. By unpacking these statements rather than making assumptions, the entrepreneur can work to understand the mindset of the customer and how he sees himself struggling to make progress in a particular part of his life.

Klement later discusses two well-known case studies in the disruptive innovation literature, Kodak and Apple (iPhone vs. iPod), and reinterprets the story through the JTBD framework. With this, we see that Kodak’s business was annihilated not because they were complacent and didn’t see how technology would make their product irrelevant, but because their focus was on optimizing a particular solution (traditional film) for a particular JTBD rather than focusing on that JTBD itself and trying to ask what is the best way to help customers make progress on that in light of changing technology. In contrast, Apple took a very profitable product, the iPod, and thought about what kind of job it was fulfilling and what was a better way to do that job, the iPhone, rather than thinking about how to build a better iPod. This is because “no solution for a JTBD is permanent.”

One thing I found challenging in trying to digest this new framework was identifying the JTBD itself. Klement offers a few guidelines for deciding if you do NOT have a JTBD defined properly:

  • Does it describe an action?
  • Can you visualize somebody doing this?
  • Does it describe “how” or “what” and not why?

If the answer is yes, it is likely not a JTBD because JTBDs are emotional and represent psychic states. They are ways people experience their own existence and how they progress from one state of existence to another, they are not the thing that makes the progress themselves. Sometimes these JTBDs are exceedingly obvious. But a lot of the time, they’re subtle and can only be defined with confidence after a long, empathy-driven process of interviewing and conversing with customers to better understand what they think they’re trying to do. This is hard work! The JTBD framework is certainly not a quick or easy fix to the dilemma of how someone with an entrepreneurial bent can design great new products and services that meet peoples needs.

The book is chock full of case studies and deeper explanations of the basic components summarized above. I highlighted and underlined various meaningful passages that I won’t bother typing into these notes because they’d be too out of context to add clear meaning to a reader; besides, I read this book earlier this year and didn’t get to write up my notes until now, so I can’t even remember with some of them why I found them impactful at the time.

Alan Klement offers free consultation services and aspires to help people on a paid basis as well. I have spoken to him a number of times as I have read his book and attended the Design Thinking Bootcamp to share thoughts and ideas about the JTBD framework, especially as it applies to personal design challenges I am exploring in my own business. He informed me that he is working on a revised and re-organized 2nd edition which he plans to release soon. I will likely revisit the book then and consider publishing further notes and thoughts about the JTBD framework as I become more familiar with it and even work to use it in my own design challenges in the future.


Finding My Buffett

Charlie listened. Eventually he asked, “Do you think that I could do something like that out in California?” Warren paused for a moment and looked at him. This was an unconventional question coming from a successful Los Angeles lawyer. “Yeah,” he said, “I’m quite sure you could do it.”

[…]

“Why are you paying so much attention to him?” Nancy asked her husband.

“You don’t understand,” said Charlie. “That is no ordinary human being.”

~The Snowball

Who wouldn’t want Warren Buffett as a friend? Who wouldn’t want to be the ultimate coattail rider as the Charlie Munger of the Berkshire Hathaway-type life story?

While it’s never been clear to me what value Charlie Munger brought to the duo aside from his acerbic wit and getting-high-on-my-own-supply love for See’s Peanut Brittle which undoubtedly boosted sales, it’s fairly obvious what Munger got out of Buffett– encouragement.

And that seems to be all Munger needed to find greatness in himself.

It is actually amazing that this bond was formed and that Buffett was not only willing to share with Munger his secrets but pushed him to try it himself. Why did he do this then? The truth is, it doesn’t matter. The only thing that matters, for Munger anyway, is that Buffett did this.

When I look back at my own history, particularly with regards to my interest in investing, I don’t see any encouraging moments like this. Perhaps I have simply forgotten them, or perhaps they did not occur. I think I had ample opportunity to be encouraged by others and yet I don’t have any recollection of it. As I am currently seeking after my passion in life and searching for what my own greatness might be about, I seem to remember at one time it might have had something to do with being a great investor. Along the way I lost sight of that vision, became discouraged, dejected and doubtful.

This might seem like a good opportunity to blame the various people in my life who might have encouraged me to keep going but did not. That isn’t my point and it isn’t what I believe or am focused on right now. Instead, I notice one more thing about the time that Charlie met Warren. That thing is this:

Charlie asked for what he wanted.

Notes On Reading With Our Little Lion

The Wolf and I have been a bit negligent about reading with our Little Lion to date. When he was just out of the womb, I spent the first few weeks of life reading through “Our Oriental Heritage” from the Story of Civilization series, while the Little Lion and the Wolf breastfed to sleep. We made a lot of progress– we got through all of Ancient Egypt and most of the Mesopotamian cultures, through to Persia. I think we stopped right around Ancient India.

Many things got in the way when we set the book down and forgot to come back to it, not just one thing. But the most important reason in my mind is that it seemed like our Little Lion developing his other skills and capabilities was more important than trying to read every day. Eating, sleeping, walking (me + stroller + doge), rolling and crawling, etc. Reading was one more thing that seemed to have limited benefit on a relative basis.

I know all Good Parents read to their kids everyday, even when they’re not paying attention or can’t sit still on their lap. I also know all Good Parents do Tummy Time. We didn’t do Tummy Time. And we didn’t read to our Little Lion every day. So we might not be Good Parents. We’ll see.

One thing we do with our Little Lion is we talk a lot. We listen to music. We have adult conversations with one another, using adult words, and with our Little Lion, using adult words. We talk about our emotions and we don’t hide from him when we aren’t getting along with ourselves, each other or other people. His home is partially bilingual (trilingual… but I can’t seem to catch a break on getting that third language spoken more frequently than the second!) so our Little Lion is getting a lot of exposure to language.

The Wolf and I are big readers. Even if we’ve been negligent so far with our Little Lion, he will have no questions about whether he’s living in a literary household. Some day he’ll read our reviews on this blog, and hopefully contribute his own! He will see the Lion and the Wolf reading all kinds of things, nearly every day, often for long stretches of time. If he grows up hating books, I don’t think it will be because we didn’t do a lot of story time for the first ten months of his life.

That being said, our Little Lion seems like he’s able to get some benefit from being read to now and seems like he can actually enjoy the interaction actively. So we’re diving in a bit on this one now, reviewing potential titles to add to his library. We’re also thinking about principles for selecting books for reading and principles for how to benefit from reading together. Here is what we have thought about so far.

Principles for Selecting Books

  • Avoiding fantasy themes until much older; no books that depict characters or events which could not possibly be witnessed in real life
  • Emphasizing characters, events, animals, natural environments, that our Little Lion has a good chance of experiencing in his present location; there is plenty of time, as he develops and over the course of his reading career, to explore places and things beyond “home”
  • Emphasizing people, emotions and simple story lines with vivid images (real, or highly realistic is fine)
  • Action emphasized over values and meanings, though values and meanings we agree with are okay (things we’re not okay with: PC culture, sharing is caring, collective inclusion and individual exclusion, embedded authoritarian messaging)
  • Baby-centric narratives are okay for now, but modeling relationships and older people is okay, too
  • Questionable– “fairy tale” type stories like Aesop’s Fables. The Fables characters are animals, who usually talk, the emphasis is on the lesson and the action, not the talking animal, but the animals could easily be retold as people to make the stories useful
  • You can’t know if every book is appropriate ahead of time, it might take flipping through a copy at a book store or actually trying to read it after buying it to figure out it’s a joke

Principles for Enjoying Reading Time Together

  • Try it when everyone is well rested
  • Okay to read “the same thing” over and over, especially if baby chooses to do so; it’s new to them!
  • There’s more to story time than being read to or following the story; touching, looking, making noises, tasting, etc. are all part of the experience
  • If baby doesn’t want to sit on the lap and read actively, he can be read to “passively” while he plays, crawls, etc. in a safe space nearby
  • The adults can read “children’s books”, or read their own books that fall within these guidelines (actually much more likely with an “adult” book), whatever they’ll be interested to read with the child
  • Act it out and get animated if you like; tell a good story!
  • Use the book as a prop to tell a different story if you like, especially if it has limited text and can be easily modified
  • Talk ABOUT the book as much as you READ the book; discuss what’s going on, see what baby is reacting to, ask baby questions about the story; as baby gets older, you can both evaluate what you read afterward, and do critical reviews of “joke” books you’re sorry you read
  • Read baby history and the classics when desired (we’ll be working our way back through the Story of Civilization, and through some Shakespeare as well)
  • Don’t feel compelled to finish any book you start or to stop baby from “interrupting”, let baby do what they will and work with it; if it’s too distracting, try story time another day; the goal is to be together, not to “read” together
  • Understand that reading to “passive” baby is a specific activity and shouldn’t replace actively observing baby’s playtime or come to dominate such interactions

Beyond this, we’ll be treating it like a science experiment and expecting a lot of learning from failure!

Quotes – Excelling In Trivialities

Anger, spite, malice, impatience, and a vehement desire of getting the better in a concern wherein it were more excusable to be ambitious of being overcome; for to be eminent, to excel above the common rate in frivolous things, nowise befits a man of honor. What I say in this example may be said in all others. Every particle, every employment of man manifests him equally with any other.

~Michel de Montaigne

Review – Shoe Dog

Shoe Dog: A Memoir by the Creator of Nike

by Phil Knight, published 2016

What can we learn from business books, especially business biographies?

I used to laugh about this with a friend a considerable amount– all these dopey books about businesses, business men and business secrets, written by ghost writers and know-nothing journalists (hack writers), developed for and marketed to mass audiences who want an entertaining dream and not an edifying edifice to stare at imponderably.

We would be amazed at how absent these books were of any meaningful details, in fact, precisely the meaningful details necessary to actually understand what was going on and “how’deedodat?” It was like some kind of conspiracy of incompetent stupidity, to write books about business without margins, without tax rates, without rates of return on capital, without the capital structure outlined and revisited periodically as an enterprise grew, without definitions of risk and explanations of strategy.

Instead, lists of names, dates, places. Stylized depictions of tragedy and success. Cliched, retrospective business wisdom, as if the hustler-entrepreneur thought in any terms other than pure, maddening survival or unbridled, sociopathic dominance of everyone around him. Overlooking special revenue or R&D relationships with governments that were critical to a firm’s mastery of its market or early survival, or ignoring impolitic questions of how the founder avoided getting swept up in the local social conflagration du jour and being drafted out of existence.

To this mish-mash of storytelling sins this book adds a new one, anachronistic language. Somehow, Nike/Blue Ribbon was a “startup” before startups in the 1960s (and even into the 1970s, when it had been around for almost a decade… just getting going, really!) and one of the guiding philosophies of Knight and his “Buttface” crew (more on this in a bit) was to “fail fast”, nearly five decades before the software development revolution convinced the business world that iterative testing and quick trial to failure was the right way for all businesses to grow and not just a specialized niche that could essentially emulate A/B variants of its product or service offering at no cost or risk with the simple push of a button. But yeah, the shoe makers were doing that back when Vietnam was a thing.

That is why I read “Shoe Dog” with skepticism and found myself lusting after a critical beatdown as I turned the pages. A 25 year-old Phil Knight travels to Japan and secures a distributorship for a top Japanese athletic shoe, quite by chance and without any explanation of how he surmounted the language barrier in post-war Japan, then proceeds to tour the globe for four months by himself as some kind of backpacker-type tourist while his order samples, presumably, sit and wait for him the whole time? This is the beginnings of what would become Nike. And it went just like that.

Yeah, right.

The book is full of these glaring contradictions. Knight wanted to avoid the standard, stultifying corporate life, so he built a massive corporation. He believed in playing it straight as he advised his Eagle Scout nominees, so he lied to his financiers and production partners to grow his business. He never had enough cash to keep the bank happy and grow the business organically, so he bought himself a nice home and took the team on bi-annual corporate retreats to luxurious places (the book suddenly introduces this information about 12 years into the company’s history, where it is also revealed that they endearingly refer to one another as “buttfaces”, somehow demonstrating their open and transparent corporate culture). His co-founder fools him into giving majority control of the enterprise at the time of founding, then gives him 2/3rds of his share when trying to retire without fuss or challenge.

What “Shoe Dog” taught me, then, is that I’ve been naive to think there is anything esoteric one can learn from business books like this. It is my mistake for coming to a mass market piece of media and expecting to hear an honest telling, or even an interesting one. These books are written to entertain, glorify the egos of those who they are written about or nominally by, and perhaps even to some extent to distract, delude or otherwise throw off of the scent the would-be competitors who read them.

Reading between the lines, Knight was an alcoholic. He was clearly unscrupulous and at times cruel in his dealings with others. He did not spend the time with his family that they wanted from him. He lied, consciously, to his business partners and financiers. And he sued and counter-sued to stay in business or gain advantage. He did some other stuff, too, but these are the kinds of things that seem to set people apart, alongside luck. Some people play by the rules, either legally or their own conscience or both, and some people find ways to stretch these factors or simply break them without regret. Those people go on to be billionaires. And they have an incentive to lie about what they did and how they did it because after all, lying is what got them there in the first place.

You will never know how a business was really built by reading a book about it. And you would probably never find out even if you were a friend of the founder. You may not even be clear on what happened if you were inside the company itself. It’s too complicated and there are too many human factors involved that lend themselves to obfuscating the truth, if it can even be remembered.

One thing I learned from “Shoe Dog” is it’s my own fault if I keep reading this stuff and find myself frustrated at being anything but entertained.

3/5

A Tale Of Three Video Game Players

This past week I attended an event peopled mostly by engineers. Many of the engineers were trained as mechanical engineers but now work in companies on the forefront of engineering science– data and software-driven companies.

A topic that came up with several participants was the woeful state of education systems in the US, but not for the standard lament of their failure to properly teach the “STEMs”, but because of how efficient they are at killing creativity and the spirit to tinker, two things every engineer considers to be key to their mindset and personality.

Related to this lament were concerns about young people and screen time. There is a belief, backed by a lot of scientific study, that screen-based activities such as TV, video games and social media, breed passive minds because of their overstimulative effects. These engineers were concerned that many children will miss an opportunity to become creative and mechanically-oriented because their formative childhood years are increasingly dominated by interaction with media that treats them like a malleable consumer rather than a tool-wielding, problem-solving creator.

I share this overall concern, partly based in logic, partly based in my browsing of the scientific literature and partly based off my own personal experience. It has informed how we’ve approached the use of screens in front of our Little Lion– short story, we try hard not to use them at all in his presence, and frequently discuss how our habits and routines will need to change as it gets more and more difficult to use them only in his absence.

However, talking about this with the engineers got me thinking about three people I knew when I was younger who were video game players who all ended up with different life outcomes.

The first person I remember as a video game player growing up spent a lot of time playing games. Most of the times I visited him at his house we’d end up in front of the TV, usually with me watching him play something I didn’t have or that he was better at than me (an archaic form of the “Let’s Play” phenomenon). This went on for multiple video game generations, from the Nintendo SNES to the Nintendo 64. Over the course of our friendship we spent hours accumulating in days in front of the TV, playing games.

We also played outside a lot– handball against his garage door, riding bikes around the neighborhood, meeting up with other kids and hanging out. This friend was in Boy Scouts and was frequently found on camping trips on the weekends. He eventually made Eagle Scout. And he played team sports as a child, mostly soccer, until high school when he became an accomplished water polo player.

The second person I remember did not play many console games when we were younger. He was the first person who introduced me to PC gaming. I distinctly remember the weekend his family purchased an extremely economical “eMachines” brand PC with a Celeron-processor (read: slow) and a copy of the already almost decade-old Civilization II game. We stayed up until 2am, mindlessly punching keys trying to figure out how the game worked, for whatever reason we never thought to try reading the manual even though we were good enough readers to have done that. When we finally figured it out we were so excited we stayed up another 3 hours feverishly playing the game until we were so exhausted we passed out on the floor in the study where the PC was situated.

This person also introduced me to the card game “Magic”, and later in the era of the Xbox and complicated networking technology he was known for hosting Halo LAN-parties where he’d talk several other people into bringing their Xboxes and TV screens to his house where up to 4 supporting 4 players each could be networked together for a raucous neighborhood get together.

We, too, spent a lot of time riding our bikes around town together, he was also a Boy Scout and eventually an Eagle Scout, competed in soccer and other sports while younger and water polo in high school. Throughout his childhood he was extremely mechanical, building and racing offroad RC cars and RC gliders, camping and helping his parents rebuild and maintain an International Harvester Scout truck.

The final person I remember as a gamer growing up probably spent the least time overall playing games of the three, but it was definitely part of his life. I remember the time he brought his SNES over to my house and how jealous I felt seeing all the cool games he had that I did not. We also spent a lot of time riding around the neighborhood on our bikes, but a bit more aimlessly than the other two. With him we’d ride around until we found some mischief to get into, while for the first two bikes were a means of conveyance to other destinations and activities we were into.

He played soccer and basketball as a youngster, and in high school he did some cross country and track before giving up on team sports and, to some extent, giving up on his studies as well.

What happened to these three individuals who all played video games growing up?

The first one graduated high school with an excellent GPA after excelling in our school’s “magnet” math and science program. He was accepted at Stanford where I believe he studied engineering and may have continued playing water polo. He was hired by Accenture, the consulting firm, and I think has had a lucrative and enjoyable career.

The second one also graduated high school with an excellent GPA and also excelled in the school’s math and science program. He was accepted at MIT and studied mechanical engineering. I believe he went into a specialized mechanical field and has also had a productive and enjoyable career so far. Both of these guys are married and have families of their own now.

The third guy was a slightly sadder story. He seemed to burn out before high school ended. I don’t think he ever made it to college and last I had heard, he could be found around the beach on his skateboard with a very long beard and the nickname of “Jesus” because of his appearance. He may have even spent some time in jail for some pretty minor stuff I’d call “mischief” or “bad luck” rather than some kind of anti-social or menace to society kind of antics.

What I find interesting about all of this is that I never would’ve thought of the impact of video game exposure as children to their life outcomes until I had spoken to some of these engineers. Truly, what seemed to be more consistent in terms of impacting the drive and personality of each of these guys was their family lives. The first two guys grew up with siblings, their parents stayed married and they had what I’d call strong family cultures and values, even though they were slightly different from my own.

The third guy was a latchkey kid whose parents stayed together but it seemed like an awkward pairing and he’d regularly ridicule them behind their backs. It’s not clear what values their family had or that they even got through to their son about them.

Early video game exposure didn’t seem to stop the first two guys from having other interests and being mechanical and outdoorsy (Eagle Scouts) nor athletic (water polo, a terribly demanding sport). They seemed to be creative and had strong engineering minds (math and science outperformance) despite the stimulating effects of video games.

I don’t think I’d blame video games for “Jesus’s” life going down the tubes, either. As I mentioned, he played games but probably spent the least time with them. He was a decently intelligent individual and certainly didn’t struggle with math and science as subjects, he just didn’t seem to care much about them, school in general, or even apparently his life.

What I take away from all of this is that video games and screen time may not be “good” for a child’s development and may be distracting or counterproductive in terms of generating a passive vs. active mind and a consumptive vs. productive approach to stimulation. But looking at these anecdotes, it’s hard to draw the conclusion that video games or screen time necessarily would prevent a person from achievement in these areas.

More likely, natural ability mixed with a supportive family environment and complementary family values and lifestyle choices seem much stronger influences over future engineering talent and ability than how much time a child spends with screen-based gadgets.

What Is Design Thinking?

This post is a follow-up to some earlier posts about my recent participation at Stanford’s Design Thinking Bootcamp program. I want to reflect on what I think I know about the “design thinking” approach. I am not an expert or a scholar and I haven’t even read any books on the subject! This is my attempt to process my experiences, not to be authoritative.

As I now think about design thinking, I believe it is really three things:

  1. a specific process for generating new product and service ideas centered around “user experience” (ie, emotion)
  2. a general approach to being creative and innovative, particularly when working in a team
  3. a mindset, attitude or philosophy of psychology which addresses known cognitive biases which prevent people from accessing their natural creativity

I want to tackle these in reverse order.

The Design Thinking mindset

Everyone is and can be creative.

When I say design thinking is a mindset, I think about how much of what I’ve learned centers on the idea of putting oneself into a creative frame of mind. We seem to have both a creative mind, which is open, limitless, imaginative, fun and even a bit wacky, and a critical mind, which is narrow, realistic, fear-based, serious and deeply rooted in the known and knowable.

Design thinkers talk about the “Yes, and…” attitude, taking ideas offered by others and building upon them, rather than trying to shoot them down or explain why they’re wrong or off target. They separate the act of generating ideas from the act of evaluating ideas. They emphasize how we need to understand failure as an opportunity to learn, and to let go of control or thinking you can predict outcomes.

This is really a different way of experiencing life psychologically from what most people know. It’s not just about being positive, though the professional design thinkers I encountered were more positive on average than most people I know. It is an entirely different way to process one’s experiences and infer meaning from them.

Most of the time, most people are trying to avoid making what they perceive to be mistakes, and are looking for the quickest, cheapest way to accomplish a specific goal. But design thinking sets that aside. Mistakes are a part of learning and are to be embraced. It’s not that one purposefully makes mistakes, it’s that what a mistake is is not certain until it’s made and when it’s made, it is accepted as valuable data that shows us what doesn’t work.

And it’s not that design thinking looks for the longest, most expensive way to accomplish a specific goal, it’s an attitude that the destination is not obvious at the outset and so some serendipity is required to make the journey. When I was working on a design thinking project with a co-worker upon my return from the program, they were baffled by my line of questioning in some of the user interviews we conducted– we know what problem we’re trying to solve and how we intend to solve it, so why aren’t we asking people about that? I was taking the conversation anywhere but there, because as I understood it, the problem and what we think is the solution is just a place to start, but the true mindset we want to create is one of open consideration that we’re actually trying to arrive some place very different than the land we think we know.

A general approach to creativity

The mindset mentioned above is indeed a major component to the general creative approach design thinking represents. Without putting yourself into the right mental state, you have little hope of generating the breakthrough creative leaps the design thinking approach is known for.

A related concept is paying attention to space and materials when engaged in creative work. If you want to do different work and think different thoughts, you must physically work differently. Don’t sit at your keyboard, stand up in front of a white board. Don’t keep the ideas you’re ruminating about in your head, write them on colorful sticky notes and splatter them all over the walls so you and your compatriots can fully consider them. And don’t, by any means, think you can find all the answers in your office or traditional workspace– you absolutely must go into the field and talk to real people to find out what they think, rather than assume and guess at the thoughts, experiences and emotions of demographic strawmen.

I might have put this into the mindset area but another important principle is the “bias toward action.” This means not overthinking things and instead trying things. Come up with an idea, and then play with it, try it out on people you come across, see how they react. It rejects the idea that something must be perfectly engineered before it can be shown to other people. Seek “good enough” to get the major point across and go from there.

Design thinking certainly seems to offer tools and value for the individual designer, yet I think it emphasizes teamwork. There is an embedded belief that the individual is never as creative by himself as he is being creative in front of other people trying to do the same thing. Using that “Yes, and…” attitude, a group of people working creatively can work themselves into a motivational frenzy and the energy and random nature of exchange and +1 can take them to territory they don’t otherwise have a map to reach. The path isn’t clear and it isn’t contiguous.

One reason design thinking advocates doing and trying is that it’s a cheaper way to fail, and failure is seen as inevitable. Because humans are not omniscient and are extremely unlikely to come up with the perfect answer the first time, it is easy to predict that it will require multiple attempts at creativity and implementation to get to the final form that works as a solution (if even the problem itself isn’t transformed and reinterpreted along the way).

As a result, there is an emphasis on failing quick and often and not building a lot of cost into failure. Design thinking says that crude mockups and models of intended products or feature sets and the use of play-acting or imaginative role play is enough to try an idea out, get feedback and change. When you’re new to it, it seems a bit ridiculous, a bunch of grown adults essentially playing dress up and putting on a show for one another. Even more ridiculous is trying to get perfect strangers on the street to play along.

But this frugal approach allows you to try a lot of ideas quickly and cheaply. And if you get interesting or unusual reactions, you are gathering the exact data you would’ve wanted to get from focus groups, market surveys, etc.

An interesting aspect of all of this play is that it is highly experiential and is used as a tool to connect with people’s past experiences. That is what design thinkers are after– what is a real experience someone had in the past, and how did it make them feel, and how can they make them feel that same way with a new experience they’re trying to design into a product or service?

A specific process process for generating user experiences

So that is some of the philosophical ideas behind design thinking. What we learned was also a specific process with 5 main steps:

  1. Empathize
  2. Define
  3. Ideate
  4. Prototype
  5. Test

The first step involves conducting live empathy interviews with “users” a euphemism for a person who might ultimately be the user of a product or service offering you are thinking about creating. Using a “probe”, which in our case was a set of flash cards with a variety of emotions and a prompt such as “Think of a time when you last X, sort these cards in the order of how strongly you felt each emotion”, the design thinker has an excuse to begin talking to strangers.

It’s easy to fool oneself into believing that the conversation is about the probe/prompt, or about the design problem itself, but it’s not. The goal of the conversation is to get people talking about themselves, sharing experiences and specific memories along with the emotional states they triggered. When those experiences are found or those emotional states are identified, certain transitions can be used to keep digging deeper, such as “You said you were feeling Y, can you tell me about another time you really felt Y?” or “You mentioned Z, can you tell me about a specific time you did Z?”

When doing empathy work, the DTBC recommended the following:

  • Engage with the probe
  • Notice surprising decisions, awkward pauses, facial expressions
  • Follow up and ask “Why?” about the things you notice
  • Seek stories and ask about another time they felt or behaved this way

By capturing strongly felt emotions and the real experiences that generated them, the design thinker is able to move to the second step in the process, which is to Define the user. This is different than what is commonly done in standard market research by studying demographic data, because demographic data is broad, general and based on averages, whereas the design thinking “user” is specific, real and quite limited in their profile. An example of a user definition might be something like this:

“We met Paul, a graphic designer living in the city who fantasizes about running his own dairy farm whenever he eats cheese, his favorite snack”

Paul here is not a demographic profile. He’s a real, quirky dude (that I made up) with a strange contradiction between where he lives and what he fantasizes about, for example. Defining the user typically follows a process called Point of View, which looks like this:

  1. We met… (user you were inspired by)
  2. We were surprised to notice… (tension, contradiction or surprise from their interview)
  3. We wonder if this means… (what did you infer?)
  4. It would be game changing to… (frame up an inspired challenge to solve without dictating what the solution is or might be)

Whether you had a specific design problem when you started, the Define step and the Point of View process can either help bring more clarity to what your problem might really look like, or it might uncover an entirely new problem you had never actually thought of solving before.

The next step is to Ideate. Ideation is the brainstorming part of the design thinking process and most calls for teamwork. You start with a simple prompt, such as “How could we X for Y so they can Z?” You then start coming up with ideas and “Yes! And…” each one as they’re created to add to it or add another idea it inspired. The goal at this stage is not to critique or rationalize ideas but to simply create as many as possible. You’re not after “one idea” you could implement, or the one that is the final solution. You don’t know what that would be, and coming up with only one simply means you have a high chance of discovering later on you’re wrong and picked the wrong horse to bet on.

One technique for coming up with greater volume of new ideas is to use constraints. The constraints could be real but are usually arbitrary and somewhat outlandish, such as “Each idea must cost $1M to implement” or “Each idea must involve technology to implement”. By focusing your creativity tightly around a special constraint you can actually be more creative within that specific domain because your mind is forced to think about the problem from a new angle.

A similar technique is to think about the emotions involved for your user and think of people or organizations or places that those emotions are strongly tied to, then to ask yourself “What would that person/organization/place create for this user?”

When you come up with a large quantity of ideas, you can then move to the next step which is to prototype one of them. As discussed earlier, prototyping is crude. First, the DTBC recommended a role play. Take your idea and set a scene, define the roles involved in playing out the scene to demo the solution selected and improvise within the role play as you try it out multiple times.

Once you’ve role played, you can actually create a crude prototype and other props to do the role play with users. You want to test one key function at a time, so your prototype includes the following information:

  • Product/service name
  • Target user (the one you defined earlier)
  • Intended impact (what does it change for the user?)
  • One key function (this is what you’ll demo/test in the field with your role play)

Materials like cardboard boxes, construction paper, glue, saran wrap, markers, pipe cleaners, PVC tubes, etc. are all sufficient quality for the purposes mentioned. What’s more, they’re cheap and just about any physically able person can design with them.

You’re now ready to take it to the field and Test. But here’s the trick! The Test is really the first step, Empathize. And the prototype is really your probe. It’s all an elaborate ploy to get people talking to you some more, but this time with a slightly more concrete circumstance and with the goal of eliciting that precious experiential and emotional feedback in connection to a real product/service you’re thinking about creating.

Over these 5 steps, which can cycle with as many iterations as necessary to find a worthwhile problem to design for and an exciting solution to create (as defined by user feedback), the innovator is going through what the DTBC refers to as “flare and focus”. In the first step, you flare out your ideas and thinking in new and unusual directions, remaining open to new possibilities and experiences you had never thought of or encountered before. When you begin defining your user, you are focusing on something specific about them you’ve noticed, something concrete that can inspire your design. When you ideate for that user’s dilemma, you’re flaring again, trying to get wildly creative with the belief that no idea is a bad idea. Then you select an actual idea you’re excited about and focus again by developing a specific prototype to demonstrate it to the user. And when you test, you flare out and open up to new reactions and possibilities and begin the cycle anew.

Throughout this flaring and focusing you want to keep your eye on your alignment assessment– how close is your “frame”, the way you’re thinking about a problem that needs solving, to your “concept”, the specific solution you have in mind for solving the problem? Your frame and your concept might both change or only one change as you iterate. You might find your frame is sound but your concept is off the mark, or that you actually have a really interesting product or service but you haven’t quite found the right user who would benefit from it.

Some hallmarks of frame and concept alignment in the form of user feedback are:

  • “Thanks! Is that all you need from me?” indicating the problem or solution do not seem relevant or inspiring to the user
  • “You know what you guys could do that’s a REALLY good idea?” indicating that the user is experiencing relevancy but doesn’t think what’s being offered would work the right way
  • “So is this available for purchase? What does it cost?” indicating that the team has a frame and concept which are closely aligned and verging upon being ready for market

Conclusion

I think there is something to Design Thinking and I am interested to learn more. I am trying to internalize some of the attitudinal or mindset ideas which I think can be helpful in many domains beyond that of creating new product or service ideas specifically. I like a lot of the general processes, tools and techniques for generating creative ideas and tackling solutions to problems from unique angles. I especially like the idea of questioning whether you have the right problem (frame) in the first place!

One application I am considering is using design thinking principles within my family. How might common family problems be resolved differently with design thinking principles employed? What kind of family life or activity could be designed with design thinking?

The concept of designing for a specific user is also challenging for me to consider. As is focusing on real, past experiences rather than future hypotheticals– design thinkers throw out as unusable any speculation about how a person WOULD behave or WOULD feel in a given anticipated situation because it isn’t certain, whereas how they did feel in a specific experience from the past is known.

I plan to read a bit more on the subject and try to rethink some of the organizational problems we face in our business from the mindset of design thinking. Despite my initial failure to complete my Post Program work, I want to use Design Thinking to find a breakthrough, game changing solution rather than find some kind of incremental progress. If our future and existence as an organization truly hangs in the balance, incrementalism can only delay the inevitable, whereas a paradigm shift could offer not only a survival strategy but a way to actually thrive.

Some Takeaways From My Time At The D.School

I’m back from Stanford’s d.school and have a few ideas I jotted in my notebook while I was there:

  1. Learn to celebrate failure; watch how you react to it
  2. Let go of your desire to control outcomes; with humans involved, nothing ever goes according to plan
  3. Try things, practice, iterate
  4. Don’t build expense into prototyping; the more it costs, the harder it is to iterate and change and the less you can learn from your failures
  5. Don’t make insight generation complicated
  6. Where is the burning platform? Look for that place and work on the problems involved
  7. Innovation is the outcome of a process, and innovators are the people who do it
  8. The design thinking process: empathize, define, ideate, prototype, test and back again
  9. The answers are not in this building
  10. When empathizing, spend 15% of your time engaging, noticing and following-up and 85% of your time seeking stories
  11. The purpose of your empathy research is to capture emotion; what is it? where does it come from?
  12. Gravitate in your empathizing and your design thinking process between flaring and focusing
  13. When defining, start with an observation, make an inference, then form a hunch that can carry you to insight
  14. Solve one problem at a time
  15. POV essentials: preserve emotion and the individual, use strong language, sensical wording, non-obvious leaps and generate possibilities that lead to problems the team wants to help solve
  16. 5 users are sufficient to capture 85% of usability cases
  17. Tail-end users have explicit needs and better represent the implicit needs of median users
  18. The future is already here, but it’s not evenly distributed
  19. Trusting relationships are the foundation of generative work
  20. Learn how things fail before it matters, not when it does
  21. You can only learn by doing, not by planning
  22. Match prototyping resolution to idea certainty to allow yourself to hear the inevitable critical feedback
  23. Testing = empathy; your prototype is your empathy probe
  24. The value is in the user and their emotions, not in the prototype or experience model itself
  25. The goal is to develop empathy with the user, not the make the prototype perfect; seek understanding
  26. All action aims at advancing the frame and the concept towards convergence
  27. What do your users say about the concept? The users’ reactions and excitement indicate proximity to convergence and likely next steps
  28. 3 elements of storytelling: action, emotion and detail
  29. 100% of people who succeed, start
  30. Struggle and learning are complements; there is no learning without struggle, and the more one struggles, the more one has opportunity to learn; you can not master new knowledge from a place of comfort

Some or even many of these are probably difficult to make sense of or place without further context about the design thinking process.

A Theory of Corporate Governance

“Good managements produce a good average market price, and bad managements produce bad market prices.”

~Benjamin Graham, the Dean of Wall Street, “The Intelligent Investor”

Introduction

In the world of value investing, which fundamentally concerns itself with securities trading at a large discount to indicated or intrinsic value (the Margin of Safety), one thing investors are always on the look out for is the value trap. A value trap is a company that looks really cheap but turns out to be cheap for a reason, ie, it’s actually fairly valued at its present price. Companies in general become mispriced for a variety of reasons, and while value traps are no different in this regard, one reason stands far above others in generating its unfair share of value traps– bad management.

This essay will explore in greater detail the genesis of bad management value traps via the principle that “corporate value is a function of owner agency.” Companies with bad management tend to demonstrate the least owner agency, sometimes approaching an effective zero. As of the present, the principle of owner agency can be explored across separate 8 sub-domains pertaining to the company’s corporate governance standards.

The 8 Sub-domains of Corporate Governance

Whether a company realizes it or not, it can and must make a decision about its corporate governance policy in at least 8 different areas which affect owner agency and thus corporate value:

  • The Board of Directors
  • Company purpose
  • Communication standards
  • Capitalization/capital structure
  • Reporting
  • Fairness
  • Competence
  • Barriers

Each of these sub-domains and the choices involved will be explored below. At the end, we will summarize the “official positions” with regards to what good corporate governance looks like in light of the theory promulgated in this essay.

The Board of Directors

In a company with a diversified ownership structure, the Board of Directors exists to represent shareholders and direct the behavior of management according to their wishes. In other words, the BoD is the primary tool of agency for shareholders of the company who, without official titles or positions of management themselves, have no direct way to influence the conduct of the company, its strategy or policies as owning individuals. The BoD is similar to a “house of representatives” in an elected republic– the representatives exist to serve not their own interests, or the government’s interests, but the interests of the individual voters who put them into power.

The BoD should have broad authority to put in place an overall competitive strategy for the company (what do we make or sell? how do we do it? who do we compete with?) and to hire and fire key, C-level managers (CEO, CFO, COO, corporate comptroller or treasurer). These managers should be fully “answerable” to the BoD and thus, the shareholders, whose property they are responsible for utilizing and safeguarding in the course of business.

In modern public companies, it is common for these top managers to be represented on the board, for example, the CEO is also often the chairman of the BoD and presides over its affairs. This is an enormous conflict of interest, because the CEO can not hold himself accountable as a member of the board, and the purpose of the board is to be influenced by the shareholders, not the hired management. This is especially problematic when the CEO is not a substantial shareholder himself.

Another common state of affairs in public companies is that the BoD does not represent significant shareholders. Individuals legally important stakes (5%+) or significant economic stakes (10-25%) often do not get offered representation on the boards of the companies they own and sometimes nominally control due to the distribution of share ownership in a company. If the Board of Directors doesn’t include individuals who represent the interests of shareholders, it serves no purpose other than to rubber-stamp the initiatives of the management, which means it serves no purpose at all besides the propaganda value of pretending the company has functioning corporate governance through the existence of a Board of Directors.

Company purpose

Why do companies exist?

Historically, companies were formed for the benefit of their owners in order to turn a profit. Some of the first joint stock companies were engaged in material manufacture or entrepreneurial discovery of new lands and trading routes. Long pre-dating formal joint stock companies of Europe in the early 1500s were numerous merchant combines across cultures and the ages which were formed to pool risk in long-distance hauling of cargoes. Because the owners were the only people who put capital into the company, it was the owners who were the only people expecting to derive a direct benefit from the operation of the company in so far as it generated profits– the agents of the company might earn salary and bonus according to the terms of their employment contract, and of course the prevalent State often wished to interest itself via tax, but otherwise the issue was pretty cut and dry.

The modern era has brought with it many innovations in the area of an answer to that question, but none of them seem to be any good. Today we hear talk of “stakeholders”, where a stakeholder seems to be any economic or political interest, such as customers, communities, employees, vendors, foreign nationals, labor unions, governments, etc. who isn’t an actual equity owner in the company. We hear of “corporate social responsibility” (CSR) which is just another way to plead the case of certain “stakeholders” with regards to the deployment of a company’s capital. In vogue since the late 1980s and still popular today is the idea that long-serving management of the company should be the real beneficiaries of the existence of the company and that they should accumulate a lion’s share of the value the company creates because of the key role they play in making the company capital fecund in the first place.

Yes, it seems today that companies exist to serve everyone but those who own them.

Regardless of the answer to this question, it is important to simply have an answer. It becomes a standard of value that a company’s management and employees can be held to in observing their choices and behavior. It can serve to answer the simple question, “Are they doing a good job?” from which many other questions and decisions might emanate.

Without a stated purpose, it is not only impossible to agree to where everyone is going but it is impossible to govern the corporation so that it gets there. Certain purposes exclude certain ends and certain methods while allowing certain others.

Communication standards

With regards to how the company and the Board of Directors communicates with shareholders, there are also certain standards that can be implemented to guide action.

A common policy seemingly in place at many companies is clubsmanship and secrecy– executive management is unwilling to provide basic answers to shareholder questions and requests for information, often going so far as to put up unnecessary obstacles to proving they are in fact a shareholder in the first place. And the Board of Directors, captured by the management, facilitate this by refusing to assist the shareholders in their requests, to bring pressure upon management to provide the information (legally) requested and often times they will even make themselves unavailable or unresponsive to shareholders entirely.

The opposite pole would look like this: the management of the company assumes a goodwill posture and provides answers to any (legal) information request made. If the company is of sufficient size and scale and it is fielding a lot of such requests, it may make a special individual (such as an IR agent) available to help source answers. It might also look for a scalable solution, by putting commonly requested corporate documents (financial statements, records of ownership, minutes from board meetings, etc.) into the public domain via its website, and to also offer an FAQ session for answers to repeated inquiries.

As such information is legally due to shareholders anyway and can’t really harm the company by being shared, it makes sense to offer it to anyone who asks, shareholder, potential shareholder or simply a curious stranger. It is not a redacted espionage memo and it doesn’t require any special classification system or hierarchy of security clearances to access.

The Board can facilitate this process as well by being in regular contact with larger shareholders to understand their needs and concerns for the company they own, and to communicate these thoughts to management in board meetings and report back their findings to shareholders in the process.

Capitalization/capital structure

Public companies are in a unique position in terms of their ability to raise capital and finance their projects. Because of their public nature, it is a relatively simple affair to do a rights offering and issue new shares, debt or other securities. Even more important, if ever the market treats the company unfairly, they have the opportunity to buy back their shares from concerned shareholders at a discount to intrinsic value. The company is always in a better position when it is owned by people who believe in the vision and direction of the company, which can be achieved by buying back shares from those “distressed” sellers who have lost confidence.

One role of the BoD and corporate governance is to determine what the best capital structure is at any given time in a company’s life given its future plans and strategies. This means making high level decisions about the debt to equity ratio, if applicable, and also about the issuance or buyback of shares more generally.

Another thing the BoD can facilitate as an act of corporate governance is being efficient with the company’s capital– dividending it out when the company has more capital than projects, and issuing rights to bring capital back in when it has more profitable projects than it has capital to deploy on them.

This is not a one-time decision. It is something a company should be examining on a periodic basis– either quarterly, annually, or any time a major change in its market price or project pipeline occurs. Companies that hoard capital they don’t need do their investors a disservice because they forgo the economic returns available on the surplus capital, which could be deployed at higher rates of return in other enterprises. And companies that refuse to expand the share base in response to important project opportunities make a similar mistake but inverse.

Reporting

Markets move on information. Without information about a company, investors are left with nothing to make a decision off of and so they can not act rationally. They become forced to gamble and speculate. For a company that is not in a hyped industry, the gamble is often made in fear– shareholders sell out at any price to avoid association with a “black box.” It is a critical aspect of corporate governance to have a consistent reporting policy in place to update shareholders on the performance of the company’s strategy over time and to explain key financial data to them.

This kind of reporting requires: transparency, honesty and articulate capabilities. The chairman, being the head of the Board of Directors which represents the shareholders, is the most likely individual to communicate with shareholders about the state of their company. He might append letters from the CEO and other key executives as well if he so desires, but each of these individuals has an incentive to patronize their reader and focus on what went well. The chairman, having no duty to anyone but the shareholders and reality, is in a better position to see the whole hog and not just the lipstick on the pig.

For reporting to be meaningful, it must take into consideration the entire strategy and how the operations worked to achieve it or fail it. Glossy PR brochures highlighting the charity and good works of the management or employees, of the high level successes that did not translate to the bottom line, or to a stylized, marketing view of the company and its operations that does not drive to the key objectives and how they were met or missed, do not do shareholders any good.

While it’s true that the annual report is a key “marketing” piece in attracting knowledgeable shareholders, its primary purpose is to inform, not to sell. It must focus on the good, the bad and the ugly, not the positive or the bright side.

Fairness

Tied up in the ideas of representation and company purpose is the idea of fairness– are all shareholders treated equally? And are all managers and employees treated the same with regards to their duties to the shareholders?

There are two separate but related concepts of fairness at stake. One is the fairness of decisions between majority and minority shareholders, aka, “taking minority capital hostage.” The other is the fairness of decisions between shareholders and agents of the company, aka, “being subservient to loyalty or tradition.”

It is a sadly common sin amongst many public companies with decisive majority owners, especially owners who are insiders and part of management, that they find ways to employ the company’s capital or govern the company which benefit them at the expense of the passive, minority shareholders. An example of this would be a majority shareholder who is also a manager, who is earning an outsize salary and delivering a subpar return on equity compared to the industry or market, who refuses to “fire” themselves as a manager or scale back their pay. The minority shareholders are in effect subsidizing this poor performance with their capital, which is trapped in the company controlled by the majority shareholder.

This is not “fair” because it doesn’t treat the minority and majority shareholders as economic equals– the majority shareholder enjoys a special benefit or subsidy that the minority shareholder pays for. If the company did not exist, and this arrangement was being proposed as a condition of forming the company, no rational minority shareholder would agree to it. If they wouldn’t agree to it de novo, they can’t be thought of as agreeing to it as part of a going concern. This would be similar in a political system where some citizens are treated as “second class” by the law and discriminated against to the advantage of the privileged class.

The other sin amongst public companies is holding on to operating units or employees or managers who are underperforming in their jobs by some agreed upon, objective standards. These units are typically retained out of a sense of tradition (“We’re an X company, we’ll always be an X company”) or personal loyalty (“Y has been with the company for so many years, we can’t put them out on the street now”). Clearly, these kinds of decisions could easily conflict with a stated purpose such as “To maximize profits to shareholders.” They again represent subsidy. And the fact is that no company has infinite resources or can afford to engage in charity without limit; and if it can’t afford without limit, it can’t afford WITH limits, as the economic consequences are the same– the company is wasting capital on ineffective means.

Adhering to loyalty or tradition at the expense of shareholders means turning the business into a charity. Charity is a private virtue and a public vice and it has no place in a public company in this sense.

Competence

Modern companies are complex organizations with extensive economic resources at their command. The average public company, regardless of market price, has millions to tens of millions of dollars of shareholder capital involved in ongoing operations. There is too much to keep track of, and too much at stake, for a company to allow incompetent people to manage this level of responsibility.

Corporate governance serves another function here in setting standards of value for managers and employees in terms of the competence required in their positions of relative responsibility. Importantly, the Board of Directors can set standards in specific areas, such as financial or economic concepts which have an important bearing on the company’s risk position or the stability and profitability of its operations over time. Internal capital allocation, that is, the determination of how to deploy the company’s capital (buybacks, dividends, the raising of finance, or the investing of capital into operations or liquidating of capital so employed), is a seemingly simple discipline which nonetheless has a magnified impact on the company’s operations and its wealth as a whole– it requires a specific level of competence in the basic concepts and dilemmas involved for a person to add value. Many companies are run by people who do not understand capital allocation, have never studied the issues involved and often aren’t even aware of the momentous decisions they are making with regards to it, instead letting personal prejudice or momentary whim be the arbiter of decisions costing millions of dollars with long-lasting consequences for the company into the uncertain and unknowable future.

The Board of Directors can strongly influence the competence of the company and its management by researching and instituting relevant standards of competence needed in key decision-making areas and working to educate and provide resources to the company’s agents employed in these areas.

Barriers

In economic and business literature the concept of “competitive advantage” often revolves around a related concept of “moats”. A moat is a barrier to entry in a competitive market that preserves the value of incumbent firms by allowing them to spend resources on deploying their business model rather than spending those resources on defending it from competitors looking to do the same.

In the world of corporate governance, a similar phenomenon exists: “shareholder defense” tactics aimed at preventing “takeovers.” However, there is a subtle difference in the nature and virtue of each.

In the business competition sense, moats which provide competitive advantage usually exist as a structural part of the industry– they are embedded in the nature of the economic activity itself or the incentives competitors would face that are innate to margin structure, human behavior, etc. They usually can not be constructed or developed purposefully. Not so with takeover defenses. These are things that a company can or can not choose to employ and which the law often gives power to, implicitly or explicitly.

Competitive advantages protect companies from other companies. But shareholder defense mechanisms do not protect shareholders from other investors– they protect managers from their shareholders!

The actual effect of takeover defense mechanisms, when employed, is to drive a wedge between the people who own the company (the shareholders) and the people who control it (the management) by limiting the authority and control the shareholders have over dismissing or countermanding the management’s decisions.

Staggered boards, for example, help to ensure that change at the board level happens slowly (if at all), rather than as quickly as shareholder ownership changes. If there are 5 board seats and all are held by “insiders” and only 2 come up for bid every few years, then it may be 6 or more years, for example, for a shareholder who manages to obtain a majority of shares of the company to see his majority influence reflected in the composition of the board. That means a long period of time where existing management can work against the shareholder or at cross-purposes.

Poison pills, another common strategy, work to similar effect. A poison pill provision essentially neuters the voting power of a shareholder who manages to accumulate a substantial fraction of the company’s outstanding shares. If the provision says that any shares owned over 10% will vote at 10%, it prevents any specific shareholder from obtaining voting control, which protects the management from being told to change their tune or from being thrown out entirely.

It seems counter-intuitive, but removing barriers to entry for ownership of the firm is an important piece of corporate governance policy to work out. And much like the popular theory of democratic politics or republicanism, reserving the “right to vote” or the legitimate authority of the voters over their political appointees results in a situation where the appointees behave irresponsibly and often build up power and prestige at the expense of the people they were hired to represent.

“Official Positions” of Good Corporate Governance
Outlined below is an attempt at an “official” good corporate governance doctrine that any concerned company, its Board and shareholders could adopt to improve the corporate governance situation at the company. In so doing, it is believed that the company will attract quality, long-term oriented shareholders willing to pay a fair price for a properly managed and profitable enterprise. The items elaborated on below serve to maximize owner agency and with corporate value being a function of that agency, they should also serve the maximize the value of the company.
  • The board of directors should represent — meaning, be constituted of — significant shareholders and/or their agents
  • The company should be run for the purpose of maximizing the present value of expected cash flows to shareholders
  • There should be a constant dialog at the board level which includes larger shareholders about the best way to achieve the stated purpose
  • When the opportunity for capital/equity is low, money should flow out of the company; share buybacks and dividends are the way for money to flow out; when the opportunity is high, capital should flow back in; a rights offering (with transferable rights) is the cheapest and fairest way for money to flow back in
  • The annual report should have an essay or letter by the chairman (who is ultimately responsible for achieving the stated purpose) reiterating the objective, discussing the level of achievement in the prior year and outlining the strategy that has been agreed upon to pursue it going forward
  • It is unfair for a majority or manager to retain employees or operations for sentimental reasons unless they satisfy the purpose of maximizing the present value of expected cash flows to shareholders
  • Anyone responsible for achieving the objective should have the necessary grounding in finance and economics to understand how to carry the work out (study an agreed upon bibliography)
  • Management/corporate “shareholder defense”/takeover defense mechanisms such as staggered boards, poison pills, limits on shareholder meetings and proposals, secrecy/lack of disclosure, etc., destroy shareholder value by driving a wedge between ownership and control