Review – Common Stocks And Uncommon Profits (#investing, #stocks, #growth, #business)

Common Stocks and Uncommon Profits: And other writings by Philip A. Fisher (buy on Amazon.com)

by Philip A. Fisher, published 1996, 2003

Stock market investors who have studied Warren Buffett in detail know that he has cited two “philosophers” of investment theory more than anyone else in being influential in the formation of his own investment approach: Benjamin Graham and Phil Fisher. Graham represents the cautious, conservative, balance sheet-driven Buffett, while Fisher represents the future-oriented, growth-focused, income statement-driven Buffett. If you ask Buffett, while Graham got him started and taught him key lessons in risk management (Margin of Safety and the Mr. Market metaphor), Fisher was the thinker who proved to have the biggest impact in both time and total dollars accumulated. Buffett today, whether by choice or by default due to his massive scale, is primarily a Phil Fisher-style investor.

And yet, in my own investment study and practice, I have dwelled deeply on Graham and did little if anything with Fisher. I tried to read Fisher’s book years ago when I was first starting out and threw my hands up in disgust. It seemed too qualitative, too abstract and frankly for a person of my disposition, too hopeful about the future and the endless parade of growth we’ve witnessed in the markets for several decades since the early 1980s. Surely there would be a time where the Fisher folks would hang their heads in shame and the Grahamites would rise again in the fires of oblivion! After all, “Many shall be restored that are now fallen and many shall fall that are now in honor.”

As my professional career wore on, however, I found there was less and less I could do with Graham and more and more of what Fisher had said that made sense. And if you’re in business, you can’t help but be growth oriented– buying cheap balance sheets isn’t really the way the world works for the private investor. So, I decided it was time to take another look at Fisher’s book and see what I could derive from it as an “older and wiser” fellow. What follows is a review of Part I of the book; I plan to read and review Part II, which is a collection of essays entitled “The Conservative Investor Sleeps Well At Night”, separately.

Keep Your Eye On The Future

One thing I noticed right away is the consistent theme of future-orientation throughout Fisher’s book. Whereas balance sheets and the Graham approach look at what has happened and what is, Fisher is always emphasizing a technique that involves conceptualizing the state of the future. For example, in the Preface he states that one of the most significant influences on his own investment results and those of other successful investors he was aware of was,

the need for patience if big profits are to be made from investment.

“Patience” is a reference to time preference, and time preference implies an ability to envision future states and how they differ from the present and therein see the arbitrage available between the two states. The other key he mentions is being a contrarian in the market place, which sounds a lot to me like the lesson of Mr. Market.

Fisher also says that market timing is not a necessary ingredient for long-term investment success,

These opportunities did not require purchasing on a particular day at the bottom of a great panic. The shares of these companies were available year after year at prices that were to make this kind of profit possible.

While he cites the structural inflationary dynamic of the modern US economy and seems to suggest the federal government’s commitment to responding to business cycle depressions with fiscal stimulus puts some kind of ultimate floor under US public company earnings (unlike in Ben Graham’s time where large companies actually faced the threat of extinction if they were caught overextended in the wrong part of the cycle, Fisher suggests the federal government stands ready to create conditions through which they can extend their debt liabilities and soldier on), he says that the name of the game over the long-term is to find companies with remarkable upside potential which are, regardless of size, managed by a determined group of people who have a unique ability to envision this potential and create and execute a plan for realizing it. In other words, the problem of investing is recognizing strong, determined management teams for what they are, that is, choosing superior business organizations in industries with long runways.

Getting the Goods: The Scuttlebutt Approach

People who know about Fisher typically identify him with the “scuttlebutt approach”. Fisher says scuttlebutt can be generated from:

  • competitors
  • vendors
  • customers
  • research scientists in universities, governments and competitive companies
  • trade association executives
  • former employees (with caveats)

Before one can do the scuttlebutt, however, one has to know where to look. Fisher says that “doing these things [scuttlebutt] takes a great deal of time, as well as skill and alertness […] I strongly doubt that [some easy, quick way] exists.” So, you don’t want to waste your time by going to all the trouble for the wrong idea. He says that 4/5 of his best ideas and 5/6 of the total gains generated over time that he could identify originated as ideas he gleaned from other talented investors first, which he subsequently investigated himself and found they fit the bill. Now, this is not the same thing as saying 4/5 ideas he got from others were worth investing in– the proportion of “good” ideas of the “total” he heard about is probably quite low, but the point again is not quantitative, but qualitative. He’s talking about where to fish for ideas, not how successful this source was.

When I thought about this section, I realized the modern day equivalent was investment bloggers. There are many out there, and while some are utter shit (why does this guy keep kidding himself?) some are quite amazing as thinkers, business analysts and generators of potential ideas. I have too many personal examples of my own here to make mention of them all. But I really liked this idea, cultivating a list of outstanding investment bloggers and using that as your primary jumping off point for finding great companies. The only problem for me in this regard is most of my blogroll are “value guys” that are digging in the trash bins (as my old boss sarcastically put it), whereas to find a Fisher-style company I would need to find a different kind of blogger interested in different kind of companies. But that’s a great to-do item for me to work on in this regard and should prove to be highly educational to boot!

So, assuming you’ve got a top notch idea, what’s next? Fisher is pretty clear here: do not conduct an exhaustive study of the company in question just yet. (In other words, don’t do this just yet, though I loved SoH’s follow-up where he explained what kind of things would get him to do that.) What he does do is worth quoting at length:

glance over the balance sheet to determine the general nature of the capitalization and financial position […] I will read with care those parts covering breakdown of total sales by product lines, competition, degree of officer or other major ownership of common stock […] all earning statement figures throwing light on depreciation, profit margins, extent of research activity, and abnormal or non-recurring costs in prior years’ operations

Then, if you like what you see, conduct your scuttlebutt, because,

only by having what “scuttlebutt” can give you before you approach management, can you know what you should attempt to learn when you visit a company […] never visit the management of a company [you are] considering for investment until [you have] first gathered together at least 50 per cent of all knowledge [you] would need to make the investment

This is the part that really gives a lot of investors pause about Phil Fisher’s approach, including me. Can you really do scuttlebutt, as he envisions it, in the modern era? Can the average investor get the ear of management? Does any of this stuff still apply?

First, some skepticism. Buffett’s biographer Alice Schroeder has said in interviews that much of what made Buffett successful early on in his career is now illegal and would amount to insider trading. The famous conversation with the GEICO chief is one of many that come to mind. This was classic scuttlebutt, and it worked amazingly well for Buffett. And even if it wasn’t illegal, most individual investors are so insignificant to a company’s capital base that they can’t expect nor will they ever receive the ear of management (unless they specialize in microcap companies, but even then management may be disinterested in them, even with significant stakes in their company!) And, assuming they DO somehow get management’s ear, they aren’t liable to learn much of value or interest specifically because most managements today are not only intellectually and politically sophisticated, but legally sophisticated and they are well aware that if they say anything more general than “We feel positive about our company” they’re liable to exposure under Reg FD. This seems like a dead end.

But let me try to tease the idea out a little more optimistically. Managements do provide guidance and color commentary on quarterly earnings calls, and if you are already dealing with a trustworthy, capable management (according to the 15 points outlined below), then there is opportunity to read between the lines here, even while acknowledging that there are many other people doing the same with this info. And people who do get managements’ ear are professional analysts employed by major banks. Again, lots of people read these reports, but there is some info here and it adds color and sometimes offers some “between the lines” information some might miss. And while the information you can get from any one company may be limited, by performing this analysis on several related companies you might be able to fill in some gaps here and there to the point that you can get a pretty fair picture of how the target company stacks up in various ways.

I hesitate a little, but I think the approach can be simulated to a fair degree even today. It’s still hard work. It can’t be done completely, or perhaps as Fisher imagined it. But I think it can be done. And it still comes down to the fact that, even with all this info that is out there, few will actually get this up close and personal with it. So, call it an elbow-grease edge.

After all,

Is it either logical or reasonable that anyone could do this with an effort no harder than reading a few simply worded brokers’ free circulars in the comfort of an armchair one evening a week? […] great effort combined with ability and enriched by both judgment and vision [are the keys to unlocking these great investing opportunities] they cannot be found without hard work and they cannot be found every day.

The Fisher 15

Fisher also is known for his famous 15 item investment checklist, a checklist which at heart searches for the competitive advantage of the business in question as rooted in the capability of its management team to recognize markets, develop products and plans for exploiting them, execute a sales assault and finally keep everything bundled together along the way while being honest business partners to the minority investors in the company. Here was Fisher’s 15 point checklist for identifying companies that were highly likely to experience massive growth over decades:

  1. Does the company have sufficient market scale to grow sales for years?
  2. Is management determined to expand the market by developing new products and services to continue increasing sales?
  3. How effective is the firm’s R&D spending relative to its size?
  4. Is the sales organization above-average?
  5. Does the company have a strong profit margin?
  6. What is being done to maintain or improve margins? (special emphasis on probable future margins)
  7. What is the company’s relationship with employees?
  8. What is the company’s relationship with its executives?
  9. Is the management team experienced and talented?
  10. How strong is the company’s cost and accounting controls? (assume they’re okay unless you find evidence they are not)
  11. Are there industry specific indications that point to a competitive advantage?
  12. Is the company focused on short or long-term profits?
  13. Can the company grow with its own capital or will it have to continually increase leverage or dilute shareholders to do it?
  14. Does the management share info even when business is going poorly?
  15. Is the integrity of the management beyond reproach? (never seriously consider an investment where this is in question)

What I found interesting about these questions is they’re not just good as an investment checklist, but as an operational checklist for a corporate manager. If you can run down this list and find things to work on, you probably have defined your best business opportunities right there.

In the chapter “What to Buy: Applying This to Your Own Needs”, Fisher attempts to philosophically explore the value of the growth company approach. First, he tries to dispel the myth that this approach is only going to serve

an introverted, bookish individual with an accounting-type mind. This scholastic-like investment expert would sit all day in undisturbed isolation poring over vast quantities of balance sheets, corporate earning statements and trade statistics.

Now, this is ironic because this is actually exactly how Buffett is described, and describes himself. But Fisher insists it is not true because the person who is good at spotting growth stocks is not quantitatively-minded but qualitatively-minded; the quantitative person often walks into value traps which look good statistically but have a glaring flaw in the model, whereas it is the qualitative person who has enough creative thinking power to see the brilliant future for the company in question that will exist but does not quite yet, a future which they are able to see by assembling the known qualitative facts into a decisive narrative of unimpeded growth.

Once a person can spot growth opportunities, they quantitatively have to believe in the strategy because

the reason why growth stocks do so much better is that they seem to show gains in value in the hundreds of percent each decade. In contrast, it is an unusual bargain that is as much as 50 per cent undervalued. The cumulative effect of this simple arithmetic should be obvious.

And indeed, it is. While great growth stocks might be a rarer find, they return a lot more and over a longer period of time. To show equivalent returns, one would have to turnover many multiples of incredibly cheap bargain stocks. So this is the philosophical dilemma– fewer quality companies, fewer decisions, and less room for error in your decisions with greater return potential over time, or many bargains, many decisions, many opportunities to make mistakes but also less chance that any one is critical, with the concomitant result that your upside is limited so you must keep churning your portfolio to generate great long-term results.

Rather than being bookish and mathematically inclined (today we have spreadsheets for that stuff anyway), Fisher says that

the successful investor is usually an individual who is inherently interested in business problems. This results in his discussing such matters in a way that will arouse the interest of those from whom he is seeking data.

And this still jives with Buffett– it’s hard to imagine him boring his conversation partner.

Timing Is Everything?

So you’ve got a scoop on a hot stock, you run it through your checklist and you conduct thorough scuttlebutt-driven due diligence on it. When do you buy it, and why?

to produce close to the maximum profit […] some consideration must be given to timing

Oh no! “Timing”. So Fisher turns out to be a macro-driven market timer then, huh? “Blood in the streets”-panic kind of thing, right?

Wrong.

the economics which deal with forecasting business trends may be considered to be about as far along as was the science of chemistry during the days of alchemy in the Middle Ages.

So what kind of timing are we talking about then? To Fisher, the kind of timing that counts is individualistic, idiosyncratic and tied to what is being qualitatively derived from one’s scuttlebutt. Timing one’s purchases is not about market crashes in general, but in corporate missteps in particular. Fisher says:

the company into which the investor should be buying is the company which is doing things under the guidance of exceptionally able management. A few of these things are bound to fail. Others will from time to time produce unexpected troubles before they succeed. The investor should be thoroughly sure in his own mind that these troubles are temporary rather than permanent. Then if these troubles have produced a significant decline in the price of the affected stock and give promise of being solved in a matter of months rather than years, he will probably be on pretty safe ground in considering that this is a time when the stock may be bought.

He continues,

[the common denominator in several outstanding purchasing opportunities was that ] a worthwhile improvement in earnings is coming in the right sort of company, but that this particular increase in earnings has not yet produced an upward move in the price of that company’s shares

I think this example with Bank of America (which I could never replicate because I can’t see myself buying black boxes like this financial monstrosity) at Base Hit Investing is a really good practical example of the kind of individual company pessimism Phil Fisher would say you should try to bank on. (Duh duh chhhhh.)

He talks about macro-driven risk and says it should largely be ignored, with the caveat of the investor already having a substantial part of his total investment invested in years prior to some kind of obvious mania. He emphasizes,

He is making his bet upon something which he knows to be the case [a coming increase in earnings power for a specific company] rather than upon something about which he is largely guessing [the trend of the general economy]

and adds that if he makes a bad bet in terms of macro-dynamics, if he is right about the earnings picture it should give support to the stock price even in that environment.

He concludes,

the business cycle is but one of at least five powerful forces [along with] the trend of interest rates, the over-all government attitude toward investment and private enterprise [quoting this in January, 2017, one must wonder about the impact of Trump in terms of domestic regulation and taxation, and external trade affairs], the long-range trend to more and more inflation and — possibly most powerful of all — new inventions and techniques as they affect old industries.

Set all the crystal ball stuff aside– take meaningful action when you have meaningful information about specific companies.

Managing Risk

Fisher also gives some ideas about how to structure a portfolio of growth stocks to permit adequate diversification in light of the risk of making a mistake in one’s choices (“making at least an occasional investment mistake is inevitable even for the most skilled investor”). His example recommendation is:

  • 5 A-type, established, large, conservative growth companies (20% each) -or-
  • 10 B-type, medium, younger and more aggressive growth companies (10% each) -or-
  • 20 C-type, small, young and extremely aggressive/unproven growth companies (5% each)

But it is not enough to simply have a certain number of different kinds of stocks, which would be a purely quantitative approach along the lines of Ben Graham’s famous dictums about diversification. Instead, Fisher’s approach is again highly qualitative, that is, context dependent– choices you make about balancing your portfolio with one type of stock require complimentary additions of other kinds of stocks that he deems to offset the inherent risks of each. We can see how Buffett was inspired in the construction of his early Buffett Partnership portfolio weightings here.

For example, he suggests that one A-type at 20% might be balanced off with 2 B-type at 10% each, or 6 C-type at 5% each balanced off against 1 A-type and 1 B-type. He extends the qualitative diversification to industry types and product line overlaps– you haven’t achieved diversification with 5 A-types that are all in the chemical industry, nor would you achieve diversification by having some A, B and C-types who happen to have competing product lines in some market or industry. For the purposes of constructing a portfolio, part of your exposure should be considered unitary in that regard. Other important factors include things like the breadth and depth of a company’s management, exposure to cyclical industries, etc. One might also find that one significant A-type holding has such broadly diversified product lines on its own that it represents substantially greater diversification than the 20% portfolio weighting it might represent on paper. (With regards to indexation as a strategy, this is why many critics say buying the S&P 500 is enough without buying “international stock indexes” as well, because a large portion of S&P 500 earnings is derived from international operations.)

While he promotes a modicum of diversification, “concentration” is clearly the watchword Fisher leans toward:

the disadvantage of having eggs in so many baskets [is] that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them […] own not the most, but the best […] a little bit of a great many can never be more than a poor substitute for a few of the outstanding.

Tortured egg basket metaphors aside (why on earth do people care what their egg baskets look like?!), Fisher is saying that the first mistake one can make is to spread your bets so thin that they don’t matter and you can’t efficiently manage them even if they did.

Aside from portfolio construction, another source of risk is the commission of errors of judgment.

when a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favorable than originally believed

one should sell their holdings, lick their wounds and move on. This needs to be done as soon as the error is recognized, no matter what the price may be:

More money has probably been lost by investors holding a stock they really did not want until they could “at least come out even” than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.

Further,

Sales should always be made of the stock of a company which, because of changes resulting from the passage of time, no longer qualifies in regard to the fifteen points… to about the same degree it qualified at the time of purchase […] keep at all times in close contact with the affairs of companies whose shares are held.

One vogue amongst certain investors is to be continually churning the portfolio from old positions to the latest and greatest idea, with the assumption being that time has largely run its course on the earlier idea and the upside-basis of the new idea is so much larger that liquidity should be generated to get into the new one. Fisher advises only using new capital to pursue new ideas rather than giving in to this vanity because,

once a stock has been properly selected and has borne the test of time, it is only occasionally that there is any reason for selling it at all

The concept of “investment” implies committing one’s resources for long periods of time. You can’t emulate this kind of trading activity in the private market, which is a very strong indication that you should try to avoid this behavior in public markets. A particularly costly form of this error is introducing macro-market timing into one’s portfolio management, ie, this stock has had a big run up along with the rest of the market, things are getting heady, I will sell and get back in at a lower cost. I’ve done this myself, most recently with Nintendo ($NTDOY) and even earlier with Dreamworks ($DWA). Fisher says it’s a mistake:

postponing an attractive purchase because of fear of what the general market might do will, over the years, prove very costly […] if the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 per cent overpriced? That which really matters is not to disturb a position that is going to be worth a great deal more later.

It plays to a logical fallacy that a company that has run up has “expended” its price momentum, while a company that has not had a run-up has something “due” to it. On the contrary, Fisher points out that many times the material facts about a company’s future earnings prospects change significantly over time from the original purchase, often to the good, such that even with a big run-up, even more is in the offing because the future is even brighter than before– remember, always keep an eye on the future, not the present or the past!

And similarly, if one has an extremely cheap cost basis in a company, one has an enormous margin of safety that should give further heed to trying to jump in and out of the stock when it is deemed to be overvalued.

He adds that, like wines, well-selected portfolio holdings get better with age because,

an alert investor who has held a good stock for some time usually gets to know its less desirable as well as more desirable characteristics

and through this process comes to develop even more confidence in his holdings.

If you’ve read some of my thinking about the philosophy of building multi-generational wealth through a family business, you’ll see once again the direct parallel to private market investing in Fisher’s conclusion:

If the job has been correctly done when a common stock is purchased, the time to sell it is– almost never.

Conclusion

Distilling Part I down to its essence, I concluded that the most important skill for generating long-term gains from one’s investing is still about having a disciplined and consistent investment program followed without interruption and in the face of constantly nagging self-doubt (“In the stock market a good nervous system is even more important than a good head.”) The particular program that Fisher recommends be followed is to:

  1. Create a network of intelligent investors (bloggers) from which to source ideas
  2. Develop a strong scuttlebutt skill/network to develop superior investment background
  3. Check with management to confirm remaining questions generated from the 15 step list
  4. With the conviction to buy, persevere in holding over a long period of time

If you can’t do this, you probably shouldn’t bother with the Fisher approach. Whether it can be done at all is an entirely separate matter.

4/5

The Oath Of The Brand (#loyalty, #politics, #education, #children, #America)

Imagine for a moment that you work for a big company (maybe you do), and that at the start of every work day, you and the other people in your department gather around a large copy of the company logo, place your hand over your heart and recite the “Oath of the Brand” like so:

I give my oath

to this brand

the greatest company in all the land,

and to the management

much like it, grand;

one organization, one vision, never to be divested of its capital,

with jobs and security for all.

What might you think of this company, and its desire to instill its values via a hypnotic morning oath like this? Would you think this company would be populated by workers who can think for themselves and question the decisions of management when they’re called for? Would you think management expects to be challenged and “kept honest” by its workers? Does it seem odd that there is no mention of customers and the need to serve them faithfully? Would this company seem to operate a bit like a cult?

Of course by now you’ve realized that I have simply parodied the American “Pledge of Allegiance”, recited mindlessly by millions of school children in public institutions every single morning, and by millions of government functionaries and politicians at certain solemn occasions. Why do our public schools do this? Why can’t our political system earn its loyalty through efficiency, effectiveness and good works, rather than by neurolinguistically programming developing minds too immature to notice they’re being manipulated? And why do parents tolerate such madness?

In case you’ve been out of school for awhile, here is the actual Pledge of Allegiance:

I pledge allegiance,

to the flag

of the United States of America,

and to the Republic

for which it stands;

one nation, under god, indivisible,

with liberty and justice for all.

As defined by the pledge, liberty and justice are clearly codewords for the good feelings one gets from honoring one’s fealty to the flag. And the “Republic” is not the country, but a particular system of political management of the country– there are other possible ways to politically manage the country, but the Pledge doesn’t really permit such thinking, it demands obedience. I read something a few months ago wherein a Progressive author was lamenting the way “right wingers” were now referring to public schools as “government schools,” the concern being that a public school implies something verging on objectivity, while a government school is what one finds in other, more authoritarian regimes, where the curriculum is strongly centered around building loyalty to the party in power. But asking small children to recite a pledge to their political management seems like a good place to start a case for arguing that what we have in this country are, in fact, government schools.

This doesn’t work for me. I don’t want my children’s education to include inculcated obedience to the state– I want my children to be able to think for themselves on this one. So this is another reason I am not interested in putting my children in public schools.

The history of the Pledge of Allegiance is pretty interesting.

And for a snarky treatment of the subject, try this skit by the “Whitest Kids U Know”:

“This is not a form of brainwashing.”

More Thoughts On “Father, Son & Co.” (#business, #family)

These comments are from an email to a friend with regards to my recent review of Father, Son & Co.:

The book excited me at first because in the intro Jr says that if you have the opportunity to go into business with your father, you should do it. I figured the book would be filled with all the fulfilling things that he experienced as a result of that relationship.

Instead, it seemed to be chock full of warning signs! His father seemed to be interested in exposing him to the business at a young age. He took him on a cross country train ride for business around age 10 and introduced him to managers, sales people, toured plants, etc. Sr was thinking of him and the business from the start. But what Sr never seemed to figure out was how to actually transition his son into business and power.

Junior started out a salesman and did that for several years with small success after initial frustration. Eventually he was brought in as a manager, but there was no set plan for Senior to retire and hand over the reins. They also hadn’t worked out how a space for Juniors younger brother would be handled. It seemed like Senior was either enjoying the prestige too much, or had his ego too wrapped up the business, and was reluctant to give up power, even when it seemed clear his energy and mental faculties were failing.

Junior and Senior fought constantly, and violently. It’s likely a lot of the fights were due to this unresolved question of power sharing and succession. They had different ideas about how to grow the company, junior seeing value in computers and senior being skeptical of them. They always made up in the end but what a terrible toll to take on one another emotionally and physically!

Eventually junior asserted himself and got his dad to agree to give power to him. It was almost like he was waiting for him to man up and insist. One of the challenges of the transition was that there was a perception that senior had surrounded himself with loyal yes men. Junior ended up canning a lot of these people, and then canning other people he and his dad had both picked for different positions, until he had culled the management team down to just a group he had advanced himself. This is typical in business and represents a challenge especially for family succession. An ideal situation would see the aged old guard nearing retirement right around the same time as the younger new guard is ready to take over, that way there are no hurt feelings or dicey incentives from one regime to another.

So I think some takeaways were:
-talk early and often about strategic questions, especially succession timelines and process
-have an agreement to transition an entire management team, don’t expect the successor to play well with people he didn’t groom himself
-if there are other family members involves in the business, discuss roles and opportunities (based on merit) early and often and establish a clear hierarchy of who reports to who and why
-the son or family successor will never be comfortable and confident exercising power, and will never be taken completely seriously, until the previous family member officially and totally transitions out
-don’t let business issues poison personal family relationships, if you find yourselves fighting outside of work, seek counseling

Review – Good To Great (#business, #investing, #review)

Good To Great: Why some companies make the leap and others don’t

by Jim Collins, published 2001

The G2G Model

“Good To Great” seeks to answer the question, “Why do some good companies become great companies in terms of their market-beating stock performance, while competitors stagnate or decline?” After a deep dive into varied data sources with a team of tens of university researchers, Collins and his team arrived at an answer:

  1. Level 5 Leadership
  2. First Who… Then What
  3. Confront The Brutal Facts (Yet Never Lose Faith)
  4. The Hedgehog Concept (Simplicity Within The Three Circles)
  5. A Culture Of Discipline
  6. Technology Accelerators

The first two items capture the importance of “disciplined people”, the second two items refer to “disciplined thought” and the final pair embodies “disciplined action”. The concepts are further categorized, with the first three components representing the “build up”, the ducks that must be gotten into a row before the second category holding the last three components, “breakthrough”, can take place. The entire package is wrapped up in the physical metaphor of the “flywheel”, something an organization pushes on and pushes on until suddenly it rolls forward and gains momentum on its own.

This book found its way onto my radar several times so I finally decided to read it. I’d heard it mentioned as a good business book in many places but first took the idea of reading it seriously when I saw Geoff Gannon mention it as part of an essential “Value Investing 101” reading list. I didn’t actually follow through on the initial impulse until I took a “leadership science” course recently in which this book was emphasized as worth covering.

I found G2G to be almost exactly what I expected– a rather breathless, New Age-y, pseudo-philosophical and kinda-scientific handbook to basic principles of organizational management and business success.  The recommendations contained within range from the seemingly reasonable to the somewhat suspect and the author and his research team take great pains to make the case that they have built their findings on an empirical foundation but I found the “We had no theories or preconceived notions, we just looked at what the numbers said” reasoning scary. This is actually the opposite of science, you’re supposed to have some theories and then look at whether the data confirms or denies them. Data by itself can’t tell you anything and deriving theory from data patterns is the essence of fallacious pattern-fitting.

Those caveats out of the way, the book is still hard to argue with. Why would an egotistical maniac for a leader be a good thing in anything but a tyrannical political regime, for example? How would having “the wrong people on the bus” be a benefit to an organization? What would be the value in having an undisciplined culture of people who refuse to see reality for what it is?

What I found most interesting about the book is the way in which all the principles laid out essentially tend to work toward the common goal of creating a controlled decision-making structure for a business organization to protect it from the undue influence of big egos and wandering identities alike. In other words, the principles primarily address the psychological risks of business organizations connected to cult-like dependency on great leaders, tendency toward self-delusional thinking and the urge to try everything or take the easy way out rather than focus on obvious strengths. This approach has many corollaries to the value investing framework of Benjamin Graham who ultimately saw investor psychology as the biggest obstacle to investor performance.

I don’t have the time or interest to confirm this hypothesis but I did wonder how many of the market-beating performances cataloged were due primarily to financial leverage used by the organization in question, above and beyond the positive effects of their organizational structure.

A science is possible in all realms of human inquiry into the state of nature. Man and his business organizations are a part of nature and thus they fall under the rubric of potential scientific inquiry. I don’t think we’re there yet with most of what passes for business “research” and management or organizational science, but here and there the truth peeks out. “Good To Great” probably offers some clues but it’s hard to know precisely what is the wheat and what is the chaff here. Clearly if you inverted all of the recommendations of the book and tried to operate a business that way you’d meet your demise rather quickly, but that is not the same thing as saying that the recommendations as stated will lead in the other direction to greatness, or that they necessarily explain the above-average market return of these public companies.

I took a lot of notes in the margin and highlighted things that “sounded good” to me but on revisiting them I am not sure how many are as truly useful as they first seemed when I read them. I think the biggest takeaway I had from the book was the importance of questioning everything, not only as a philosophical notion but also as a practical business tool for identifying problems AND solutions.

3/5

The Free Capital Blog Digest (@guy_thomas, #valueinvesting)

The following is a digest of posts from Guy Thomas’s Free Capital blog from Feb 2011 through Jan 2012.  Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

How important is analytical intelligence in investing?

  • Equity trading is not as reliant on raw mental strength (IQ, analytical ability) as fixed-income trading; instead, equity trading is more dependent upon mental characteristics such as:
    • Actively seeking information from dis-confirming sources
    • Adjusting for one’s biases
    • Accepting uncertainty for long periods
    • Deferring decisions for as long as possible
    • Calibrating your certainty to the weight of evidence
    • Responding unemotionally to new information
    • Indifference to group affiliation
  • The mental characteristics which are helpful in investing are not universal positives and may be useless or negative characteristics in other endeavors

Max, min and average payoffs

  • Most activities can be categorized as max payoff, min payoff or average payoff
  • Max payoff means the activity is “positive scoring”, your payoff is your highest or best result and failure carries no lasting consequences
  • Optimal traits for max payoff are:
    • high energy
    • irrational optimism
    • persistence
  • Examples of max payoff activities include:
    • selling
    • leadership
    • most sports
  • Min payoff means the activity is negative scoring, your payoff is your lowest result and even a single failure may have lasting consequences
  • Optimal traits for min payoff are:
    • meticulous care
    • good judgment
    • respecting your limitations
  • Examples of min payoff activities include:
    • flying a plane
    • driving a car
    • performing brain surgery
  • Average payoff activities combine elements of both max and min; investing is an average payoff activity, with particular emphasis on the min aspects
  • A lot of success in investing comes from simply avoiding mistakes (min payoff)

Discussion of diversification (posts 1, 2, 3 & 4)

  • Diamonds and flower bulbs
    • Diamonds are companies with exceptional economics and long-term competitive advantages that you’d be happy to hold if the stock exchange closed tomorrow for the next five years
    • Flower bulbs are companies which are cheap at the moment but which have no exceptional business qualities (they often make a good quantitative showing but not a strong qualitative one); they can usually be counted on to bloom but should be bought in modest size because they require liquidity to get back out of the position and realize the value
    • Which should you buy? Diamonds are exceptionally rare and require outstanding foresight of long-term durability; flower bulbs are more common, simpler to spot and merely require patience and a strong stomach
    • “Investing is a field where knowing your limitations is more important than stretching to surpass them”
  • How many shares should an investor hold? Some theory…
    • The optimal number of stocks to hold, N, is a function of…
      • quality of knowledge about return dispersions (decreasing)
      • $ size of portfolio (increasing)
      • volatility of shares (increasing)
      • capital gains tax rate (decreasing)
    • Exceptional investors with exceptional quality of knowledge should hold a concentrated portfolio; Buffett from 1977-2000 appears to have held approx. 1/3 of his portfolio in his best idea and changed it annually
    • With a small portfolio, liquidity is not a concern but as your portfolio scales a large number of holdings becomes optimal to maintain your liquidity which enhances your optionality by giving you the opportunity to change your mind without being trapped in a position
    • If the companies you target have highly volatile share prices, it becomes attractive to switch frequently so that you can “buy low and sell high”, thus you want to restrict your position sizing (higher number of positions) and maintain liquidity
    • If the capital gains rate is high you are penalized for turnover so you want to keep your total number of positions low and hold them for longer
  • How many shares should an investor hold? Some practicalities
    • There is clearly a trade-off between the number of positions you have and your quality of knowledge
    • A portfolio which is higher in diversification may hold many lower quality businesses (flower bulbs) but the certainty of the analysis of each might be significantly higher than a concentrated portfolio of several high quality businesses (diamonds) whose analysis is extremely sensitive to long-term forecasting accuracy
  • Concentrated investors often “come a cropper”
    • Many investors eventually disappoint because they have concentrated their bets on companies the world turns against
    • This has happened even to great investors like Warren Buffett (ex., WaPo, which now looks like a horse-and-buggy investment)
    • The danger of concentration is that nothing grows forever, and concentration + illiquidity often make it hard to escape mistakes

Meeting management

  • Opportunity cost of time: is it better spent speaking to management or investigating other ideas?
  • Getting an edge: sometimes speaking with management helps to understand the picture in a way that gives you an edge
  • Buffett: if you need to talk to management, you shouldn’t own the stock
  • Don’t be schmoozed

Analytics versus heuristics; why I don’t use DCF models

  • Time is precious and DCF models take too long
  • A good buying opportunity shouts at you from the market; if you need a calculator, let alone a spreadsheet, it’s probably too close
  • Robustness is more important than refinement; it’s easy to find apparent discrepancies in valuation, but most are false– it’s more important to seek out independent insights which confirm or deny the discrepancy than to calculate its size; when info quality is good, focus on quantifying and ranking options, but when it is poor, focus on raising it
  • Non-financial heuristics are often quicker and sufficiently accurate to lead to correct decisions; you may make more errors than the rigorous analyst but you can work much faster and evaluate many more opportunities which is usually a good trade-off

Recession Risk, The Ultimate Risk Paradigm Of Modern Business Operations (#business, #risk, #recession, #management)

The business cycle rotates periodically between boom and bust. This is one of the inevitable consequences of centrally planning the economy’s interest rates and forcing them below their market equilibrium levels. Because it is inevitable, it is “predictable” and thus every business person must conduct their affairs in light of the fact that at some point in the future they will be faced with a recession. The key measure of risk for a business person operating in a central bank-managed economy, then, is “How will I feel when the recession comes?”

If a recession poses no risk to the financial structure of his holdings and he is positioned in his operations to weather a storm, he may be termed “low risk.” If instead a recession represents an existential threat and/or the potential for severe hardship for his operations, he may be termed “high risk.”

As an ideal, a sufficiently low risk operator should eagerly anticipate a recession as it will represent a cheap buying opportunity during which he will consolidate the failing enterprises of his competitors, scooping up their assets at bargain prices and thereby leap ahead of them without the use of leverage or cheap competitive tactics. Conversely, a sufficiently high risk operator will find the economic Sword of Damocles plunging through his neck in a recession, permanently severing the connection between himself and his former assets. How then to manage financial and operational risk so that continued growth can occur in a manner that is sustainable in all possible economic environments?

In terms of financial risk, we could sort our assets in two ways, by asset quality and by financing quality. The asset with the highest asset quality is the one which has the largest earnings yield relative to its current value. The asset with the highest financing quality is the one which is cheapest to own (ie, annual interest cost).

Practically speaking, sorting assets by asset quality and financing quality and then selling low quality assets and paying down outstanding debt would move an organization toward a more favorable balance between asset quality and finance quality, with an emphasis on equity in the balance sheet. The capital that is freed up in the process is now available to purchase a higher quality asset in the future.

In a recession, the cash flows from low quality assets dwindle while the finance charges on debt remain fixed; not only does such a mixture create a problem in a recession but it falsifies the true “free cash” position of the company in a boom because, to operate prudently, extra cash must be maintained on the balance sheet to offset the risk this low quality asset and debt represent should a recession appear.

The insistence on focusing on the management of financial risk first offers us clues as to a sound growth strategy overall. To be successful and sustainable through all potential economic conditions, growth must be purposeful and planned and should only occur when three conditions are met: there is abundant free cash on the balance sheet, the organization has people “on the bench” and ready for new opportunities and a good buying opportunity (represented by a fair or discount to fair value price) presents itself.

A debt-laden balance sheet is not cash rich because the cash which may be present is actually encumbered by the debt as an offset in a recessionary environment. When we are talking about a cash rich balance sheet, we’re by implication talking about an unlevered balance sheet. Otherwise, the cash is not “free” but rather is “phantom” cash– it will disappear the moment adverse economic conditions present themselves.

The organizational bench condition may be harder to evaluate objectively, but there is a decent rule of thumb. When people in each position in the organization are sufficiently organized to handle their own responsibilities with time to spare, there is organizational bandwidth to spend on promotions and new responsibilities, such as management of newly acquired assets. In contrast, when people in relatively higher positions within the organizational hierarchy are spending their time doing the work of people relatively lower in the organizational hierarchy, it indicates that there is a shortage of quality personnel to fill all positions and that those personnel available are necessarily being “mismanaged” with regards to how they are spending their time as a result.

Further, it implies the risk that growth in such a state might further dilute and weaken the culture and management control of both legacy assets and those newly acquired. This is a risky situation in which every incremental growth opportunity ends up weakening the organization as a whole and creating hardships to come in the next recession. If it’s hard to find good people, inside the organization or without, and there is a general attitude of complacency about what could go wrong in a recession, it is a strong indicator that underperforming assets should be sold and the balance sheet delevered to reduce organizational risk in the event of a recession.

Growth should be fun, exciting and profitable. If it’s creating headaches operationally, or nightmares financially, it should be avoided. You shouldn’t own or acquire assets you don’t love owning. Perhaps the best rule of thumb overall is to ask oneself, “Does owning this asset bring us joy?” If yes, look for opportunities to buy more. If no, sell, sell, sell!

Ultimately, there are three ways to get rich: randomly, with dumb luck and unpredictable market euphoria for the product or service offered (billion-dollar tech startups); quickly, with a lot of leverage, a lot of luck in terms of market cycles and a lot of risk that you could lose it all with poor timing (private equity roll-up); and slowly, with a lot of cash, a lot of patience and a lot less risk while taking advantage of the misery of others during inevitable downward cycles in the economy.

If you were fearful in the last economic cycle, it suggests your financial and organizational structures were not as conservative as you might have believed. It may be an ideal, but it’s one worth reaching for: a recession represents a golden buying opportunity for a cash rich organization to leap ahead of the competition and continue its story of sustainable growth and success.

Notes – Sam Walton’s “Made in America” (#business, @WalMart)

These are notes I used for a talk I gave on Sam Walton’s business principles as evidenced in his book Made in America:

  1. “COMMIT to your business. Believe in it more than anybody else.” If you love your work, other people will sense that, including co-workers and customers, and catch the passion from you, like a fever.
  2. PARTNERSHIP. Take MENTAL OWNERSHIP of your business, and treat the people around you at work as valued partners in your enterprise. Seek input from others, work together to achieve common goals and make decisions that you’d be happy with over the long-term, which will help you accrue the benefits over time.
  3. MOTIVATE your partners. Find different ways to keep score and new ways to challenge each other to new personal best records. Encourage your partners to ever greater heights and they will do the same for you.
  4. COMMUNICATE openly. Share information with your partners about your business and ask for information about theirs. The more everyone knows, the more able they are to act to the benefit of the entire company.
  5. APPRECIATE everything your partners do. Sharing praise and congratulations costs us nothing, but it is worth a lot to the people who receive it and will make you feel better for having shared it, too.
  6. CELEBRATE successes and don’t take yourself too seriously. Find what is funny about your failures. Have fun. At the end of the day, it’s only work and you’re only human. Such enthusiasm and energy is engaging to all.
  7. LISTEN to everyone in your company. Everyone has a different and potentially valuable perspective, from managers to cashiers, sales people to valets. Everyone sees a different part of the business and a different side of the customer experience. By getting the people you work with talking you might learn valuable information about how you could improve your customer service and meet the needs of more customers to hit more of your goals and make more money in the process.
  8. EXCEED your customer’s expectations, this is what will bring them back again and again. Have a personal standard, explain it to your customers and apologize and make it right if you ever fail to live up to it. Think about how you’d handle situations that arise if your personal motto was “Satisfaction Guaranteed.” You don’t have to do anything wild, you just have to do a little bit more than your customers were expecting.
  9. CONTROL your processes to avoid costly mistakes. Even if you do not carry a personal Profit and Loss statement with cash expenses, you can still reduce your profitability by making choices that are inconsistent with your goals and less efficient than following a consistent, well thought out process. Create a discipline that accrues every small advantage in your favor and avoids needless leaks that cost you deals and gross. These little errors can add up to thousands of dollars and hundreds of potential customer relationships missed over time!
  10. SWIM UPSTREAM. Sometimes you’ve got to go the other way to find your niche. Be ready to see people waving you down, telling you you’re going the wrong way. But realize finding what makes you unique and sticking to it is what gives you your edge, and gets others to follow you, whether they’re customers, co-workers or your family and friends.
Quote: “My life has been a tradeoff. If I wanted to reach the goals I set for myself, I had to get at it and stay at it every day. I had to think about it all the time. I had to get up every day with my mind set on improving something. I was driven by a desire to always be on the top of the heap. But in the larger sense, did I make the right choices? I can honestly say that if I had the choices to make all over again, I would make just about the same ones.”

Notes – The Physics & Chemistry of Leadership (#leadership, #business)

Notes from a leadership talk given in 2013

  1. The Business Physics Law of Ownership: “the responsibility for the performance, productivity, morale and attitude of the employees rests with the leader”
  2. Four-House Management: “maintaining balance among all 4 houses is critical”
    1. growth
    2. control
    3. process
    4. culture; drives all the other houses
    5. Kotter-Heskett Question: adaptive cultures have higher productivity per employee and thus higher net profit
    6. Zappos Company Culture Handbook, available on website
    7. Steam Employee Handbook
    8. Lou Gerstner
  3. The Law of the Poker Chips: “never confuse activity with results”
    1. focus on blue chip items rather than white chip items (easily identified/quantified items that can be checked off)
    2. identify your REAL priorities; plan and organize EVERYTHING around these priorities
    3. attention is all there is
    4. Annie Maddox:
      1. the ability to concentrate
      2. the ability to operate w/ consistent self-discipline
      3. the ability to turn abstract objectives into concrete goals and achieve them
      4. the ability to build a cohesive, focused team around those objectives
  4. The Law of F & V: “my willingness to adapt will determine my performance potential”
    1. performance potential is a function of
      1. versatility
      2. flexibility
  5. Social Learning Theory: “self-management must precede people management because most organizational behaviors are learned through observation and modeling:”
    1. credibility killers
      1. unenforced policies or operational procedures
      2. failure to resolve weak performance or work execution issues, especially when they impact other employees
      3. failure to resolve employees toxic behavior issues
      4. apparent lack of responsiveness to correctable process problems
      5. emotionally immature behavior among leaders
    2. if you can simply manage your conversation, almost everything else in life will fall into place ~ Mike Corbit
    3. you don’t have to be a perfect leader but you do have to improve, if people see you making progress this gives you leverage
    4. Dr. Albert Bandura
  6. Propulsion Theory: “energy comes from purpose”
    1. emotional intelligence
      1. self-awareness
      2. self-control
      3. self-motivation
      4. empathy for others
      5. ability to influence others
    2. what do employees care about?
      1. treatment
      2. communication
      3. meaningfulness
    3. what is motivation?
      1. the internal force that prompts to action
  7. The Chemistry Law: “human behavior is based primarily on chemistry and emotion, not logic”
    1. “stress makes people stupid.”
    2. nothing grows in nature without stress
    3. growth only occurs with the carefully managed application of appropriate levels of stress
    4. the discovery principle: positive discovery triggers the release of chemicals whose net result is the feeling of physiological betterment
  8. The Law of Engagement: “increasing our level of engagement will increase their level of engagement”
    1. total, active involvement
    2. emotional connection
    3. full participation
    4. complete interlocking for the purpose of transferring power
  9. The Algebra Teacher: “leadership success depends on desire, willingness and ability to influence, teach and develop people”
  10. Pygmalion Management: “the leader knows that how they think about employees affects their performance because people will rise or fall to the level of our expectations”
  11. The Power of Electricity: “increased productivity is a result of increased self-esteem, which is a result of ongoing, learned and personal achievement”
    1. A leader is a dealer in hope. ~Bonaparte
  12. The Power of Self-Discovery: “questions are more powerful than answers”
    1. we want to ask enough well thought-out questions to lead to either self-discovery and progress on the employees’ part or useful understanding on our part
    2. “if it was your ship, what would you do?”
  13. The Law of the Cheetah: “productivity improves as communication improves because perception drives behavior”
    1. it is the responsibility of the manager assigning the task to ensure that the request was received, understood and executed
  14. Inertia and Entropy: “never ignore unsatisfactory behavior or performance”
    1. an object at rest tends to stay at rest, in motion stays in motion, unless acted upon by an outside force
    2. the natural progression of everything in the universe is from order to chaos
  15. Curing Frustration: “the primary difference between great managers and average managers is often their willingness and ability to take action”
    1. “action cures frustration”
    2. 6 basic functions of a supervisor
      1. hire carefully, and hire character first
      2. train, teach, instruct and develop
      3. monitor and evaluate progress
      4. provide feedback, adjustment and input for correction and improvement
      5. keep people focused
      6. create and maintain an environment that is inspiring and energizing
    3. EPT training
      1. you watch me
      2. we do it together
      3. im going to watch you
      4. we review it
      5. i watch you teach
      6. you take ownership
  16. The Power of Niagara Falls: “part of leadership is being aware of theater, which creates energy”

Review – Repeatability (#strategy, #business, @HarvardBiz)

Repeatability: Build Enduring Businesses for a World of Constant Change

by Chris Zook, James Allen, published 2012

What’s this book about?

I finished reading this book over three weeks ago. Since then, I have struggled to get myself to sit down and write a review. The primary reason I’ve struggled is because I am not sure I can say with confidence what this book is about, or to which genre it belongs. Is it about strategy? Business management? Business planning? Organizational theory? Something else?

“Repeatability” chants about simplicity, but it’s full of so many buzzwords, different-but-related ideas and proprietary-sounding business catchphrases that it’s hard at times to keep up. And perhaps I’ve dropped into the late middle of an earlier conversation, as the book references a “focus-expand-redefine” growth cycle elaborated upon in three earlier works known as “the trilogy”.

A more charitable explanation of my confusion might place the blame with the authors themselves. Take the way in which they describe the main shifts in strategy they say they are witnessing, which led them to write the book:

  1. less about a detailed plan and more about general direction and critical initiatives
  2. less about anticipating how change will occur, more about having rapid testing and learning processes to accelerate adaptation to change
  3. effective strategy increasingly indistinguishable from effective organization

The central insight from their research, the authors claim, is that,

complexity has become the silent killer of growth strategies

Why? The authors don’t take pains to explain or justify the assumption that the world is more complex and that “traditional” strategic notions no longer work in this new world order. They just accept it as common wisdom and run with solutions for responding to it.

Building “Great Repeatable Models”

The next several chapters detail what Zook and Allen call “Great Repeatable Models”, which are businesses defined by the following three principles:

  1. a strong, well-differentiated core
  2. clear nonnegotiables
  3. systems for closed-loop learning

According to the authors, GRMs (germs?) were

sharply, almost obviously, differentiated relative to competitors along a dimension that also allowed for differential profitability

which I think is another way of saying they have a lucrative competitive advantage.

Similarly, the authors suggest that nonnegotiables are a company’s

core values and the key criteria used to make trade-offs in decision making

while systems for closed-loop learning enabled GRMs to

drive continuous improvement across the business, leveraging transparency and consistency of their repeatable model

which I understood to mean that the businesses had a culture and process for improving their practices over time.

The Cult of the CEO

Chapter 5 of “Repeatability” seeks to demonstrate how the CEO is the guardian of the three principles of GRMs. While it clearly makes sense that the CEO, as the chief strategiest and top of the organizational pyramid would have a role in implementing and enforcing a GRM, the authors offer little here to help other than numerous examples of success and failure in following the three principles followed by a hopeful conclusion that the “right leadership” will be in place to manage the delicate balancing act they specify as ideal. It seems to place the book in the Cult of the CEO genre (idealizing the role and superhuman nature of corporate chief executives) while simultaneously causing much of their writing up to that point to seem extemporaneous.

It’s almost as if the presence of the “right leadership” implies the presence of a GRM, and the absence of a GRM implies the absence of the “right leadership.” The book suffers from hindsight bias and tautological reasoning like this in numerous areas.

My own simple interpretation

The central tenets of this book are confusing, poorly defined and at times self-contradictory. Its research methodology (inductive empirical study to explain complex social phenomena) is frowned on by this Austrian economist. Ironically, it is the occasional element touched upon at the periphery of the book’s argument, rather than its core, where the authors manage to share something meaningful to solving the dilemmas of business people.

Unfortunately, the encouragement to keep the distance between the CEO and the customer minimal and to articulate a simple vision that even lower-level employees can grasp and rally behind, for example, is rather intuitive and obvious. Why would adding layers of bureaucracy and arbitrary decision-making, or creating a business plan so elaborate your employees don’t understand it, ever be a sound practice?

There’s a lot here including many case studies and other reference materials, but not all of it is useful or makes sense when viewed through the prism of the Great Repeatable Model. For some the digging required to find the occasional nugget of wisdom may be worth it but I can’t recommend such exertion for everybody.

2/5

The Long War: Changing Ownership, Management Incentives & Reporting Practices

Ian Cassel, founder of MicroCapClub.com, made a comment on Twitter today which grabbed my attention:

If a company is over $25m market cap they should have to have earnings conference calls w/ Q/A. Coalition Against Private Public Companies.

Shortly thereafter, he was asked by Jeff Moore of the Ragnar Is A Pirate blog:

How about if they have more than 100 shareholders?

To which Ian replied:

yes another good idea

At this point, I asked:

so you guys are for imprisoning and fining people because they won’t give you info you want?

Ian considered it and responded:

do I think every public company should, Yes. Force probably not, but cld be part of a tiered listing standard

I think this whole idea is worth a comment so I’m now going to give it one.

The first angle with which to approach Ian’s compulsory conference call proposal is the moral one and concerns the question, “Should managers of public companies, whatever their size, be compelled by force of law (ie, threat of fines or imprisonment for non-compliance) to provide the investing public conference calls regarding their earnings releases?”

The answer to such a question would hinge on whether or not, by refusing to hold such calls, these managers were committing an act of violent aggression against the investing public, such as theft, assault or fraud. If refusing to hold an earnings call is an act of theft, assault or fraud, clearly there is justification for compelling such behavior in order to remedy this affront to the rights of the individual members of the public and the answer would be “Yes”; similarly, if refusing to hold an earnings call does not represent the initiation of the use of force against members of the public, the answer to this question is clearly “No”.

I don’t want to waste anyone’s time going into a lengthy exploration of the facts on hand. I think it’s obvious that refusing to hold an earnings call is not an act of aggressive force and I don’t think Ian provided or attempted to provide any evidence that it was. In fact, he suggested this was not an issue to be handled by the law at all. I elaborated as much as I did, anyway, because there may be people reading this who did not understand the issue in this way and may have been confused prior to reading it. For their benefit, I state plainly now, the answer to the question is “NO”.

The second angle of approach is institutional. As Ian suggested in his final comment, the solution to this perceived problem could be handled at an institutional level (in this case, the voluntarily adopted rules and internal regulations of the listing exchanges) by adopting Ian’s preference for mandatory earnings calls at a certain market cap threshold as an observed “best practice” or condition of doing business on the exchange. If a company doesn’t want to follow it, they have the option of not being listed on the exchange observing such a rule. From a moral standpoint, there is no issue as there is no coercion, and compared to the alternative of creating a top-down, one-size-fits-all-companies-and-exchanges external regulation backed by force of law by government, this solution is indeed preferable because it at least allows for the possibility that some companies would not follow this practice and would find other avenues for listing their shares and allowing for equity exchange.

This leads to the third angle which, for lack of a better term, I’ll simply refer to as the “practical” considerations, of which there are several. For starters, I wonder if this is really an issue? In Ian Cassel’s (and Jeff Moore’s, perhaps?) world, it certainly seems to be. Ian Cassel’s world would be a happier place if all the public companies whose market caps were $25M or greater provided the public (of which he is a member and would stand to benefit) an earnings call upon release of each earnings statement. But embedded in such a proposal seems to be the belief that the world should reflect Ian Cassel’s preferences, and everyone else should bear the cost and expense of preparing and providing this information to Ian Cassel (and others of like mind).

Is this reasonable? If having better earnings communications from small companies is important to Ian, and if dialoging with management is a valuable commodity, Ian already has a course of action available to him to pursue such goals: he can make his own independent effort to email, write, call or visit in person the management of these companies and create a relationship whereby they would provide him answers to some of the questions he has in mind; or, he could acquire a sufficient number of shares of the company such that he is the owner of the company and the management is now fully responsible to him and he can have any and all information about the company that he pleases.

Neither of these actions require anyone being compelled to change their current practices. Both require nothing more than the expenditure of Ian’s own effort, time and wealth. If certain companies prefer not to establish such relationships or provide such information to people like Ian, Ian always has the option of walking away from them. And if he doesn’t have the financial resources to acquire such an ownership stake so as to make them more responsive to his inquiries, that would be a problem for him to solve by finding ways to produce more wealth for himself he could exchange with others for the privilege – it is not the responsibility of the company, its shareholders or anyone else.

Another practical consideration is the arbitrariness of the threshold for compliance. There’s nothing magic about a $25M market cap (nor a 100+ member shareholder base). The first number seems to be an attempt at defining “resourcefulness”, implying that a company with a certain sized market cap “should be able to afford” such accommodations. But market caps are not determined by managements and company resources, they are determined by the passions and dispositions of the investing public. It’s entirely conceivable that a company of truly inadequate resources (say, a book value of $50,000, just to harshly illustrate the point) could be bid up to a market cap of $25M in some bizarre turn of events. The fact that it has been so valued doesn’t make it more able to provide additional clarity about its business– and even if it did, it still doesn’t have an obligation to provide anyone anything like this. The shareholder base threshold is simple populism and the democratic principle– 99 of the shareholders could own one share at a penny a piece, with the remaining shareholder holding substantial control of the rest of the shares, making them truly insignificant in the ownership structure. But by creating arbitrary rules like this these individuals would create for the company sudden obligations simply by their existence.

Another practical concern is why a person, operating in the microcap space where an edge is often gained specifically because of the lack of consistent, clear information about these companies, would want to see measures taken which would serve to increase the “efficiency” of the market and thereby eliminate a lot of these mispricings and the opportunity to cheaply invest along with them. Sure, once you’ve put your money in you might have a self-interested reason to see everyone else suddenly figure out what a great company you’ve invested in because they have these wonderfully translucent earnings calls, but before that point you’d want to see opacity. Such a rule (compulsory earnings calls) would work to eliminate those opportunities before one could make their initial investment, not just after. As microcap investors, what we’re getting “paid to do”, essentially, is to find these opaque opportunities, get in there, agitate for change company-by-company and work to clear the dirt and smudges off the glass, so to speak. We want that to happen AFTER we get involved and BECAUSE we got involved, not before and regardless.

My final issue is with the cutely-named imaginary organization “Coalition Against Private Public Companies”. The implication is that public companies run like private companies constitute some kind of social ill. But if we look at the facts, it is often the owner-operator/private companies of the world which are most efficiently managed and whose business is best looked after compared to the alternative of entrenched, professional managers and disconnected, alienated and disinterested public shareholders (see this outstanding research piece by Murray Stahl [PDF] for a convincing argument, for instance). Indeed, it is often the public companies which are most dysfunctional– how is it preferable to have a management team obsessed with short-term earnings results, attempts to influence and gain the approval of Wall Street analysts, etc.? It’s perhaps syntactically confusing but what is really worth rebelling against is public private companies, not private public companies.

A public private is a company that SHOULD be private, but is in fact publicly traded and as a result the minority partners in the business, that is, the various outsider shareholders from the investing public, are treated like nuisances or smurfs whose capital is to be dissipated at the insider owners’ discretion. Such managers have no incentive to responsibly steward the outside shareholders’ capital because it doesn’t belong to the insiders and the outsiders are, in most cases, afforded an ambiguous and difficult, if not impossible, legal process to attempt to assert their equal status as capital owners. The most benefit they can receive from the capital is to issue some of it to themselves as generous salary or bonus payments, to use it as a tool for conducting ego-gratifying acquisition strategies or by sitting on it as a kind of future retirement/pension package to ensure they can care for themselves even in old age by remitting it to themselves as needed.

A private public company, on the other hand, is a company whose capital ownership is diversified and constituted by numerous members of the investing public, but which is managed and operated with the efficiency, passion, dedication and noble conservatism such as one would expect from a competent family dynasty or other limited, owner-operator control group or person. This is a company that treats capital as a precious commodity and always seeks to maximize the returns on its use which all members of the investing public so involved stand to benefit because they are treated as equals even though they have minority status. The fact that this company is publicly traded does not influence the decisions of the management and serves only to benefit all shareholders in the instances in which the management can buy back undervalued shares or issue significantly overvalued shares to raise cheap capital.

Truly, there are very few enterprises on all of planet earth that really provide their owners (shareholders) with outstanding additional benefits by virtue of their being publicly owned and exchanged. The more I think about the issue, the more I wonder why most public companies are public in the first place. Almost every IPO seems to represent an opportunity to cash in on delusional hopes and ignorant dreams rather than a genuine opportunity to “share the wealth” in exchange for some long-term capital necessary to fund profitable growth.

If I were to join a group agitating for change, I’d like to imagine it’d be called the “Coalition To Privatize Public Companies.” But honestly, I have no use for imagination, nor for agitation. I don’t seek to have others bear my cross, even as a joke or a day-dream. No, this is in fact a principle (one of several) of my efforts as a private, individual investor in the public market place and I intend to pursue it throughout my career.

It’s part of my long war.