Tag Archives: Investing

The Rebel Allocator by Jacob Taylor

Summary

  1. Through Socratic dialogue and real-world life lessons, a successful businessman (Mr. X) shares his wisdom and learnings with a skeptical young student, Nick. 

Key Takeaways

  1. Strategy ROIC > project ROIC
    1. Longer term, more fluid and dynamic
  2. Capital allocation is the study of opportunity cost. This skill is extremely important as it helps usher in resources to the highest return areas. This will not and cannot solve all problems, but if structured and incentivized correctly, can alleviate many ills

What I got out of it

  1. Really fun fiction book that gets across many important capital allocation, business, and financial ideas across in a narrative format. This short summary does not do the book justice – what took several books to convey many financial / capital allocation topics in a dry fashion, this book was able to do in a fun, narrative manner. This could and maybe should be the entry point into the world of finance and capital allocation

On Investing by John Neff

Summary

  1. John Neff, former fund manager of Windsor, recounts his history and lessons learned running one of the best performing funds of his era.

Key Takeaways

  1. Contrarian that I am, the format for this book is intentionally unorthodox as books on investing go these days. It is not about Hail Mary passes; it’s about grinding out gains quarter after quarter, year after year. My kind of investing rests on three elements: character, goals, and experience. With patience, luck, and sound judgment, meanwhile, you keep moving forward. That’s the nature of the investment game: now and then a windfall, but mostly a four-yard gain and a cloud of dust. tilt investment style can give investors a lucrative edge over the long haul. But if you can’t roll with the hits, or you’re in too big a hurry, you might as well keep your money in a mattress.
  2. Windsor’s roller coaster experience with Citi underscored a crucial point: investment success does not require glamour stocks or bull markets. Judgment and fortitude were our prerequisites. Judgment singles out opportunities, fortitude enables you to live with them while the rest of the world scrambles in another direction. Citi exemplified this investment
  3. Shortcuts usually grease the rails to disappointing outcomes.
  4. One time, we delivered a compressor to Tecumseh Products in Tecumseh, Michigan. We got top dollar because they needed it right away.Working for my father at least taught me that you don’t need glamour to make a buck. Indeed, if you can find a dull business that makes money, it is less likely to attract competition.
  5. The Navy paid us every two weeks, and the first night after payday six or seven poker games sprang up. By the following night, there were only one or two poker games. Much like money in the stock market, poker money migrated to the most proficient and well financed players, a group that usually included me. Observing occasionally, I noted how sailors who ultimately went home with cash in their pockets played consistently and with good knowledge of the odds. They were not lured into action for big pots unless the numbers were on their side. If those sailors applied the same philosophy to stocks, some of them are successful investors today.
  6. In classic fashion, frantic efforts to correct the underperformance only compounded Windsor’s plight. Windsor had succumbed to infatuation with small supposed growth companies without sufficient attention to the durability of growth. Then, as now, I assigned great weight to a judgment about the durability of earnings power under adverse circumstances.
  7. I’d seen enough hitting behind the ball. By playing it safe, you can make a portfolio so pablum-like that you don’t get any sizzle. You can diversify yourself into mediocrity. This sounds like heresy to many advocates of modern portfolio theory, but sticking our neck out worked for Windsor.
  8. Brain surgery it’s not, but I’ve always found that investors who skip elementary steps stumble sooner rather than later.
  9. Windsor was never fancy, fad-driven, or resigned to market performance. We followed one durable investment style whether the market was up, down, or indifferent. These were its principal elements:• Low price-earnings (p/e) ratio.• Fundamental growth in excess of 7 percent.• Yield protection (and enhancement, in most cases).• Superior relationship of total return to p/e paid.• No cyclical exposure without compensating p/e multiple.• Solid companies in growing fields.• Strong fundamental case.In a business with no guarantees, we banked on investments that consistently gave Windsor the better part of the odds. It wasn’t always a smooth ride; at times, we took our lumps. But, over the long haul, Windsor finished well ahead of the pack.
  10. Windsor was not fancy. As in tennis, I tried to keep the ball in play and let my adversaries make mistakes. I picked stocks with low p/e multiples primed to be upgraded in the market if they were deserving, and endeavored to keep losers at break-even levels. Usually, I returned home with more assets in the Windsor Fund than the day before. And I slept well-and still do.
  11. Low p/e companies growing faster than 7 percent a year tipped us off to underappreciated signs of life, particularly if accompanied by an attention-getting dividend.
  12. No solitary measure or pair of measures should govern a decision to buy a stock. You need to probe a whole raft of numbers and facts, searching for confirmation or contradiction.
  13. Judgment lies in recognizing which way the fundamentals point. Conventional wisdom and preconceived notions are stumbling blocks as well as signs of opportunity.
  14. You can sum up the Street’s psychology this way: Hope for the best, expect the worst. Meantime, don’t stick your neck out.
  15. Dramatic actions taken by companies, as opposed to broad challenges posed by difficult industrial or economic climates, can trigger unwarranted selling pressure.
  16. Investing is not a very complicated business; people just make it complicated. You have to learn to go from the general to the particular in a logical, sequential, rational manner.
  17. Refusal to partake in groupthink caused us to underperform the market by 9.8 percentage points in 1980 but cascaded to Windsor’s benefit in 1981. We recovered our footing and surpassed the S&P 500 by better than 21.7 percentage points. We’d pinned our reputation to a rout of that sort.
  18. Windsor did not achieve superior results by going against the grain at every chance. Stubborn, knee-jerk contrarians follow a recipe for catastrophe. Savvy contrarians keep their minds open, leavened by a sense of history and a sense of humor.
  19. Measured Participation established four broad investment categories:1. Highly recognized growth.2. Less recognized growth.3. Moderate growth.4. Cyclical growth.Windsor participated in each of these categories, irrespective of industry concentrations. When the best values were available in, say, the moderate growth area, we concentrated our investments there. If financial service providers offered the best values in the moderate growth area, we concentrated in financial services. This structure enabled us to flout the constraints that usually condemn mutual funds to ho-hum performance.
  20. The debate over top-down versus bottom-up investing has always seemed a little fuzzy to Inc. I just keep an eve on the economy and ask, where is a sector that’s overdue for recognition
  21. Many investors can’t bear to part company with a stock on the way up, lest they miss the best gain by not holding on. They persuade themselves that a day after they sell, they will have short-changed themselves by not capturing the penultimate dollar. My attitude is: I’m not that smart.
  22. When you feel like bragging about a stock, it’s probably time to sell.
  23. Conventional wisdom suggests that, for investors, more information these days is a blessing and more competition is a curse. I’d say the opposite is true. Coping with so much information runs the risk of distracting attention from the few variables that really matter. Because sound evaluations call for assembling information in a logical and careful manner, my odds improve, thanks to proliferating numbers of traders motivated by tips and superficial knowledge. By failing to perform rigorous, fundamental analyses of companies, industries, or economic trends, these investors become prospectors who only chase gold where everyone else is already looking.
  24. At least a portion of Windsor’s critical edge amounted to nothing more mysterious than remembering lessons of the past and how they tend to repeat themselves. You cannot become a captive of historical parallel, but you must be a student of history.
  25. As the market grew more excited, we grew more cautious.
  26. I wasn’t uncomfortable going into retirement. I had given Windsor my all. I was going out while I still had a lot left, which had been my intention.

What I got out of it

  1. Entertaining book, simple language, some important takeaways. Take a simple idea, and take it seriously

The Star Principle by Richard Koch

Summary

  1. What is a star venture? It has two qualities. One, it operates in a high-growth market. Two, it is the leader in that market.

Key Takeaways

  1. The answer is not to work or invest in the great majority of ventures. The key is to select the ventures that are likely to succeed anyway. Without superhuman people. Without perfect balance between the skills of the people. Without blood, toil, tears and sweat.Without the need to keep chopping and changing before the correct formula emerges. The useful answer is not ‘people, people, people’. The really potent, consistently successful answer is ‘positioning, positioning, positioning’.
  2. There is another clue as to whether or not a niche market is viable, and it is simply this: is the niche highly profitable? Does it generate a lot of cash? Leadership in a niche is not valuable unless, sooner or later, the niche is very profitable and gushes out cash.
  3. A leading firm should have higher prices, or lower costs, than a similar business that is a follower. Why higher prices? Because the customers prefer the product. Why lower costs? Because the firm can spread its fixed costs over a much greater volume of business than competitors can.
  4. About 1 in 20 start-ups is a star. So stars are rare. But they are not so rare that, with a bit of patience and careful thought, you can’t discover one – or create one yourself. If you look intelligently for a star, you will find it.
  5. My own experience is that, as I have made more money and started more successful ventures, the less I have worked. Hard work is either a red herring, or negatively correlated with success.
  6. A cash cow can be turned into a star when the concept of the product category is transformed – David’s vision of personal organisers as upscale fashion accessories reinvented the whole market.
  7. A star that is fast losing market share, or an ex-star that has lost it, may be an attractive prospect.
  8. It’s not as unusual as you might expect to find a hole in the market – even a market as big and profitable as gin. Seek a hole and sooner or later you will find one.
  9. Ecologists know that two species of animal that try to exist in exactly the same way become deadly enemies. If two species compete head-on for food, only one of them can win. The other species must change either the food it seeks or the way it hunts for it. If it does neither, the weaker species will die out. It is the same with business, except the time to extinction is compressed. Any business that imitates another slavishly will not be successful. The numbers are against it. It will be competing in the same market as the market leader. It will be smaller. It will have less appeal to customers. It will be less profitable and usually loss-making. It will have to do something different, or die.
  10. Imitation, even of a highly profitable and savvy player, won’t lead to a star business. There are only two exceptions. One is geography – a player may be imitated in a new country or region where it is not present, and sometimes the advantage of being first and the differences in the local market’s preferences can lead the imitator to a star position that can be defended even against the business imitated. The other exception is where the follower has more money or a much better approach than the originator. 
  11. There are seven steps necessary for creating a star venture.The seven steps give you an easy template for devising your star.
    1. Divide the market.
    2. Select a high-growth niche.
    3. Target your customers.
    4. Define the benefits of the new niche.
    5. Ensure profitable variation.
    6. Name the niche you plan to lead.
    7. Name the brand in a way that complements the category name. Make the name short, memorable, easy to recognise, appealing to the target market and associated with the niche.
  12. Many great innovations simultaneously divide markets and combine the attributes of two previously unrelated markets.
  13. Start with the markets you and your friends know. How could you turn them upside down, inside out, to create a new category? Here are 32 useful triggers. Some of them are opposites, using one extreme or another to create a new niche. Go against the conventional wisdom of the main market. Many of these triggers are related or similar, but they are included just in case they prompt an idea that otherwise might not occur to you. Don’t be overwhelmed by the list – it’s there to help, not to hold you up. If you can’t relate to a prompt, pass swiftly on to the next.
    1. YOUR IDEAL PRODUCT DOESN’T EXIST
    2. UPMARKET/DOWNMARKET
    3. AFFORDABLE LUXURIES
    4. MARKET VERSUS NICHE
    5. BIGGER PRODUCT VERSUS SMALLER PRODUCT
    6. EMOTIONAL VERSUS FUNCTIONAL – Emotion is warm and expensive. Function is no-nonsense, rational, inexpensive, stripped down to the essentials. Can you create a new niche by going ‘emotional’ in a market that is mainly ‘functional’?
    7. HEALTHIER VERSUS TEMPTING
    8. SAFE VERSUS RACY
    9. CONVENIENCE VERSUS PURITY
    10. SAVING TIME VERSUS EXTENDING TIME
    11. FIXED VERSUS MOBILE
    12. UNISEX VERSUS SINGLE SEX
    13. MASCULINE VERSUS FEMININE
    14. GO GAY
    15. GO GREY – Education: universities for those aged 50-plus?
    16. LOW VERSUS HIGH SERVICE, AND DIFFERENTSERVICE
    17. DIY VERSUS PROFESSIONAL SERVICE
    18. PERSONALISED VERSUS UNTAILORED
    19. BUNDLED VERSUS FOCUS AND SUBTRACTION – Focus is by far the best way to create a new star venture.
    20. EXPERT VERSUS INEXPERT USERS
    21. CENTRALISED VERSUS DECENTRALISED USE
    22. TOTAL COST VERSUS INITIAL PRICE
    23. FIRST PLACE VERSUS THIRD PLACE
    24. SECOND PLACE VERSUS THIRD PLACE
    25. OWNED VERSUS RENTED VERSUS FRACTIONALLY OWNED
    26. NARROWED EXPERTISE VERSUS ADDED EXPERTISE
    27. ORCHESTRATING A SUPPLIER ALLIANCE
    28. ONLINE VERSUS OFFLINE, OR A DIFFERENT DISTRIBUTION CHANNEL
    29. ENTREPRENEURIAL JUDO – This is a different kind of prompt, courtesy of the management guru Peter Drucker. The idea is to catch the leading players in a market off balance by turning their strength into a weakness.
    30. GO GREEN
    31. IDEAS FROM OTHER INDUSTRIES – Identify an industry that has a peculiar practice that somehow seems to work well. Could you adapt the practice to a completely different context?
    32. IDEAS FROM OTHER PLACES
  14. We cannot create a new star without creating a new category. The new niche must be oriented towards the target customers and must offer a sharply different basket of benefits from the main market. The more the benefits of the new category vary clearly and substantially from the existing market, the greater the chance that the new venture will fly. There are three ways of varying the benefits:
    1. increasing one or more benefits of the product in the main market to a marked degree;
    2. creating one or more new benefits that do not currently exist in the main market; and
    3. subtracting benefits that exist in the main market.
  15. To launch a star venture successfully, three conditions must apply.
    1. Your target customers want something different from the main market.
    2. You understand what it is that they want and can provide it with a new product category.
    3. The new category can be supplied profitably, because you can charge more for it, and/or because you can subtract elements of the main market product that are expensive to provide, so that the new category has lower costs than the main market.
  16. Make things happen reliably, consistently, economically. Make the venture a machine.
  17. The delivery formula has been cracked when all the following events always happen.
    1. Products are delivered to the same high standard, on time, every time.
    2. This year’s product is measurably better than last year’s.
    3. This year’s product costs at least 5 per cent less to make than last year’s.
    4. Volumes can be doubled within a year without panic or loss of quality.
    5. Work is delegated to the lowest-level person who is fully competent to do it.
    6. Everyone increases his or her skill level significantly each year and works better and faster.
    7. The workplace exudes calm, order and discipline.
    8. Standards and procedures are written down, clear, unambiguous – and observed!
    9. Logos, colours and designs are attractive and consistent.
    10. Budgets are always met or exceeded.
    11. Cash is always higher than planned.
    12. The firm is a machine – smooth-running, reliable, relentless, self-maintaining and self-improving.
    13. Nobody is indispensable. If the best people leave, the firm rolls on regardless. New leaders come to the fore.
  18. The way to maximise your chance of take-off is to form four small teams – each comprising a founder and two other employees – charged with masterminding each element of take-off: customer attraction; the commercial formula for fat margins; delivery; and innovation.
  19. At least 90 per cent or more of a star’s value over the long haul derives from its growth. For businesses that grow for a very long time, such as McDonald’s and Coca-Cola, the number is over 99 per cent. Nearly everyone hugely underestimates the growth potential of stars. Typically, the growth potential is underrated not by 100 or 200 per cent but by 1,000 per cent or 10,000 per cent.
  20. Almost all founders of star businesses underestimate their growth potential and value. Two action implications: never sell a star business (while it remains a star); and demand much faster growth.
  21. The nub here is that you should generally ‘outsource’ as much of your operations as possible, retaining only the few things that you do uniquely well. In particular, get other people to make things for you. Since you probably won’t be investing in factories, offices or other physical cash sinks, what’s left is expense investment – the costs of your people, plus external marketing. The joy of stars is that they take modest investment to get to cash break even. Thereafter, investment can be funded out of the star’s own cash flow.
  22. Be willing to accept lower profits to build a dominant market position. As long as you remain cash-positive, short-term profits are totally irrelevant to the long-term value of the business. Build by far the best product and service in your niche, moving further away ahead of would-be rivals.
  23. The trouble with founders who remain executives is that it is very difficult to shift them, even when they are palpably acting in the interests of the managers rather than the owners.
  24. Growth is everything. Star ventures should grow at least 20-50 per cent each year in their first decade. This rate of advance is so far beyond most people’s experience that enormous effort is required to impose ‘unreasonable expectations’.
  25. Profits also rise because of the market growth, but profits should rise faster than sales. In a normal market, profitability is constrained by competition. In a star market, profitability is constrained only by what customers will pay.
  26. Only puny secrets need protection. Big discoveries are protected by public incredulity. Marshall McLuhan

What I got out of it

  1. Niche that is growing 10%+ each year, leader in that market

The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail by Clayton Christensen

Summary

  1. The research reported in this book supports his latter view: it shows that in the cases of well-managed firms, good management was the most powerful reason they failed to stay atop their industries. Precisely because these firms listened to their customers, invested heavily in new technologies that would provide their customers more and better products of the short they wanted, and because they carefully studied market trends and systematically allocated investment capital to innovations that promised the best returns, they lost their positions of leadership. What this implies at a deeper level is that many of what are now widely accepted principles of good management are, in fact, only situationally appropriate. There are time at which it is right not to listen to customers, right ot invest in developing lower-performance products that promise lower margins, and right to aggressively pursue small, rather than substantial markets. 

Key Takeaways

  1. One common theme to all of these failures, however, is that the decisions that led to failure were made when the leaders in question were widely regarded as among the best companies in the world
  2. The failure framework is built upon 3 findings. The first is that there is a strategically important distinction between what I call sustaining technologies and those that are disruptive. Second, the pace of technological progress can, and often does, outstrip what markets need. This means that the relevance and competitiveness of different technological approaches can change with respect to different markets over time. And third, customers and financial structures of successful companies color heavily the sorts of investments that appear to be attractive to them, relative to certain types of entering firms
  3. Case for investing in disruptive technologies can’t be made confidently until it is too late
  4. Established firms confronted with disruptive technology typically viewed their primary development challenge as a technological one: to improve the disruptive technology enough that it suits known markets. In contrast, the firms that were most successful in commercializing a disruptive technology were those framing their primary development challenge as a marketing one: to build or find a market where product competition occurred along dimensions that favored the disruptive attributes of the product. 
  5. It has almost always been the case that disruptive products redefine the dominant distribution channels, because dealers’ economics – their models for how to make money – are powerfully shaped by the mainstream value network, just s the manufacturer’s are. 
  6. Principles of disruptive innovation
    1. Companies depend on customers and investors for resources – difficult for companies tailored for high-end markets to compete in low-end markets as well. Creating an independent organization that can compete in these disruptive technologies is the only viable way for established firms to harness this principle. Promise of upmarket margins, simultaneous upmarket movement of customers, and the difficulty of cutting costs to move downmarket profitably create a powerful barrier to downward mobility. In fact, cultivating a systematic approach to weeding out new product development initiatives that would likely lower profits is one of the most important achievements of any well-managed company. Creates a vacuum in the low-end market that attracts competition
    2. Small markets don’t solve the growth needs of small companies – create small organizations that get excited about small opportunities and small wins
    3. Markets that don’t exist can’t be analyzed – those who need analysis and quantification before they invest become paralyzed when faced with disruptive technologies
    4. Technology supply may not equal market demand – sometimes “good enough” is competitive and established firms tend to overshoot what the market demands. Moves from functionality to reliability to convenience to price
    5. Not wise to always be a technological leader or a follower – need to take distinctly different postures depending on whether they are addressing a disruptive or sustaining technology. Disruptive technologies have a large first-mover advantage and leadership is important

What I got out of it

  1. Great way to think about how you could do all the right things and still lose. Helmer’s counterpositioning in action

eBoys: The True Story of the Six Tall Men Who Backed eBay, Webvan, and Other Billion Dollar Start-ups by Randall Stross

Summary

  1. A behind the curtain look at the early days of Benchmark, one of the premier venture capital firms 

Key Takeaways

  1. Benchmark / VC
    1. It is a wee bit eerie to see, in hindsight, how the Benchmark boys’ original notion of a partnership of equals turned out to have been echoed in impersonal performance statistics. Even the partners themselves would never have guessed in advance that four and a half years after Benchmark’s founding, of the five investments that were the firm’s all-time biggest hits to date, no two had been discovered and directed by the same partner: five hits, five partners.
    2. A group of three young venture capitalists in Menlo Park—Bruce Dunlevie, Bob Kagle, and Andy Rachleff—decided to step free of their old firms, and with software entrepreneur Kevin Harvey they set up Benchmark Capital.
    3. Entrepreneurs who sought venture funding usually did not need to invest any more personal money into the venture than they had already spent to bring it to life. But some venture capitalists did demand more. Arthur Rock, the senior dean of American venture capitalists and an early investor in Intel, always insisted whenever his venture firm put money into a start-up that the entrepreneur co-invest one third of his total net worth, whether it be large or small. If the entrepreneur was extremely wealthy, the venture firm had higher expectations about his co-investing. The venture guys didn’t want the high-net-worth entrepreneur to regard the start-up as a hobby. To prove commitment, he was asked to have skin in the game, and that was what Beirne asked of Borders,
    4. On the golf course the other day, he said, a friend had floated a theory that leaders, in business or anything else, are driven by demons. The best guys have them—implacable, subterranean demons that are the source of greatness.
    5. Daniel Webster: “There is always room at the top.”
    6. No company looks better than the one that professes it does not need your money.
    7. Kagle gently cautioned Beirne: “We all have our blind spots, right? Our greatest strength is our greatest weakness. And I think in this case, Dave, we’re all conscious of the fact that there’s a lot of marquee players around this thing. You’re all about marquee players. So we need to make sure that you’re not getting too colored by that relative to all the other stuff.” “Salesmen are more likely to be sold,” Rachleff added.
    8. What the partners were looking for were categories that were ripe for “disintermediation”—removing a middle layer in the distribution chain. In this case, that layer was the twelve thousand or so art galleries in the country
    9. “There sure are a lot of signs,” Rachleff repeated. He wasn’t concerned about Benchmark’s overall reputation being badly damaged. “The amazing thing about our business is, everyone forgets the losers—they remember the winners.”
    10. Rachleff pointed out that in a portfolio, the emotions that Beirne would experience would always be biased toward the end of the spectrum representing pain. “The amazing thing is it hurts more on the downside than the good feelings on the upside.”
    11. “That’s my experience—three orders of magnitude,” Dunlevie quickly agreed. “Yeah,” Rachleff said, and then redid the ratio of intensity of pleasure versus pain. “One-X versus fifty-X.”
    12. Bob Kagle could not take much pleasure in the event either, imagining, as he did, whispers that the eBay success was a fluke, akin to picking up a winning lottery ticket. He found himself working all the harder after eBay, to silence criticism that he had not actually heard but that he could imagine, beyond his hearing. One monkey don’t make no show, he’d say.
    13. When the Benchmark partners got together, most days, most of the time, their conversations were interrupted by jokes, laughter, word play, self-confessed foibles, and still more laughter. They positively reveled in one another’s company.
  2. Gurley
    1. The cultural fit had to be just right, too. It was this issue that the partners would spend the most time agonizing over. The five Benchmark partners felt keenly the closeness of a basketball team; in moments of private vanity they liked to think of themselves as the Chicago Bulls in the early nineties, but it wasn’t apt—this was a team that was knocking down wins but without a single dominating presence like Michael Jordan. So maintaining the chemistry that permitted all to feel that the others brought out their individual best was regarded as paramount, even if it meant Benchmark could not expand.
    2. Beirne added his own high praise, which was that the attention Gurley received as a sought-after speaker at industry gatherings had secured for Gurley “a lot of mindshare.”
    3. You think he’d be a good investor?” asked Bruce Dunlevie. “I do, but the reason I do is because he’s a rare combination of highly intellectually curious and humble. I think he really is open to questioning his own thought process and what’s really working, what’s not working.”
    4. Benchmark’s self-proclaimed “fundamentally better architecture” was based on a bedrock tenet: equal partners, without hierarchical separation, with equal votes and equal compensation. They had used it brilliantly from the beginning to differentiate themselves from the rest of the firms on Sand Hill Road.
    5. Bill doesn’t know what hiring people is all about. He wants to learn it all. He’s a total learn-it-all guy. He was asking me questions: ‘How do you spend your time? How do you recruit? What do you look for? What do you ask people? What do you do?’ ” “He’s pretty humble,” said Rachleff. Beirne agreed, and added, “He does a very good job at the shows. He doesn’t just stand in the back and not talk to anybody—he’s out talking to everybody.” “How old is he?” asked Kagle. “He’s thirty-two.” “He’s a mature thirty-two, too.”
    6. Harvey had also been impressed by his willingness to chase a wild boar down a steep cliff. “He is kind of an animal,” Harvey said with manifest respect. “I love that,” said Kagle.
    7. Kagle said to Harvey, “Okay, make him the offer.” Harvey turned to Gurley. “First, I want to know if you’ll take it.” This was the way Harvey preferred to seal a deal with an entrepreneur: to secure the agreement before bringing out the term sheet with all of the details. Here Harvey feared that if he brought out the terms of the partnership offer, Gurley’s analytical bent would lead him to say, “Okay, I’ll take this home and think about it.” Harvey wanted him to show trust that the partners had put together a generous package that accorded him fully equal status from day one. Gurley came through and, without asking to see the terms, accepted on the spot.
    8. Gurley cast cold water on the proposal to go public, however, by asking, “Is it built to win?” He explained, “GM is built to last, but it’s got so much bureaucracy, it’s not going anywhere.” Maybe “built to last” was not the right criterion to optimize on.
  3. eBay
    1. When eBay, a small Internet auction company based in San Jose, California, sought venture capital, it had to pass an informal test administered by the venture guys before they would consider making an investment: Was there a reasonably good likelihood that the investors could make ten times their money within three years? 
    2. It was late 1996, and eBay’s online auction business had been solidly profitable since it was launched; the company did not need a cent. But Pierre Omidyar, twenty-nine, the original founder, and his new partner, Jeff Skoll, thirty-one, were the rare entrepreneurs who knew they needed to hire a CEO and other seasoned executives with skills they lacked. It appeared to them that the only way they would be able to attract people with deeper management experience than they had was by obtaining the imprimatur of a well-regarded venture capital firm. Selling a minority share of their equity to venture capitalists was the intermediate step they had to take to get the good people they sought.
    3. Over the next two weeks, he met with Omidyar outside of Benchmark’s office and discovered that he was an anomalous kind of engineer, one who was consumed by the idea of community—every other sentence, he spoke about the eBay community, building the community, learning from the community, protecting the community. It was a passion similar to what, in Bob-speak, Kagle had for deals that brought out the humanity; that’s what Kagle liked most of all, the humanity. The more Omidyar talked about his community vision, the more Kagle, as he put it, was “lovin’ him—this guy is good people.” And Omidyar felt the same way about Kagle.
    4. EBay was an anomaly: a profitable company that was able to self-fund its growth and that turned to venture capital solely for contacts and counsel. No larger lesson can be drawn. When Benchmark wired the first millions to eBay’s bank account, the figurative check was tossed into the vault—and there it would sit, unneeded and undisturbed.
    5. By temperament, Skoll could not help but pour himself into the work in a scarily total fashion—once he started at eBay, he worked hundred-hour weeks for the next two and a half years. But he wasn’t driven by materialist hungers, and he thought of himself not as a businessperson but as a writer.
    6. EBay had an enormous advantage over the competition that it only then, under challenge, was coming to appreciate: a nicely balanced critical mass of sellers and buyers in each of hundreds of categories. This delicate balance had been achieved through the natural evolution of the eBay ecosystem, without the intervention of any guiding hand. If in any given category there were too many sellers compared with buyers, the sellers would have been discouraged and quick to jump to eBay’s rivals to try their luck there. If there were too many buyers, and in order to win an auction one had to offer up a ludicrously high price, this too would have led to mass defections. Fortunately for eBay, the number of sellers and buyers, while growing exponentially, had remained well apportioned. EBay’s users remained loyal for another reason: feedback ratings. Buyers, after a transaction, could send in a report about their experience with the seller, which future prospective buyers could consult; sellers had an identical opportunity to evaluate their experience with the buyer. Over time, both sellers and buyers accumulated a number of positive-feedback ratings at eBay, a neatly quantifiable reputation, that they were loath to abandon. The eBay “community” stayed put.
    7. “That’s the biggest risk in the whole thing,” Kagle said. “In fact I can argue with you guys very persuasively that keeping this low profile we’ve had in the company has been absolutely the healthiest thing to do. Absolutely the healthiest thing to do. We’ve already broken the systems a couple times, in spite of that. So we’ve been barely able to manage the traffic operationally so far.” Kagle said there had been a second benefit. “This organic growth has led to this very nice set of community values; people are honest, people treat each other fairly, there’s not a lot of scamming going on in it. And if you turn up the volume way high, the woodwork gets filled with a lot of weird guys, and the whole tone of the thing could change. So that’s a risk.”
    8. On the day after eBay’s IPO, when Pierre Omidyar, just back from New York, stood on Benchmark’s terrace, he observed that the world had imputed strategic savvy to the company that it did not really have. “Our system didn’t scale,” he said, “so we didn’t grow big enough to attract competition. Everybody thought we were flying below the radar screen on purpose.” He gave a little laugh.
    9. Up until early summer 1998, eBay’s primary competition was Jerry Kaplan’s Onsale Exchange, which had launched in October 1997 and had failed to attract a critical mass. When Bob Kagle introduced eBay to Benchmark’s limited partners at the annual meeting in early June, eBay had an 89 percent market share. Kagle said that the company anticipated major entrants, but “we think they don’t get it. We think they don’t understand all the stuff about the community and what’s really special and unique about this.” He also noted that in addition to first-mover advantage, economies of scale, and definitive selection in the various categories, eBay also enjoyed another advantage: Users faced high switching costs. “After you get this reputation built up online,” Kagle explained, “you’ve got all these people who have dealt with you, you’ve got seventy-five people who’ve said good things about you. That’s a pretty fundamental thing.”
    10. A good business will attract good competitors. This eBay’s executives knew in the abstract, but like the abstract concept of war, the theory necessarily bore a limited relationship to the thing itself.
    11. But knowing that the CEO was personally fielding calls from angry customers when they could not find someone to speak with in his department would provide all the incentive he needed, and she knew it.
  4. Priceline
    1. Our biggest competition, Walker explained, was cars and couches; Priceline’s system “collected demand” from people who would not otherwise be flying. And by promising to get back with an answer within one hour—why one hour? Glasses in an hour, photos in an hour; consumers already understand the unit—Walker was deliberately creating in the consumers’ mind the idea that Priceline was a virtual gladiator fighting on their behalf: “It’s going to take us an hour to knock on everybody’s door, punch him in the jaw, give him your offer, and get back to you with an answer, but be assured we’re out there working for you!” 
    2. Since we’re not actively shopping for capital, Walker summed up, this isn’t about the money per se. It’s really about two teams—your team, our team. We’ve got a multibillion-dollar asset here if played right. We’re not greedy; we’re not pigs. We’re players. Game theorists that we are, we understand the game trade. And we’re not afraid to make a trade for the right set of circumstances.
  5. Other
    1. The very reason that start-ups had an advantage over these incumbents—speed in execution—was the same reason that the old companies acted so slowly, even when the task was to organize a new entity that would be free to compete without organizational drag. “So they know they’re in a tough spot.” Still, the inertial drag in a big company was the most powerful factor in the equation.
    2. Edward Chancellor’s history of financial manias, Devil Take the Hindmost, urging them to read it. Chancellor’s account of England’s railway mania of 1845 had made an especially deep impression on Kagle, who saw all of the similarities between the railroad, then hailed as a revolutionary advance without historical parallel, and the Internet. In both cases the technological change was as fundamental as its champions claimed, but investors’ enthusiasm about imminent opportunities to reap fortunes moved beyond the reasonable. All businesses must earn a profit in order to be viable; Kagle refused to relinquish this simple truth.
    3. Kevin Harvey took the view that Red Hat could avoid a frontal challenge to Microsoft’s business model; he worked to reposition the company away from the business of selling packaged software in boxes (Harvey’s old business) and move it toward providing support services and a central website for the Linux community. The only way Microsoft could compete with Red Hat, he would say gleefully, “is by abandoning five billion dollars of annual revenue, which they can’t!”
    4. His firm, TVI, had funded Microsoft, Compaq, and other notable technology companies, but it was not these that McMurtry wished to talk about. Rather, he wanted to talk about the companies that did not succeed. He recalled that in the mid-1970s, having been in the business a number of years, he had become depressed because “out of ten start-ups, we would lose three or four—lose all our money. Maybe just get our money back in two deals. Then you’ve got two or three where you get one to five times your money. That leaves just one or two deals [out of ten] where you make more than five times your money.” The high payoffs for one or two never erased the pain of those that did not survive: “You feel so responsible for the disasters.”
    5. The claim was empty bluster, however. Mike Moritz, of Sequoia Capital, peeled back the truth with mordant detachment: “One of the dirty little secrets of the Valley is that all the jobs-creation we like to talk about is probably less than the Big Three automakers have laid off in the last decade. One of the best ways to have a nice Silicon Valley company is to keep your head count as low as possible for as long as possible.”

What I got out of it

  1. Really fun book that gives an inside look at VC investing – power law returns and their importance really stuck out to me, as did the culture at Benchmark and how they thought about their investments 

Latticework: The New Investing by Robert Hagstrom

Summary

  1. Latticework: success in investing based on a working knowledge of a variety of disciplines

Key Takeaways

  1. Latticework
    1. Latticework is itself a metaphor. And on the surface, quite a simple one at that. Everyone knows what latticework is, and most people have some degree of firsthand experience with it. There is probably not a do-it-yourselfer in America who hasn’t made good use of a four-by-eight sheet of latticework at some point. We  use it to decorate fences, to create shade over patios, and to support climbing plants. It is but a very small stretch to envision a metaphorical lattice as the support structure for organizing a set of mental concepts
  2. Physics – Equilibrium
    1. Physics is the science that investigates matter, energy, and the interaction between them – the study, in other words, of how our universe works. It encompasses all the forces that control motion, sound, light, heat, electricity, and magnetism, and their occurrence in all forms, from the smallest subatomic particles to entire solar systems. It is the intellectual foundation of many well-recognized principles such as gravitation and such mind-boggling concepts as quantum mechanics and relativity.
    2. Equilibrium is defined as a state of balance between opposing forces, powers, or influences. An equilibrium model typically identifies a system that is at rest; this is called “static equilibrium.”
    3. The concept of equilibrium is so deeply embedded in our theory of economics and the stock market, it is difficult to imagine any other idea of how these systems could possible work…One place where the question is being raised is the Santa Fe Institute, where scientists from several disciplines are studying complex adaptive systems – those systems with many interacting parts that are continually changing their behavior in response to changes in the environment…If a CAS is, by definition, continuously adapting, it is impossible for any such system, including the stock market, ever to reach a state of perfect equilibrium. What does that mean for the stock market? It throws the classic theories of economic equilibrium into serious question. The standard equilibrium theory is rational, mechanistic, and efficient. It assumes that identical individual investors share rational expectations about stock prices and then efficiently discount that information into the market. It further assumes there are no profitable strategies available that are not already priced into the market. The counterview from SFI suggests the opposite: a market that is not rational, is organic rather than mechanistic, and is imperfectly efficient. 
    4. The SFI pointed out 4 distinct features they observed about the economy: dispersed interaction, no global controller, continual adaptation, out of equilibrium dynamics. 
  3. Biology – Evolution
    1. What we are learning is that studying economic and financial systems is very similar to studying biological systems. The central concept for both is the notion of change, what biologists call evolution. The models we use to explain the evolution of financial strategies are mathematically similar to the equations biologists use to study populations of predator-prey systems, competing systems, or symbiotic systems. 
    2. Complex systems must be studied as a whole, not in individual parts, because the behavior of the system is greater than the sum of the parts. The old science was concerned with understanding the laws of being. The new science is concerned with the laws of becoming
  4. Social Sciences – Complexity, Complex Adaptive Systems, Self-Organized Criticality
    1. Although Johnson’s maze is a simple problem-solving computer simulation, it does demonstrate emergent behavior. It also leads us to better understand the essential characteristic a self-organizing system must contain in order to produce emergent behavior. That characteristic is diversity. The collective solution, Johnson explains, is robust if the individual contributions to the solution represent a broad diversity of experience in the problem at hand. Interestingly, Johnson discovered that the collective solution is actually degraded if the system is limited to only high-performing people. It appears that the diverse collective is better at adapting to unexpected changes in structure. 
      1. Folly to think you can eliminate every waste, every performer who doesn’t meet the highest bar, and excel and survive. Can shift the entire bell curve to the right, but you still need the full spectrum
      2. Notes: We have observed anecdotal evidence of emergent behavior, perhaps without realizing what we were seeing. The recent bestseller, Blind Man’s Bluff: The Untold Story of american Submarine Espionage, presents a very compelling example of emergence. Early in the book, the authors relate the story of the 1966 crash of a B-52 bomber carrying four atomic bombs. Three of the four bombs were soon recovered, but a fourth remained missing, with the Soviets quickly closing in. A naval engineer named John Craven was given the task of locating the missing bomb. He constructed several different scenarios of what possibly could have happened to the fourth bomb and asked the members of the salvage team to wager a bet on where they thought the bomb could be. He then ran each possible location through a computer formula and – without ever going to sea! – was able to pinpoint the exact location of the bomb based on a collective solution
    2. It is when the agents in the system do not have similar concepts about the possible choices that the system is in danger of becoming unstable. And that is clearly the case in the stock market…The value of this way of looking at complex systems is that if we know why they become unstable, then we have a clear path to a solution, to finding ways to reduce overall instability. One implication, Richards says, is that we should be considering the belief structures underlying the various mental concepts, and not the specifics of the choices. Another is to acknowledge that if mutual knowledge fails, the problem may center on how knowledge is transferred in the system. 
  5. Psychology – Mr. Market, Complexity, Information
    1. Another aspect of behavioral finance is what some psychologists refer to as mental accounting – our tendency to think of money in different categories, putting our funds into separate “mental accounts,” depending on circumstances. Mental accounting is the reason we are far more willing to gamble with our year-end bonus than our monthly salary, especially if it is higher than anticipated. It is also one further reason why we stubbornly hold onto stocks that are doing badly; the loss doesn’t feel like a loss until we sell
  6. Philosophy – Pragmatism
    1. Strictly for organizational simplicity, we can separate the study of philosophy into 3 broad categories. First, critical thinking as it applies to the general nature of the world is called “metaphysics”…Metaphysics means “beyond physics.” When philosophers discuss metaphysical questions, they are describing ideas that exist independently from our own space and time. Examples include the concepts of God and the afterlife. These are not tangible events like tables and chairs but rather abstract ideas that metaphysical questions readily concede the existence of the world that surrounds us but disagree about the essential nature and meaning of the world. The second body of philosophical inquiry is the investigation of 3 related areas: aesthetics, ethics, and politics. Aesthetics is the theory of beauty. Philosophers who engage in aesthetic discussions are trying to ascertain what it is that people find beautiful, whether it be in the objects they observe or in the state of mind they achieve. This study of the beautiful should not be thought of as a superficial inquiry, because how we conceive beauty can affect our judgments of what is right and wrong, what is the correct political order, and how people should live. Ethics is the philosophical branch that studies the issues of right and wrong. It asks what is moral and what is immoral, what behavior is appropriate and inappropriate. Ethics makes inquiries into the activities people undertake, the judgments they make, the values they hold, and the character they aspire to achieve. Closely connected to the idea of ethics is the philosophy of politics. Whereas ethics investigates what is good or right at the individual level, politics investigates what is good or right at the societal level. Political philosophy is a debate over how societies should be organized, what laws should be passed, and what connections people should have to these societal organizations. Epistemology, the third body of inquiry, is the branch of philosophy that seeks to understand the limits and nature of knowledge. The term itself comes from two Greek words: episteme, meaning “knowledge,” and logos, which literally means “discourse” and more broadly refers to any kind of study or intellectual investigation. Epistemology, then, is the study of the theory of knowledge. To put it simply, when we make an epistemological inquiry, we are thinking about thinking. When philosophers think about knowledge, they are trying to discover what kinds of things are knowable, what constitutes knowledge (as opposed to beliefs), how it is acquired (innately or empirically, through experience), and how we can say that we know a thing.
    2. For pragmatism, anyone who seeks to determine the true definition of a belief should look not at the belief itself but at the actions that result from it. He called the proposition “pragmatism,” a term, he pointed out, with the same root as practice or practical, thus cementing his view that the meaning of an idea is the same as its practical results. “Our idea of anything, Peirce explained, “is our idea of its sensible effects.” In his classic 1878 paper, “How to Make Our Ideas Clear,” Peirce continued: “The whole function of thought is to produce habits of action. To develop its meaning, we have, therefore, simply to determine what habits it produces, for what a thing means is simply what habits it involves.” 
    3. A belief is true, James said, because holding it puts a person into more useful relations with the world…People should ask what practical effects come from holding one philosophical view over another
    4. If truth ad value are determined by their practical applications in the world, then it follows that truth will change as circumstances change and as new discoveries about the world are made. Our understanding of truth evolves. Darwin smiles.
    5. So we can say that pragmatism is a process that allows people to navigate an uncertain world without becoming stranded on the desert island of absolutes. Pragmatism has no prejudices, dogmas, or rigid canons. It will entertain any hypothesis and consider any evidence. If you need facts, take the facts. If you need religion, take religion. If you need to experiment, go experiment. “In short, pragmatism widens the field of search for God,” says James. “Her only test of probable truth is what works best in the way of leading us.” 
    6. Pragmatism, in summary, is not a philosophy as much as it is a way of doing philosophy. It thrives on open minds, and gleefully invites experimentation. It rejects rigidity and dogma; it welcomes new ideas. It insists that all possibilities should be considered, without prejudice, for important new insights often come disguised as frivolous, even silly notions. it seeks new understanding by redefining old problems. 
    7. One of the secret to Bill Miller’s success is his desire to take a Rubik’s Cube approach to investing. He enthusiastically examines every issue from every possible angle, from every possible discipline, to get the best possible description – or redescription – of what is going on. Only then does he feel in a position to explain. To his investigation he brings insights from many fields…He continually studies physics, biology, and social science research, searching for ideas that will help him become a better investor…In an environment of rapid change, the flexible mind will always prevail over the rigid and absolute…Because you recognize patterns, you are less afraid of sudden changes. With a perpetually open mind that relishes new ideas and knows what to do with them, you are set firmly on the right path. 
  7. Literature – self-education of a Latticework through books, Adler’s Active Reading
    1. We must educate ourselves and the vehicle for doing so is a book supplemented with all other media both traditional and modern…So we are talking about learning to become discriminating readers: to analyze what you read, to evaluate its worth in the larger picture, and to either reject it or incorporate it into your own latticework of mental models…We can all acquire new insights through reading if we perfect the skill of reading thoughtfully. The benefits are profound: not only will you substantially add to your working knowledge of various fields, you will at the same time sharpen your skill at critical thinking.
    2. The central purpose of reading a book, Adler believes, is to gain understanding…This is not the same as reading for information. 
    3. Reading that makes you stop and think is the path to greater understanding – not solely because of what you are reading but also because of the process of reflection in which you are engaged. You are learning from your own thinking as well as from the author’s ideas. You are making new connections. Adler describes as the difference between learning by instruction and learning by discovery. It’s evident of in the satisfaction we feel when we figure out something on our own, instead of being told the answer. Receiving the answer might solve the immediate problem, but discovering the answer by your own investigation has a much more powerful effect on your overall understanding. 
    4. Adler proposes that all active readers need to keep 4 fundamental questions in mind: what is the book about as a whole, what is being said in detail, is the book true, in whole or in part, what of it? The heart of Adler’s process involves 4 levels of reading: elementary, inspectional, analytical, and syntopical. Each level is a necessary foundation for the next, and the entire process is cumulative. 
      1. Elementary reading is the most basic level, the one we achieve in elementary education
      2. In inspectional reading, the second level, the emphasis is on time and the goal is to determine, as quickly as possible, what the book is about. It has two levels: prereading and superficial reading. Prereading is a fast review to determine whether a book deserves a more careful reading. Look at the table of contents, index, how much can you learn about the main themes through this overview. Next, Adler recommends systematic skimming. Read a few paragraphs here and there, read the author’s conclusion. These two activities should take between 30-60 minutes and help you determine if it is worth your time to read the book
      3. Analytical reading is the most thorough and complete way to absorb a book. Through analytical reading you will answer what is the book about as a whole and in detail and provide you the most complete answer to if the book is true. It has  goals: develop a detailed sense of what the book contains, interpret the contents by examining the author’s own particular point of view on the subject; and to analyze the author’s success in presenting that point of view convincingly. Take notes, make an outline, write in your own words what you think the book is about, write the author’s main arguments
      4. The fourth and highest level is what Adler calls syntopical reading, or comparative reading. In this level of reading, we are interested in learning about a certain subject, and to do so we compare and contrast the works of several authors rather than focusing on just one work by one another. Adler considers this the most demanding and most complex level of reading. It involves two challenges: first, searching for possible books on the subject; and then deciding, after finding them, which books should be read
    5. The challenge for us as readers is to receive that knowledge and integrate it into our latticework of mental models. How well we are able to do so is a function of two very separate considerations: the author’s ability to explain, and our skills as careful, thoughtful readers. We have little control over the first, other than to discard one particular book in favor of another, but the second is completely within our control
    6. I believe in…mastering the best that other people have figured out, [rather than] sitting down and trying to dream it up yourself…You won’t find it that hard if you go at it Darwinlike, step by step with curious persistence. You’ll be amazed at how good you can get…It’s a huge mistake not to absorb elementary worldly wisdom…Your life will be enriched – not only financially but in a host of other ways – if you do. – Charlie Munger, Poor Charlie’s Almanack 
  8. Decision Making – Continuously add more building blocks to your knowledge base in order to build more robust mental models
    1. Failures to explain are caused by our failures to describe
    2. Our institutions of higher learning may separate knowledge into categories, but wisdom is what unites them.

What I got out of it

  1. A beautiful book on how to approach being a multidisciplinary thinker as it applies to investing. 

On Bill Gurley’s Above the Crowd

I spent this past month reading Bill Gurley’s fantastic posts on Above the Crowd.

Bill has been blogging since 1996 and it was fascinating to look back through time and see his thinking and thought process over these past 25 years, specifically as it applies to technology and consumer internet companies. The link at the bottom of the page is a compilation of all his posts and my favorite were: The Most Powerful Internet Metric of All, The Smartest Price War Ever, All Revenue is Not Created Equal, and The Thing I Love Most About Uber.

Margin of Safety: Risk-Averse Value Investing for the Thoughtful Investors by Seth Klarman

Summary

  1. “My goals in writing this book are twofold. In the first section, I identify many of the pitfalls that face investors. By highlighting where so many go wrong, I hope to help investors learn to avoid these losing strategies. For the remainder of the book, I recommend one particular path for investors to follow—a  value-investment philosophy. Value investing, the strategy of investing in securities trading at an  appreciable discount from underlying value, has a long history of delivering excellent investment  results with very limited downside risk.”

Key Takeaways

  1. Introduction
    1. Ideally this will be considered, not a book about investing, but a book about thinking about investing. Like most eighth-grade algebra students, some investors memorize a few formulas or rules and superficially appear competent but do not really understand what they are doing. To achieve long-term success over many financial market and economic cycles, observing a few rules is not enough. Too many things change too quickly in the investment world for that approach to succeed. It is necessary instead to understand the rationale behind the rules in order to appreciate why they work when they do and don’t when they don’t. I could simply assert that value investing works, but I hope to show you why it works and why most other approaches do not.
    2. The temptation of making a fast buck is great, and many investors find it difficult to fight the crowd.
    3. Regardless of the market environment, many investors seek a formula for success. The unfortunate reality is that investment success cannot be captured in a mathematical equation or a computer  program.
    4. Ultimately investors must choose sides. One side—the wrong choice—is a seemingly effortless path  that offers the comfort of consensus. This course involves succumbing to the forces that guide most  market participants, emotional responses dictated by greed and fear and a short-term orientation  emanating from the relative-performance derby. Investors following this road increasingly think of  stocks like sowbellies, as commodities to be bought and sold. This ultimately requires investors to  spend their time guessing what other market participants may do and then trying to do it first. The  problem is that the exciting possibility of high near-term returns from playing the  stocks-as-pieces-of-paper-that-you-trade game blinds investors to its foolishness. The correct choice for investors is obvious but requires a level of commitment most are unwilling to  make. This choice is known as fundamental analysis, whereby stocks are regarded as fractional  ownership of the underlying businesses that they represent. One form of fundamental analysis—and  the strategy that I recommend—is an investment approach known as value investing. There is nothing esoteric about value investing. It is simply the process of determining the value  underlying a security and then buying it at a considerable discount from that value. It is really that  simple. The greatest challenge is maintaining the requisite patience and discipline to buy only when  prices are attractive and to sell when they are not, avoiding the short-term performance frenzy that  engulfs most market participants. The focus of most investors differs from that of value investors. Most investors are primarily oriented  toward return, how much they can make, and pay little attention to risk, how much they can lose.
    5. The value discipline seems simple enough but is apparently a difficult one for most investors to grasp  or adhere to. As Buffett has often observed, value investing is not a concept that can be learned and  applied gradually over time. It is either absorbed and adopted at once, or it is never truly learned.
  2. Where Most Investors Stumble
    1. Mark Twain said that there are two times in a man’s life when he should not speculate: when he can’t  afford it and when he can. Because this is so, understanding the difference between investment and  speculation is the first step in achieving investment success.
    2. Investors believe that over the long run security prices tend to reflect fundamental developments  involving the underlying businesses
    3. Investors in a stock thus expect to profit in at least one of three possible ways: from free cash flow  generated by the underlying business, which eventually will be reflected in a higher share price or  distributed as dividends; from an increase in the multiple that investors are willing to pay for the  underlying business as reflected in a higher share price; or by a narrowing of the gap between share  price and underlying business value.
    4. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing  based upon that prediction is a speculative undertaking.
    5. The distinction is not clear to most people. Both investments and speculations can be bought and sold.  Both typically fluctuate in price and can thus appear to generate investment returns. But there is one  critical difference: investments throw off cash flow for the benefit of the owners; speculations do not.  They return to the owners of speculations depends exclusively on the vagaries of the resale market.
    6. If you look to Mr. Market as a creator of investment opportunities (where price departs from underlying  value), you have the makings of a value investor. If you insist on looking to Mr. Market for investment  guidance, however, you are probably best advised to hire someone else to manage your money.
    7. Many unsuccessful investors regard the stock market as a way to make money without working rather  than as a way to invest capital in order to earn a decent return. Anyone would enjoy a quick and easy  profit, and the prospect of an effortless gain incites greed in investors. Greed leads many investors to  seek shortcuts to investment success. Rather than allowing returns to compound over time, they  attempt to turn quick profits by acting on hot tips. They do not stop to consider how the tipster could  possibly be in possession of valuable information that is not illegally obtained or why, if it is so  valuable, it is being made available to them. Greed also manifests itself as undue optimism or, more  subtly, as complacency in the face of bad news. Finally greed can cause investors to shift their focus away from the achievement of long-term  investment goals in favor of short-term speculation
    8. It is human nature to seek simple solutions to problems, however complex. Given the complexities of the investment process, it is perhaps natural for people to feel that only a  formula could lead to investment success. Just as many generals persist in fighting the last war, most investment formulas project the recent past  into the future. Some investment formulas involve technical analysis, in which past stock-price  movements are considered predictive of future prices. Other formulas incorporate investment  fundamentals such as price-to-earnings (P/E) ratios, price-to-book-value ratio, sales or profits growth  rates, dividend yields, and the prevailing level of interest rates. Despite the enormous effort that has  been put into devising such formulas, none has been proven to work.
  3. Nature of Wall Street Works Against Investors
    1. Wall Streeters get paid primarily for what they do, not how effectively they do it. Wall Street’s  traditional compensation is in the form of up-front fees and commissions. Brokerage com-missions are  collected on each trade, regardless of the outcome for the investor. Investment banking and  underwriting fees are also collected up front, long before the ultimate success or fail-ure of the  transaction is known. All investors are aware of the conflict of interest facing stockbrokers. While their customers might be  best off owning (minimal commission) U.S. Treasury bills or (commission-free) no-load mutual funds,  brokers are financially motivated to sell high-commission securities. Brokers also have an incentive to  do excessive short-term trading (known as churning) on behalf of discretionary customer accounts (in  which the broker has discretion to transact) and to encourage such activity in nondiscretionary  accounts. Many investors are also accustomed to conflicts of interest in Wall Street’s trading activities,  where the firm and customer are on opposite sides of what is often a zero-sum game.
    2. The point I am making is that investors should be aware of the motivations of the people they transact  business with; up-front fees clearly create a bias toward frequent, and not necessarily profitable,  transactions.
  4. The Institutional Performance Derby: The Client is the Loser
    1. Economist Paul Rosenstein-Rodan has pointed to the “tremble factor” in understanding human  motivation. “In the building practices of ancient Rome, when scaffolding was removed from a  completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the  first to know. Thus his concern for the quality of the arch was intensely personal, and it is not  surprising that so many Roman arches have survived.”
    2. Remaining fully invested at all times certainly simplifies the investment task. The investor simply  chooses the best available investments. Relative attractiveness becomes the only investment yardstick;  no absolute standard is to be met. Unfortunately the important criterion of investment merit is obscured  or lost when substandard investments are acquired solely to remain fully invested. Such investments  will at best generate mediocre returns; at worst they entail both a high opportunity cost—foregoing the  next good opportunity to invest—and the risk of appreciable loss.
    3. Remaining fully invested at all times is consistent with a relative-performance orientation. If one’s goal  is to beat the market (particularly on a short-term basis) without falling significantly behind, it makes  sense to remain 100 percent invested. Funds that would otherwise be idle must be invested in the  market in order not to underperforms the market. Absolute-performance-oriented investors, by contrast, will buy only when investments meet absolute  standards of value. They will choose to be fully invested only when available opportunities are both  sufficient in number and compelling in attractiveness, preferring to remain less than fully invested  when both conditions are not met. In investing, there are times when the best thing to do is nothing at  all. Yet institutional money managers are unlikely to adopt this alternative unless most of their  competitors are similarly inclined.
    4. Investing without understanding the behavior of institutional investors is like driving in a foreign  land without a map. You may eventually get where you are going, but the trip will certainly take  longer, and you risk getting lost along the way.
    5. Avoiding losses is the most important prerequisite to investment success
  5. Defining Your Investment Goals
    1. Warren Buffett likes to say that the first rule of investing is “Don’t lose money,” and the second rule is,  “Never forget the first rule.” I too believe that avoiding loss should be the primary goal of every  investor. This does not mean that investors should never incur the risk of any loss at all. Rather “don’t  lose money” means that over several years an investment portfolio should not be exposed to  appreciable loss of principal.
    2. Greedy, short-term-oriented investors may lose sight of a sound mathematical reason for avoiding loss:  the effects of compounding even moderate returns over many years are com-pelling, if not downright  mind boggling. Table 1 shows the delightful effects of compounding even relatively small amounts.
    3. Investors must be willing to forego some near-term return, if necessary, as an insurance premium  against unexpected and unpredictable adversity.
    4. Rather than targeting a desired rate of return, even an eminently reasonable one, investors should  target risk
  1. Value Investing: The Importance of a Margin of Safety
    1. Value investing is the discipline of buying securities at a significant discount from their current  underlying values and holding them until more of their value is realized. The element of a bar-gain is  the key to the process. In the language of value investors, this is referred to as buying a dollar for fifty  cents. Value investing combines the conservative analysis of underlying value with the requisite  discipline and patience to buy only when a sufficient discount from that value is available. The number  of available bargains varies, and the gap between the price and value of any given security can be very  narrow or extremely wide. Sometimes a value investor will review in depth a great many potential  investments without finding a single one that is sufficiently attractive. Such persistence is necessary,  however, since value is often well hidden. The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The  greatest challenge for value investors is maintaining the required discipline. Being a value investor usually means standing  apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment  winds. It can be a very lonely undertaking. A value investor may experience poor, even horrendous,  performance compared with that of other investors or the market as a whole during prolonged periods  of market overvaluation. Yet over the long run the value approach works so successfully that few, if  any, advocates of the philosophy ever abandon it.
    2. Value investors continually compare potential new investments with their current holdings in order to  ensure that they own only the most undervalued opportunities available. Investors should never be  afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses  on the sale of current holdings. In other words, no investment should be considered sacred when a  better one comes along.
    3. Because investing is as much an art as a science, investors need a margin of safety. A margin of safety  is achieved when securities are purchased at prices sufficiently below underlying value to allow for  human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.  According to Graham, “The margin of safety is always dependent on the price paid. For any security,  it will be large at one price, small at some higher price, nonexistent at some still higher price.” Buffett described the margin of safety concept in terms of tolerances: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive  10,000-pound trucks across it. And that same principle works in investing.”
    4. How can investors be certain of achieving a margin of safety? By always buying at a significant  discount to underlying business value and giving preference to tangible assets over intangibles. (This  does not mean that there are not excellent investment opportunities in businesses with valuable  intangible assets.) By replacing current holdings as better bargains come along. By selling when the  market price of any investment comes to reflect its underlying value and by holding cash, if necessary,  until other attractive investments become available. Investors should pay attention not only to whether but also to why current holdings are undervalued. It  is critical to know why you have made an investment and to sell when the reason for owning it no  longer applies. Look for investments with catalysts that may assist directly in the realization of  underlying value. Give preference to companies having good managements with a personal financial  stake in the business.
    5. A market downturn is the true test of an investment philosophy. Securities that have performed well in  a strong market are usually those for which investors have had the highest expectations.
    6. Investors should understand not only what value investing is but also why it is a successful  investment philosophy. At the very core of its success is the recurrent mispricing of securities in the marketplace. Value investing is, in effect, predicated on the proposition that the efficient-market  hypothesis is frequently wrong. If, on the one hand, securities can become undervalued or overvalued,  which I believe to be incontrovert-ibly true, value investors will thrive. If, on the other hand, all  securities at some future date become fairly and efficiently priced, value investors will have nothing to  do. It is important, then, to consider whether or not the financial markets are efficient.
    7. The efficient-market hypothesis takes three forms. The weak form maintains that past stock prices  provide no useful information on the future direction of stock prices. In other words, technical analysis  (analysis of past price fluctuations) cannot help investors. The semistrong form says that no published  information will help investors to select undervalued securities since the market has already  discounted all publicly available information into securities prices. The strong form maintains that  there is no information, public or private, that would benefit investors. The implication of both the  semi-strong and strong forms is that fundamental analysis is useless. Investors might just as well select  stocks at random.
    8. An entire book could be written on this subject alone, but one enlightening article cleverly rebuts the  efficient-market theory with living, breathing refutations. Buffett’s “The Superinvestors of  Graham-and-Doddsville” demonstrates how nine value-investment disciples of Benjamin Graham,  holding varied and independent portfolios, achieved phenomenal investment success over long  periods.
    9. In a sense, value investing is a large-scale arbitrage between security prices and underlying business  value. Arbitrage is a means of exploiting price differentials between markets.
  2. At the Root of a Value-Investment Philosophy
    1. There are three central elements to a value-investment philosophy. First, value investing is a bottom-up  strategy entailing the identification of specific undervalued investment opportunities. Second, value  investing is absolute-performance-, not relative-performance oriented. Finally, value investing is a  risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right  (return).
    2. In investing it is never wrong to change your mind. It is only wrong to change your mind and do  nothing about it.
    3. The risk of an investment is described by both the probability and the potential amount of loss. The risk  of an investment— the probability of an adverse outcome—is partly inherent in its very nature. A  dollar spent on biotechnology research is a riskier investment than a dollar used to purchase utility  equipment. The former has both a greater probability of loss and a greater percentage of the investment  at stake.
    4. Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its  beginning. Risk simply cannot be described by a single number. Intuitively we under-stand that risk  varies from investment to investment: a government bond is not as risky as the stock of a  high-technology company. But investments do not provide information about their risks the way food  packages provide nutritional data. Rather, risk is a perception in each investor’s mind that results from analysis of the probability and  amount of potential loss from an investment. If an exploratory oil well proves to be a dry hole, it is  called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a  gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren’t risky  when the investment was made? Not at all. The point is, in most cases no more is known about the risk  of an investment after it is concluded than was known when it was made. There are only a few things investors can do to counteract risk: diversify adequately, hedge when  appropriate, and invest with a margin of safety. It is precisely because we do not and cannot know all  the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a  cushion for when things go wrong.
    5. The trick of successful investors is to sell when they want to, not when they have to. Investors who may  need to sell should not own marketable securities other than U.S. Treasury bills.
  3. The Art of Business Valuation
    1. In Security Analysis he and David Dodd discussed the concept of a range of value:
      1. The essential point is that security analysis does not seek to determine exactly what is the intrinsic  value of a given security. It needs only to establish that the value is adequate—e.g., to protect a bond or  to justify a stock purchase—or else that the value is considerably higher or considerably lower than the  market price. For such purposes an indefinite and approximate measure of the intrinsic value may be  sufficient.
    2. To be a value investor, you must buy at a discount from underlying value. Analyzing each potential  value investment opportunity therefore begins with an assessment of business value. While a great many methods of business valuation exist, there are only three that I find useful. The first  is an analysis of going-concern value, known as net present value (NPV) analy-sis. NPV is the  discounted value of all future cash flows that a business is expected to generate. A frequently used but  flawed shortcut method of valuing a going concern is known as private-market value. This is an  investor’s assessment of the price that a sophisticated businessperson would be willing to pay for a  business.
    3. How do value investors deal with the analytical necessity to predict the unpredictable? The only  answer is conservatism. Since all projections are subject to error, optimistic ones tend to place investors  on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative  forecasts can be more easily met or even exceeded. Investors are well advised to make only conservative  projections and then invest only at a substantial discount from the valuations derived therefrom.
    4. The other component of present-value analysis, choosing a discount rate, is rarely given sufficient  consideration by investors. A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars. Investors with a strong preference for  present over future consumption or with a preference for the certainty of the present to the uncertainty  of the future would use a high rate for discounting their investments. Other investors may be more  willing to take a chance on forecasts holding true; they would apply a low discount rate, one that  makes future cash flows nearly as valuable as today’s. There is no single correct discount rate for a set of future cash flows and no precise way to choose one.  The appropriate discount rate for a particular investment depends not only on an investor’s preference  for present over future consumption but also on his or her own risk profile, on the perceived risk of the  investment under consideration, and on the returns available from alternative investments.
    5. A valuation method related to net present value is private-market value, which values businesses  based on the valuation multiples that sophisticated, prudent businesspeople have recently paid to  purchase similar businesses. Private-market value can provide investors with useful rules of thumb  based on the economics of past transactions to guide them in business valuation. This valuation  method is not without its shortcomings, however. Within a given business or industry all companies  are not the same, but private-market value fails to distinguish among them. Moreover, the multiples paid to  acquire businesses vary over time; valuations may have changed since the most recent similar  transaction. Finally, buyers of businesses do not necessarily pay reasonable, intelligent prices.
    6. The liquidation value of a business is a conservative assessment of its worth in which only tangible  assets are considered and intangibles, such as going-concern value, are not. Accordingly, when a stock  is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an  attractive investment.
    7. In The Alchemy of Finance George Soros stated, “Fundamental analysis seeks to establish how  underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock  prices can influence underlying values.”7 In other words, Soros’s theory of reflexivity makes the point  that its stock price can at times significantly influence the value of a business. Investors must not lose  sight of this possibility.
  4. Investment Research: The Challenge of Finding Attractive Investments
    1. Value investing by its very nature is contrarian. Out-of-favor securities may be undervalued; popular  securities almost never are. What the herd is buying is, by definition, in favor. Securities in favor have  already been bid up in price on the basis of optimistic expectations and are unlikely to represent good  value that has been overlooked.
    2. Obviously investors need to be alert to the motivations of managements at the companies in which they  invest.
  5. Portfolio Management and Trading
    1. The challenge of successfully managing an investment portfolio goes beyond making a series of good  individual investment decisions. Portfolio management requires paying attention to the portfolio as a  whole, taking into account diversification, possible hedging strategies, and the management of  portfolio cash flow. In effect, while individual investment decisions should take risk into account,  portfolio management is a further means of risk reduction for investors. Even relatively safe investments entail some probability, however small, of downside risk. The  deleterious effects of such improbable events can best be mitigated through prudent diver-sification.  The number of securities that should be owned to reduce portfolio risk to an acceptable level is not  great; as few as ten to fifteen different holdings usually suffice. Diversification for its own sake is not sensible. This is the index fund mentality: if you can’t beat the  market, be the market. Advocates of extreme diversification—which I think of as overdiversification—live in fear of company-specific risks; their view is that if no single position is  large, losses from unanticipated events cannot be great. My view is that an investor is better off  knowing a lot about a few investments than knowing only a little about each of a great many holdings.  One’s very best ideas are likely to generate higher returns for a given level of risk than one’s hundredth  or thousandth best idea.
    2. Diversification, after all, is not how many different things you own, but how different the things you do  own are in the risks they entail.
    3. Some investors buy and hold for the long term, stashing their securities in the proverbial vault for years. While such a strategy may have made sense at some time in the past, it seems misguided today.  This is because the financial markets are prolific creators of investment opportunities. Investors who  are out of touch with the markets will find it difficult to be in touch with buying and selling  opportunities regularly created by the markets. Today with so many market participants having little  or no fundamental knowledge of the businesses their investments represent, opportunities to buy and  sell seem to present themselves at a rapid pace. 
    4. Being in touch with the market does pose dangers, however. Investors can become obsessed, for  example, with every market uptick and downtick and eventually succumb to short-term-oriented  trading. There is a tendency to be swayed by recent market action, going with the herd rather than against it.  Investors unable to resist such impulses should probably not stay in close touch with the market; they would be  well advised to turn their investable assets over to a financial professional
    5. The single most crucial factor in trading is developing the appropriate reaction to price fluctuations.  Investors must learn to resist fear, the tendency to panic when prices are falling, and greed, the  tendency to become overly enthusiastic when prices are rising. One half of trading involves learning  how to buy. In my view, investors should usually refrain from purchasing a “full position” (the  maximum dollar commitment they intend to make) in a given security all at once. Those who fail to  heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying  power in reserve. Buying a partial position leaves reserves that permit investors to “average down,”  lowering their average cost per share, if prices decline.
    6. All investments are for sale at the right price. Decisions to sell, like decisions to buy, must be based upon underlying business value. Exactly when  to sell—or buy— depends on the alternative opportunities that are available. Should you hold for  partial or complete value realization, for example? It would be foolish to hold out for an extra fraction of  a point of gain in a stock selling just below underlying value when the market offers many bargains. By  contrast, you would not want to sell a stock at a gain (and pay taxes on it) if it were still significantly  undervalued and if there were no better bargains available.
  6. Investment Alternatives for the Individual Investor
    1. Obviously a manager who has achieved dismal long-term results is not someone to hire to manage  your money. Nevertheless, you would not necessarily hire the best-performing manager for a recent  period either. Returns must always be examined in the context of risk. Consider asking whether the  manager was fully invested at all times or even more than 100 percent invested through the use of  borrowed money. (Leverage is neither necessary nor appropriate for most investors.)

What I got out of it

  1. A beautiful overview on value investing from one of the all-time greats

On Howard Marks’ Memos

I spent a couple of months reading Howard Marks’ memos and have attempted to make a distilled “teacher’s reference guide” which (hopefully) describes his investing philosophy in a clear, effective, and concise manner. His focus on simple and truly important ideas throughout these nearly 30 years of memos was amazing to read about and I hope this comes across!

*The vast majority of the content is from Howard’s memos and not my own words. I’ve simply distilled, compiled, and added a few notes and references.

7 Powers: The Foundations of Business Strategy by Hamilton Helmer

Summary

  1. Helmer sets out to create a simple, but not simplistic, strategy compass. His 7 powers include: scale economics, switching costs, cornered resource, counter positioning, branding, network effects, and process.

Key Takeaways

  1. Strategy: the study of the fundamental determinants of potential business value The objective here is both positive—to reveal the foundations of business value—and normative—to guide businesspeople in their own value-creation efforts. Following a line of reasoning common in Economics, Strategy can be usefully separated into two topics: Statics—i.e. “Being There”: what makes Intel’s microprocessor business so durably valuable? Dynamics—i.e. “Getting There”: what developments yielded this attractive state of affairs in the first place? These two form the core of the discipline of Strategy, and though interwoven, they lead to quite different, although highly complementary, lines of inquiry.
  2. Power: the set of conditions creating the potential for persistent differential returns. Power is the core concept of Strategy and of this book, too. It is the Holy Grail of business—notoriously difficult to reach, but well worth your attention and study. And so it is the task of this book to detail the specific conditions that result in Power
  3. The Mantra: a route to continuing Power in significant markets. I refer to this as The Mantra, since it provides an exhaustive characterization of the requirements of a strategy.
  4. The Value Axiom. Strategy has one and only one objective: maximizing potential fundamental business value.
    1. For the purposes of this book, “value” refers to absolute fundamental shareholder value—the ongoing enterprise value shareholders attribute to the strategically separate business of an individual firm. The best proxy for this is the net present value (NPV) of expected future free cash flow (FCF) of that activity.
  5. Dual Attributes. Power is as hard to achieve as it is important. As stated above, its defining feature ex post is persistent differential returns. Accordingly, we must associate it with both magnitude and duration.
    1. Benefit. The conditions created by Power must materially augment cash flow, and this is the magnitude aspect of our dual attributes. It can manifest as any combination of increased prices, reduced costs and/or lessened investment needs.
    2. Barrier. The Benefit must not only augment cash flow, but it must persist, too. There must be some aspect of the Power conditions which prevents existing and potential competitors, both direct and functional, from engaging in the sort of value-destroying arbitrage Intel experienced with its memory business. This is the duration aspect of Power
    3. Benefits are common, and they often bear little positive impact on company value, as they are generally subject to full arbitrage. The true potential for value lies in those rare instances in which you can prevent such arbitrage, and it is the Barrier which accomplishes this. Thus, the decisive attainment of Power often syncs up with the establishment of the Barrier.
  6. Complex Competition. Power, unlike strength, is an explicitly relative concept: it is about your strength in relation to that of a specific competitor. Good strategy involves assessing Power with respect to each competitor, which includes potential as well as existing competitors, and functional as well as direct competitors. Any such players could be the source of the arbitrage you are trying to circumvent, and any one arbitrageur is enough to drive down differential margins.
  7. The 7 Powers
    1. Scale Economies
      1. Scale Economies—the First of the 7 Powers The quality of declining unit costs with increased business size is referred to as Scale Economies.
        1. Benefit: Reduced Cost
        2. Barrier: Prohibitive Costs of Share Gains
    2. Network Economies
      1. Network Economies: the value of the service to each customer is enhanced as new customers join the “network.” In such a situation, having the most customers is everything,
      2. Industries exhibiting Network Economies often exhibit these attributes: Winner take all.
    3. Counter-Positioning
      1. Counter-Positioning: A newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.
      2. This chapter introduces Counter-Positioning, the next Power type. I developed this concept to depict a not well-understood competitive dynamic I often have observed both as a strategy advisor and an equity investor. I must confess it is my favorite form of Power, both because of my authorship and because it is so contrarian. As we will see, it is an avenue for defeating an incumbent who appears unassailable by conventional wisdom metrics of competitive strength.
      3. But nearly always, these featured the same outcome: the incumbent responds either not at all or too late. The incumbent’s failure to respond, more often than not, results from thoughtful calculation. They observe the upstart’s new model, and ask, “Am I better off staying the course, or adopting the new model?” Counter-Positioning applies to the subset of cases in which the expected damage to the existing business elicits a “no” answer from the incumbent. The Barrier, simply put, is collateral damage. In the Vanguard case, Fidelity looked at their highly attractive active management franchise and concluded that the new passive funds’ more modest returns would likely fail to offset the damage done by a migration from their flagship products.
      4.  What are the potential causes of such decrements? They could be numerous, but over several decades of client strategy work, I have noted two that seem common. The first involves two characteristics of challenges to incumbency:
        1. The challenger’s approach is novel and, at first, unproven. As a consequence, it is shrouded in uncertainty, especially to those looking in from the outside. The low signal-to-noise of the situation only heightens that uncertainty.
        2. The incumbent has a successful business model. This heritage is influential and deeply embedded, as suggested by Nelson and Winter’s notion of “routines,” and with it comes a certain view of how the world works. The CEO probably can’t help but view circumstances through this lens, at least in part. Together these two characteristics frequently lead incumbents to at first belittle the new approach, grossly underestimating its potential.
        3. As noted in the Introduction, Power must be considered relative to each competitor, actual and implicit. With Counter-Positioning, this is particularly important, because this type of Power only applies relative to the incumbent and says nothing regarding Power relative to other firms utilizing the new business model.
        4. Though this isn’t always the case, I have noticed a frequently repeated script for how an incumbent reacts to a CP challenge. I whimsically refer to it as the Five Stages of Counter-Positioning: Denial Ridicule Fear Anger Capitulation (frequently too late)
        5. Once market erosion becomes severe, a Counter-Positioned incumbent comes under tremendous pressure to do something; at the same time, they face great pressure to not upset the apple cart of the legacy business model. A frequent outcome of this duality? Let’s call it dabbling: the incumbent puts a toe in the water, somehow, but refuses to commit in a way that meaningfully answers the challenge. Counter-Positioning often underlies situations in which the following developments are jointly observed: For the challenger Rapid share gains Strong profitability (or at least the promise of it) For the incumbent Share loss Inability to counter the entrant’s moves Eventual management shake-up (s) Capitulation, often occurring too late
        6. Such reversals are rare in business, because contests typically take place over extended periods and with great thoughtfulness on all sides. Even a momentary lapse by an incumbent won’t present a sufficient opening. The only bet worthwhile for a challenger is one in which even if the incumbent plays its best game, it can be taken off the board. A competent Counter-Positioned challenger must take advantage of the strengths of the incumbent, as it is this strength which molds the Barrier, collateral damage.
    4. Switching Costs
      1. Switching Costs arise when a consumer values compatibility across multiple purchases from a specific firm over time. These can include repeat purchases of the same product or purchases of complementary goods.
      2. Benefit. A company that has embedded Switching Costs for its current customers can charge higher prices than competitors for equivalent products or services. This benefit only accrues to the Power holder in selling follow-on products to their current customers; they hold no Benefit with potential customers and there is no Benefit if there are no follow-on products.
      3. Barrier. To offer an equivalent product, competitors must compensate customers for Switching Costs. The firm that has previously roped in the customer, then, can set or adjust prices in a way that puts their potential rival at a cost disadvantage, rendering such a challenge distinctly unattractive. Thus, as with Scale Economies and Network Economies, the Barrier arises from the unattractive cost/benefit of share gains for the challenger.
      4. Switching Costs can be divided into three broad groups:
        1. Financial.
        2. Procedural.
        3. Relational.
        4. Switching Costs are a non-exclusive Power type: all players can enjoy their benefits.
    5. Branding
      1. Branding is an asset that communicates information and evokes positive emotions in the customer, leading to an increased willingness to pay for the product.
      2. Benefit. A business with Branding is able to charge a higher price for its offering due to one or both of these two reasons:
        1. Affective valence. The built-up associations with the brand elicit good feelings about the offering, distinct from the objective value of the good.
        2. Uncertainty reduction. A customer attains “peace of mind” knowing that the branded product will be as just as expected.
      3. Barrier. A strong brand can only be created over a lengthy period of reinforcing actions (hysteresis), which itself serves as the key Barrier.
      4. Brand Dilution. Firms require focus and diligence to guide Branding over time and ensure that the reputation created remains consistent in the valences it generates. Hence, the biggest pitfall lies in diminishing the brand by releasing products which deviate from, or damage, the brand image. Seeking higher “down market” volumes can reduce affective valence by damaging the aura of exclusivity, weakening positive associations with the product.
      5. Problem is, the qualities that make Branding a Power also make it hard to change; the considerable risk is dilution or brand destruction.
      6. Type of Good. Only certain types of goods have Branding potential as they must clear two conditions:
        1. Magnitude: the promise of eventually justifying a significant price premium. Business-to-business goods typically fail to exhibit meaningful affective valence price premia, since most purchasers are only concerned with objective deliverables. Consumer goods, in particular those associated with a sense of identity, tend to have the purchasing decision more driven by affective valence. Here’s the reason: in order to associate with an identity, there must be some way to signal the exclusion of alternative identities.
        2. For Branding Power derived from uncertainty reduction, the customer’s higher willingness to pay is driven by high perceived costs of uncertainty relative to the cost of the good. Such products tend to be those associated with bad tail events: safety, medicine, food, transport, etc. Branded medicine formulations, for example, are identical to those of generics, yet garner a significantly higher price. Duration: a long enough amount of time to achieve such magnitude. If the requisite duration is not present, the Benefit attained will fall prey to normal arbitraging behavior.
    6. Cornered Resource
      1. Cornered Resource definition: Preferential access at attractive terms to a coveted asset that can independently enhance value.
      2. Benefit. In the Pixar case, this resource produced an uncommonly appealing product—“superior deliverables”—driving demand with very attractive price/volume combinations in the form of huge box office returns. No doubt—this was material (a large m in the Fundamental Equation of Strategy). In other instances, however, the Cornered Resource can emerge in varied forms, offering uniquely different benefits. It might, for example, be preferential access to a valuable patent, such as that for a blockbuster drug; a required input, such as a cement producer’s ownership of a nearby limestone source, or a cost-saving production manufacturing approach, such as Bausch and Lomb’s spin casting technology for soft contact lenses.
      3. Barrier. The Barrier in Cornered Resource is unlike anything we have encountered before. You might wonder: “Why does Pixar retain the Brain Trust?” Any one of this group would be highly sought after by other animated film companies, and yet over this period, and no doubt into the future, they have stayed with Pixar. Even during the company’s rocky beginning, there was a loyalty that went beyond simple financial calculation.
      4. Our general term for this sort of barrier is “fiat”; it is not based on ongoing interaction but rather comes by decree, either general or personal.
      5. Another way to put this is that a Cornered Resource is a sufficient condition for potential for differential returns.
    7. Process Power
      1. I save it until last because it is rare. I will use the Toyota Motor Corporation as a case.
      2. Perhaps the best way to think of it is this: Process Power equals operational excellence, plus hysteresis. Having said that, such hysteresis occurs so rarely that I am in strong agreement with Professor Porter’s sentiments.
      3. Benefit. A company with Process Power is able to improve product attributes and/or lower costs as a result of process improvements embedded within the organization. For example, Toyota has maintained the quality increases and cost reductions of the TPS over a span of decades; these assets do not disappear as new workers are brought in and older workers retire.
      4. Barrier. The Barrier in Process Power is hysteresis: these process advances are difficult to replicate, and can only be achieved over a long time period of sustained evolutionary advance. This inherent speed limit in achieving the Benefit results from two factors:
        1. Complexity. Returning to our example: automobile production, combined with all the logistic chains which support it, entails enormous complexity. If process improvements touch many parts of these chains, as they did with Toyota, then achieving them quickly will prove challenging, if not impossible.
        2. Opacity. The development of TPS should tip us off to the long time constant inevitably faced by would-be imitators. The system was fashioned from the bottom up, over decades of trial and error. The fundamental tenets were never formally codified, and much of the organizational knowledge remained tacit, rather than explicit. It would not be an exaggeration to say that even Toyota did not have a full, top-down understanding of what they had created—it took fully fifteen years, for instance, before they were able to transfer TPS to their suppliers. GM’s experience with NUMMI also implies the tacit character of this knowledge: even when Toyota wanted to illuminate their work processes, they could not entirely do so.
  8. The Path to Power: “Me Too” Won’t Do
    1. Here’s the first important takeaway from our consideration of Dynamics: “getting there” (Dynamics) is completely different from “being there” (Statics). In other words, to assess which journeys are worth taking, you must first understand which destinations are desirable. Fortunately the 7 Powers does exactly that: it maps the only seven worthwhile destinations.
    2. The first cause of every Power type is invention, be it the invention of a product, process, business model or brand. The adage “‘Me too’ won’t do” guides the creation of Power.
    3. Planning rarely creates Power. It may meaningfully boost Power once you have established it, but if Power does not yet exist, you can’t rely on planning. Instead you must create something new that produces substantial economic gain in the value chain. Not surprisingly, we have worked our way back to Schumpeter.
    4. Power arrives only on the heels of invention. If you want your business to create value, then action and creativity must come foremost. But success requires more than Power alone; it needs scale. Recall the Fundamental Equation of Strategy: Value = [Market Size] * [Power]
    5. Invention has a powerful one-two value punch: it both opens the door for Power and also propels market size.
  9. Other
    1. By far the most important “value moment” for a business occurs when the bars of uncertainty are radically diminished with regards to the Fundamental Equation of Strategy, market size and Power. At that moment, the cash flow future makes a step-change in transparency.
    2. A primary driver of opacity is high flux: if a business is in a fast-changing environment, then the information facing investment pros tends to have much higher uncertainty bars regarding future free cash flow. But high flux also attends the sort of conditions which orbit the “value moment.” So if the 7 Powers can lead to alpha by identifying Power in these situations ex ante, it also promises to be useful in doing the same for those inventors on the ground trying to find a path to satisfy The Mantra.
    3. The 3 S’s. Power, the potential to realize persistent differential returns, is the key to value creation. Power is created if a business attribute is simultaneously:
      1. Superior—improves free cash flow
      2. Significant—the cash flow improvement must be material
      3. Sustainable—the improvement must be largely immune to competitive arbitrage

What I got out of it

  1. Helmer provides a simple, but not simplistic, strategy framework in which to analyze, build, invest in companies. SSCCBNP – scale economies, switching costs, cornered resource, counter positioning, branding, network effects, process. The book is well worth reading and re-reading. The real world examples he gives relating to his framework are helpful to better understand it all.