Book Review: University of Berkshire Hathaway

“It can’t possibly be this easy!”

A first time attendee of a Berkshire Hathaway annual meeting might find it hard to believe that there could be any skeptics in the crowd.  In contrast to the boring, useless, and perfunctory meetings held by nearly all publicly traded companies, Berkshire’s annual meeting resembles a combination of a carnival and shopping mall.  Tens of thousands of admiring fans of Warren Buffett and Charlie Munger flock to Omaha every spring to shop, socialize, and listen to words of wisdom.  However, after attending several meetings over the past eighteen years, I can confirm that there are indeed some skeptics and the most common criticism of the Buffett and Munger investing system is that  “It can’t possibly be this easy!”

Daniel Pecaut and Corey Wrenn run an Iowa based investment firm and have been regular attendees of Berkshire Hathaway annual meetings for over thirty years.  Their meeting notes form the raw material for their recent book, University of Berkshire Hathaway.  Over the past three decades, Berkshire’s meetings have grown from approximately 500 attendees to over 40,000 and the events have become much more elaborate and carnival-like.  However, the core message delivered by Warren Buffett and Charlie Munger has never really changed.  While it is true that the types of businesses Berkshire has purchased have changed dramatically, most notably tilting toward capital intensive businesses in recent years, the underlying desire to purchase excellent businesses at fair prices has never wavered.  The Berkshire Hathaway investment approach can be characterized as “simple”, at least on the surface, but in the world of finance, doing what is “simple” is not always “easy”.  There are institutional biases that clearly favor doing what is complex over what is apparently simple.

Physics Envy

Traditional curriculum in finance has long been based on the notion of market efficiency.  This supposed efficiency renders nearly all attempts to outperform the market to be akin to tilting at windmills.  And there is an element of truth in this claim.  Most markets are probably “efficient” most of the time.  The error is extrapolating “most of the time” to “all the time”.

The underlying assumption of market efficiency does make it possible to represent markets with equations that are seemingly as precise as formulas representing natural phenomena in physics.  Business and investing could now be a “real science” and professors in the field could be accorded the respect that comes along with scientific recognition.  The most famous formula in academic finance is probably the capital asset pricing model, but, of course, there are many other more specialized formulas such as the Black Scholes Model for pricing options.

These academic models, by providing apparent scientific precision in a field of social science, introduce a certain level of complexity and a requirement that market participants demonstrate a minimum level of numeracy.  No one would deny the need for a physicist to have a certain fluency in higher mathematics but, in the field of investing, Warren Buffett has long asserted that nothing more than basic mathematics is required.  If that is the case, much of the progress in the field of finance over the past half century was a waste of time.  And it is actually worse than that:  many academic models have been colossal failures in practice and the consequence has been blow-ups in the real economy.

The Buffett/Munger System

So what is the Buffett and Munger approach?  Attendees of Berkshire Hathaway annual meetings know that the leaders of the company constantly harp on topics such as understanding a company’s moat, evaluating the skills of the managers running the business, ensuring that one does not pay silly prices, and perhaps above all, insisting on a high degree of integrity.  It is true that relatively arcane topics related to accounting sometimes come up, but typically these sermons have to do with accounting rules that distort actual business results – in other words, complexity that detracts from the fundamental simplicity of investing.

But “simple” doesn’t necessarily mean “easy”.  Not by a long shot.  The judgment required to understand a business and make an evaluation of intrinsic value can take years to develop.  As Charlie Munger has emphasized for decades, one must obtain a certain amount of “worldly wisdom” in a variety of fields.  Through a multi-disciplinary approach of lifelong learning, anyone with a reasonably high IQ (think 120 rather than 180) should be able to accumulate a working understanding of enough “mental models” to be ready to strike when opportunity presents itself.  The concepts are simple but obtaining the worldly wisdom requires years and decades of sustained effort.  And the sustained effort and concentration required to obtain worldly wisdom is anything but “easy” for most people to accomplish in the age of Twitter and other distractions.

The Annual Meetings

The next best thing to attending a Berkshire Hathaway meeting (or, more recently, viewing the webcast) is to read accounts of the meetings which have become increasingly available over the years.  Prior to purchasing my first shares of Berkshire Hathaway in 2000, I read and re-read Lawrence Cunningham’s compilation of Warren Buffett’s letters to shareholders.  This compilation has since been updated to include all letters through 2015.  Much of what is covered at annual meetings is also discussed in annual letters to shareholders and this collection provides tremendous insight into the Berkshire system.  Mr. Cunningham’s compilation is arranged by topics rather than years so one can read all of Mr. Buffett’s thoughts on mergers and acquisitions, for example, spanning several years.  This is very useful, although reading the letters chronologically (available for free at Berkshire’s website) is also very useful.

Mr. Pecaut and Mr. Wrenn chose to present their meeting notes on a year-by-year basis which provides a contemporaneous account of the annual meetings.  Their book is not a transcript of the Berkshire meetings but rather a set of curated notes that highlight the topics that they found most interesting.  The notes tend to be longer for the later meetings which is probably mostly because the length of the annual meetings increased from two and a half hours in 1986 to well over five hours in recent years.  They made a point to present the notes as a historical record, that is, mostly unaltered from when they took the notes and sent them to their clients.  This is valuable because the commentary is not impacted by hindsight bias.  For example, Mr. Buffett’s glowing account of David Sokol in the early 2000s remains intact despite Mr. Sokol’s fall from grace in 2011. Similarly, many of Mr. Buffett’s comments on macroeconomic factors, particularly inflation, proved to be incorrect but those notes are left intact.  No one is infallible and the contemporaneous account of these judgments, later proven to be in error, highlight the wisdom of Mr. Buffett’s admonition to avoid investing based on macroeconomic factors.

While readers mostly benefit from the fact that the authors do not alter their notes based on subsequent information, it might have been valuable to include a small commentary after each year to note material subsequent developments.  One of the problems with the book is that it is difficult to read all of the notes on specific topics (such as inflation) because there is no index.  One must go year by year and rely on taking notes to consolidate comments on specific topics.  Perhaps this is not a problem for those who read books electronically, but it can be a little frustrating for those of us who still read physical books.  All books of this type should really feature a complete index.

Despite the small shortcomings, anyone interested in Berkshire Hathaway will find this book interesting.  Serious students of Warren Buffett and Charlie Munger will certainly want to also read the annual letters, either chronologically or through Mr. Cunningham’s compilation (or, better yet, both!).

Certain shareholders used to take pride in how cheaply one could travel to Omaha and attend the Berkshire Hathaway annual meeting.  Back in 2000, it was possible to stay downtown at non-outrageous prices, car rentals were reasonable, and it was common to walk in off the street and get a table for dinner at an Old Market restaurant after the meeting. Back then, “tuition” including airfare, lodging and meals could often be had for well under $500.

Today, the cost of attending Berkshire Hathaway meetings has become prohibitive because the 40,000+ attendees overwhelm the small city’s capacity.  For the past two years, Berkshire has webcast the annual meeting (a step we advocated back in 2010) with little impact on the number of attendees.  The annual meeting is still worth attending in person at least once to see the carnival atmosphere and, for some, to shop at a discount.  The rest of us can obtain a university class education in business simply by streaming the meeting over the internet.  As of the date of this article, the 2017 meeting livestream is still available.  Watch the webcast online for free and then buy ten or more B shares with the savings.

Disclosures:  The Rational Walk LLC received a review copy of the book.  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Book Review: The Man Who Sold America

“The settling of the country, the machine age, the coming of the automobile, telephone, movies, radio, the advances in fine arts and all the sciences, demanded that our capacity to accept and use new ideas be developed to a point never before seen on the pages of history.”

— Albert Lasker

The twentieth century was characterized by massive technological changes that impacted the course of human history in ways that would make the world of 2000 nearly unrecognizable to individuals living a century before.  Most people living today view consistent advances in standard of living to be the norm.  However, the steady advance of living standards is really a story of the past two centuries.  The family of 1800 shared much in common with the way of life of their ancestors in 1700 and 1600.  But by the early 20th century, per capita GDP had more than quadrupled from levels seen in the early 19th century.  Cynics of the early 1900s who thought that living standards had finally plateaued were quite mistaken.  Progress dramatically accelerated.  From 1913 to 2008, per-capita GDP increased nearly six-fold.

As Steve Jobs famously observed, people often do not know what they want until you show it to them.  When brand new products are introduced, consumers do not automatically line up to make purchases because the underlying need has yet to be established.  Whether the novel product is a disposable handkerchief in the 1920s, a refrigerator in the 1930s, or the iPhone in 2007, consumers need a compelling reason to part with substantial amounts of their hard earned cash.  They need a “reason why” the product should be purchased.  What does the product do for them that they previously had not conceived of?  How will it become an indispensable part of their lives?  Advertising, whether in print, over the airwaves, or on the internet, must provide a coherent storyline that consumers can embrace.  Few people in the 1950s would question the need for a refrigerator just as few today would question the need for a smartphone.  Advertising was the spark that created the initial demand.

The Advertising Century

The story of Albert D. Lasker, as told in The Man Who Sold America, is synonymous with the story of how advertising transformed the American economy during the first half of the 20th century.  Constant technological progress was a given for Lasker who was born in 1880 and grew up in booming Galveston at a time when the city was the center of trade in Texas and rivaled New Orleans as one of the nation’s largest ports.  Lasker showed streaks of entrepreneurialism as a child.  However, his passion was not in advertising but in journalism and by the age of sixteen, he was already scoring scoops and writing for the local newspaper.  Although Lasker said that “every urge in me was to be a reporter”, his father did not approve of the “drunkenness and debauchery” then common among reporters.  Lasker’s father called in a favor with Daniel Lord, one of the principals of Lord & Thomas, and Lasker soon moved to Chicago to embark on his career in advertising at the young age of 18.

Being forced into a career choice by one’s parents typically does not turn out well but Lasker’s case was an exception.  He found that he not only was exceptionally good at sales but enjoyed the work and rapidly advanced within the firm.  This was fortuitous because shortly after Lasker married in 1902, his wife contracted typhoid fever and became permanently disabled.  Facing very large medical bills, Lasker gave up any remaining dreams of switching to journalism:  “From then on, I had to concentrate on work, and from then on, I knew I was fooling myself that I would ever get out of advertising.”  By early 1904, Lasker was considering striking out on his own after achieving notable success marketing products such as Van Camp’s canned pork and beans.  At the insistence of Frank Van Camp, Lasker was made a one-quarter partner in Lord & Thomas on February 1, 1904 at the age of 23.  Following the death of Ambrose Thomas in 1906, Lasker became the leader and half owner of Lord & Thomas and by 1912 he had achieved full control of the firm which he would control for the next three decades.

Readers with an interest in advertising and marketing will find the story of Lasker’s leadership of Lord & Thomas to be particularly fascinating.  Lasker went on to pioneer many advertising techniques including “reason why” advertising and figuring out ways to measure the effectiveness of individual advertisements.  Advertising had been largely unscientific and it was difficult to measure the impact of spending by clients.  There’s an old joke that half of advertising spending is wasted but the problem is that no one knows which half.  Lasker used mail order advertisements to test and validate various approaches.  He would run variations of print advertisements and test the response rate of different variations, and then concentrate resources on those techniques that had proven effective.  This might sound familiar to those who have employed “A/B testing” in contexts such as web sites.  Lasker’s notable achievements include inventing the Sunkist and Sun-Maid brands, broaching the sensitive topic of how to market sanitary napkins with the Kotex brand, dramatically improving the performance of products such as Palmolive soap and Pepsodent toothpaste, and perhaps more controversially, expanding the appeal of Lucky Strike cigarettes to women.  Lasker, who died in 1952, is the man most responsible for transforming the advertising industry and ushering in a century of ever increasing demand for consumer products.

Advertising Today

Albert Lasker did not live to see the dawning of the Information Age and the amazing consumer products that have surfaced over the past several decades.  What can we learn from his life and legacy that might be relevant to today’s world?

It might be tempting to say that the world is so different today that few of Lasker’s insights and contributions are relevant, but this would be a hasty conclusion. “Reason why” advertising is just as relevant today as it was a century ago.  Perhaps the most salient example involves a product that no one viewed as essential a decade ago:  the smart phone.  Sure, cell phones were common during the 1990s and were viewed as important tools, but today smart phones might as well be permanent appendages for a majority of people in wealthy countries.

What changed?

The iPhone, much ridiculed by certain competitors, featured a virtual keyboard and was, quite simply, a fully featured computer that fit in one’s pocket.  Lacking the rigid physical alphanumeric keyboard featured on competing products, the iPhone could transform itself from a mere telephone to a web browser and innumerable other applications, none of which were considered “essential” by consumers prior to the product’s introduction in 2007.  But the product was initially met with much skepticism.  It took a marketing genius to convince the public that the product had mass appeal.  Steve Jobs may or may not have been inspired by Albert Lasker but he understood “reason why” advertising.  He did not respond to the current demands of consumers.  He created new demand for an entirely new product by explaining the benefits of the product and showing how it would be an indispensable part of our lives.

Mass media is still the driving force behind most advertising, although highly personalized advertising is now possible online and is being fully exploited by companies such as Facebook and Google.  Mass market advertising in print, television and radio still bears much resemblance to advertising from many decades ago and adheres to the same underlying principles pioneered by Albert Lasker.  It seems highly probable that mass market advertising will always exist in one form or another, but it is also undeniable that personalizing advertising has enormous advantages that will be fully exploited in the decades to come.  It is enormously valuable to know who one is speaking to in an advertisement.  One cannot know that when presenting a print ad in a newspaper or broadcasting an advertisement on traditional television.  One can know exactly who the target is when advertising online and on smart televisions connected to the internet.

Are traditional advertising agencies obsolete today?  To what extent are companies like Google and Facebook “disruptors” to traditional advertising?  The need to communicate information to potential consumers has not gone away by any means.  Indeed, the competitive landscape is just as challenging today as it has ever been, if not more so.  So the need to formulate compelling messages to entice consumers to purchase products has not gone away, and it seems very unlikely that this need will ever go away.  The internet in general and personalized advertising in particular are important changes to the industry that have the potential to make advertising much more targeted and effective.  However, the creative skills that were brought to bear during the early days of advertising are still relevant today, and probably more so because good personalized advertising is more difficult to accomplish effectively, not easier.

When radio was first appearing as a new platform for advertising, Albert Lasker was initially skeptical but eventually came to embrace it once it had been proven to be effective.  Radio and television were massive changes for the advertising industry but what remained constant is the fact that most messages were intended for the mass market.  What is different about the internet is the potential for more targeting but ultimately the internet is simply another platform.  The core competency of major platforms like Google and Facebook does not appear to involve the creative side of advertising.  Coming up with effective messages will always be in demand and the major players in the industry have embraced this reality organically and through acquisition of specialized digital marketing firms.

The advertising industry has consolidated rapidly over the past few decades and is now dominated by a small number of large players such as WPP, Omnicom, Publicis, and Interpublic.  These large firms are essentially holding companies for smaller individual agencies that have been acquired over many years.  Client turnover in the industry is relatively low and most companies do not change advertising agencies frequently.  Advertising firms with longstanding client relationships do not typically require tangible equity to operate, have negative working capital requirements, and throw off significant free cash flow.  However, market participants have lately expressed skepticism regarding the long term durability of these business models.  While it remains to be seen whether these fears are realized, value investors might do well to examine the advertising industry carefully.

Individuals associated with The Rational Walk LLC own shares of Omnicom.

Note to readers:

I have received a number of inquiries recently regarding The Rational Walk’s presence on “social media”, especially Twitter.  Not participating on social media in recent months has been a conscious decision made after much consideration of the amount of “noise” on social media.  The “noise” vastly overwhelms any “signal”, and this was just as true for The Rational Walk’s Twitter content as for most other accounts.  The value of posting or reading social media is very limited.  Even worse, by looking at social media multiple times per day, one engages in “context switching” that is toxic to concentration and development of deeper fluency in any subject.  For readers who are on social media, links to any future articles will appear on Twitter, Facebook, and LinkedIn but any other activity will be very rare.

Book Review: Blockchain Revolution

The idea of cutting out the middleman has always been an attractive concept because doing so promises to lower costs and produce potential benefits for both sides of a commercial transaction.  However, the role of intermediaries in the economy has persisted in a number of areas for very good reasons.  The most obvious example of an intermediary involves financial institutions.  The role of a bank, in very simplified form, has always been to attract deposits from those with excess capital and to lend out that capital to borrowers in need of funds.  The reward for acting as an intermediary is the bank’s net interest margin – the difference between the interest charged to borrowers and the interest paid to depositors.

The world is full of other intermediaries that facilitate transactions between producers and consumers.  For example, Uber and Airbnb are both essentially middlemen that take a cut of all transactions in exchange for providing a platform.  Platforms allow providers of a service to be visible to a large number of potential consumers.  In addition, a platform is supposed to provide a safe and secure means of transacting and also disseminates information on reputation.  The retail world is full of intermediaries.  For example, a car dealership theoretically exists in order to connect drivers with manufacturers and provide additional value-added services.

Anyone who follows developments in financial markets is familiar with bitcoin, the cyptocurrency conceived by a pseudonymous person or group known as “Satoshi Nakamoto” in 2008.  Bitcoin has been shrouded in mystery and intrigue ever since it was created.  The value of bitcoin has fluctuated widely, ranging from under a dollar when it was created to nearly $1,200 today, and the currency has not been free of scandal and controversy.  What gives this currency any intrinsic value?  Is it real or a ponzi scheme?  As interesting as these questions are, the real story has been largely missed in the media.  The technology that makes bitcoin possible, called blockchain, is arguably far more important that bitcoin itself.  This is the topic of Blockchain Revolution by Don and Alex Tapscott, a father and son team that set out to interview dozens of important players immersed in this emerging technology and to make sense of the implications for the economy in general.

Blockchains represent encrypted digital distributed ledgers that do not rely on any form of centralized storage or control.  Blockchains are public and transactions are verified by multiple nodes on the network. Each set of transactions in a blockchain is stored in a unit called a “block” which is linked to the preceding block.  This creates an immutable chain of transactions that is permanently time stamped.  It is impossible to alter the contents of any transaction without somehow taking control of a majority of nodes in the network and rewriting the history of all subsequent transactions in the chain.  In the case of bitcoin, significant computing power is required to process transactions and those who provide such resources are known as “miners”.  In exchange for proof of work solving a non-trivial problem, miners are awarded with bitcoin for facilitating and verifying transaction activity.  No central authorities are necessary or required with all transactions in a bitcoin block being verified every ten minutes, on average.

The book provides a general overview of how blockchain works but those who desire a more technical description will be disappointed.  The Tapscotts appear to have targeted their book toward the “business reader” – in other words, individuals who are in a position to utilize the technology rather than those who would implement it.  The problem is that without a technical appendix, the more technical reader may lack confidence in the claims that the authors make regarding the safety and efficacy of the distributed network.

Perhaps the most exciting aspect of blockchain is the potential within the field of financial services.  The authors present an important case study regarding the difficulties facing migrants who routinely send funds to relatives in their home countries.  The costs imposed by intermediaries such as Western Union can be extremely high relative to the modest sums that are sent.  The concept of using blockchain to facilitate these transactions promises to eliminate the middleman and dramatically lower, if not eliminate, costs.  With the widespread adoption of mobile phone technology in the developing world, there is no theoretical reason why migrants in rich countries cannot utilize blockchain to send funds directly to relatives in their home countries.  The need for the 500,000 Western Union locations throughout the world would disappear with widespread adoption of the technology.

The authors believe the blockchain has the potential to facilitate direct contracts between consumers and service providers, effectively cutting middlemen like Uber and Airbnb out of the equation.  Blockchain has the ability to handle very complex contracts and transactions and can also disseminate trust information through the chain.  For example, it would be possible for an American to directly seek out homeowners in Paris who might have an extra room available, to read reviews from others who have used the room, and to establish contractual payment terms that set out the details of when funds should be released.  The blockchain could even handle the transmission of a smart code to unlock the home once payment has been verified, eliminating the annoying need to personally receive a key.  The need for Airbnb would be eliminated along with its cut of the transaction.

While the concept of blockchain holds a great deal of appeal, the book begins to get repetitive in later chapters and the authors perhaps reach too far when it comes to the promise of blockchain to “rebuild government and democracy”.  The conceptual idea of using blockchain to improve voting practices and solve related problems might be attractive but it will take a very long period of time before such technologies are accepted and well understood, if such a time ever comes.  People understand and generally have confidence in low technology solutions like paper ballots that can be recounted.  Will such confidence exist with the blockchain proposals the authors make to improve the democratic process?

Returning to the question of bitcoin, one must closely examine the incentives government has when it comes to cryptocurrencies that have no central banking authority and leaves government with no control over monetary policy.  The U.S. government has insisted on treating bitcoin as an asset, meaning that every single transaction involving the currency will involve a capital gain or loss for the user.  This is a non-starter in terms of allowing bitcoin to operate as a medium of exchange.  It is likely that those who are transacting in bitcoin today are doing so in order to profit from changes in the price of the currency rather than to utilize it as a medium of exchange.  Governments are not going to readily accept the lack of control over monetary policy or the anonymity possible through the blockchain.

Blockchain Revolution presents an interesting concept and attempts to simplify the details to the point where the general business reader will understand the potential of blockchain.  It could be an interesting read for those who wish to approach the subject with these limitations.  However, many readers will seek a deeper understanding of blockchain.  In addition, those who just want a surface level overview could accomplish that objective by reading a number of free resources on the internet.  One cannot help but get the feeling that this book could have been condensed into a much shorter format or, alternatively, supplemented with a much more technical appendix.  The end result is that it is not entirely satisfying for either the business or technical reader.

Via Negativa: Wisdom Through Subtraction

Modern life is full of opportunities to seek wisdom and knowledge by adding new sources to our information diet.  If reading one newspaper is a good idea, perhaps adding a second or third will generate further enlightenment.  If a tidbit or two of information can be found on Facebook, then maybe adding Twitter, LinkedIn, or other social networks will reveal additional tidbits.  There are always numerous new books, many of which should have instead been a series of blog posts, purporting to solve complicated problems by adopting new ways to achieve some seemingly important objective.  The problem is that in our modern world, the noise can become overwhelming and any relevant signals can easily be lost in the cacophony.  Look around in any public setting and you will see people glued to their smart phones consuming “information”, some even while driving their cars or walking across busy intersections completely oblivious to the real world surrounding them.

Library of Congress

Bill Gates has long been known to take semi-annual retreats where he goes into seclusion for seven days in order to ponder various topics.  These retreats, which he characterizes as “think weeks”, were originally intended to consider Microsoft’s future but most likely have taken a broader view as Mr. Gates turned his attention toward philanthropy in recent years.  Removing oneself from the noise of day to day life is sometimes a pre-requisite for gaining insights.  In some cases, it is a requirement.  Inspired by the concept of a “think week”, I recently decided to disconnect for a few days with the goal of reading books, limiting consumption of news, completely eliminating consumption of and participation in “social media”, and giving myself the space to … think about various topics.

The silence was overwhelming.

Less Is Much More 

The concept of subtractive knowledge is discussed in quite a bit of detail in Nassim Nicholas Taleb’s Antifragile, one of the books in the Incerto series.  In life, understanding what to avoid is more important than constantly searching for positive advice to do something new. This is expressed well in the following brief excerpt:

“So the central tenet of the epistemology I advocate is as follows: we know a lot more what is wrong than what is right, or, phrased according to the fragile/robust classification, negative knowledge (what is wrong, what does not work) is more robust to error than positive knowledge (what is right, what works).  So knowledge grows by subtraction much more than by addition — given that what we know today might turn out to be wrong but what we know to be wrong cannot turn out to be right, at least not easily.  If I spot a black swan (not capitalized), I can be quite certain that the statement “all swans are white” is wrong.  But even if I have never seen a black swan, I can never hold such a statement to be true.”

Translated into the concept of a “think week”, the first and most obvious benefit was surprisingly not the content in the books I had selected to read but in the absence of the noise and useless chatter of everyday life that I left behind.  I did not completely avoid the news but strictly limited my news diet to thirty minutes right after waking up in the morning and I did not return to any form of news until late in the day.  I banned all forms of social media, turned off the ringer on my phone, and responded only to personal correspondence.  Doing this was equivalent to a fog lifting and facilitated the ability to think.  Therefore, without even turning the page of the first book I had selected, I had gained mental bandwidth by subtraction of “news” and chatter — Via Negativa.

Social Media and Emerging Events

Anyone who has been active on social media knows that reasoned discussion is rare and meaningless chatter is the norm.  On Twitter, in particular, the vast majority of “fintwit” participants are looking for actionable information that they can trade on … immediately.  Others are there for nefarious reasons such as hyping a company that they are long or attacking a company that they are short. The majority of accounts seem to be anonymous which could be understandable if they are not financially independent and rely on the benevolence of an employer who they are afraid of offending.  In general, it is best to judge these accounts based on the quality of their content rather than their anonymity, but if one chooses to not be anonymous yet interact with anonymous accounts, an important asymmetry exists in which one side is accountable for their actions while the other is not.

The following example is not related to investments but perfectly illustrates the group think and noise prevalent on the internet in general and social media in particular.

On April 4, 2017 reports of a chemical weapons attack on the town of Khan Shaykhun in Syria horrified anyone with access to the internet who observed the pictures of dead and dying civilians, many of whom were innocent children.  In the hours immediately after the attack, before any facts where known regarding the situation, it quickly became apparent that it was not permissible to even ask the following basic questions regarding the attack:

  1. Are we sure that Syrian dictator Bashar Assad ordered and oversaw the attack?
  2. Did Assad have an incentive to order such an attack?
  3. Is it possible that one or more of the rebel groups executed a “false flag” operation intended to frame the Assad regime and generate a U.S. response?
  4. Did Assad lose control of his military chain of command – was the attack unauthorized?
  5. Are we sure that Russia was involved?  What are the motives/incentives?

The only permissible opinion, both in “polite company” as well as the noise of the internet was to unequivocally declare that Assad ordered and oversaw the attack.  Anyone who dared to even ask the additional questions above was immediately branded an Assad regime apologist or, more commonly, a stooge of Russian President Vladimir Putin, an ally of the Assad regime.

Three days later, on April 7, the Trump Administration launched 59 cruise missiles in an attack on the Shayrat Air Base where the administration believed planes took off to execute the attack on Khan Shaykhun.  Yet the attacks failed to halt the use of the base for Syrian flights which resumed shortly after the attack.  Asking any of the following questions was deemed to be not only politically incorrect but disloyal:

  1. What was the goal of the operation and was it fulfilled if the air base was again being used for Syrian flights shortly after the attack?
  2. Were the benefits of attacking an air base with Russian troops present outweighed by the benefits of the attack – and, if so, please name the benefits.
  3. What U.S. interests were involved and why was Congress not asked to authorize the attack?
  4. What is the evidence that further chemical attacks will now be thwarted, whether by the Syrian regime or by rebel forces?
  5. What makes us confident in current intelligence reports given prior intelligence reports stating that 100% of chemical weapons were removed from Syria?

On April 11, four days after the missile attacks on the Shayrat Air Base, the Trump Administration released declassified information that supports the decision to attack.  The declassified report, drawing on information provided by the military and intelligence services, appears to answer some of the questions posed above.

Silencing the Jackals

There is a certain asymmetry that one must understand on social media – if one is not anonymous and chooses to interact with those hiding behind a cloak of anonymity, prepare for relentless attack if you have several thousand followers and have expressed a non-consensus view – whether it is about a particular investment or the wisdom of engaging in warfare.

What is clear is that social media, despite claims to the contrary, does not add to the discussion during times when news is breaking and the facts are foggy, at best.  There might be some exceptions when it comes to verifiable eyewitnesses, but the commentary from observers removed from the action is of very little value.  Removing such information actually adds to knowledge by eliminating mental pollution.  

One of the common sentiments on Twitter, in response to posts where some of these questions on Syria were asked, was to inform me that I should “stick to my topic” – presumably meaning investing.  But who other than the individual gets to decide what “his topic” should be, particularly when we are talking about a free website?

Nassim Taleb came up with the concept of “F*** You Money”, which in other words means that an individual has the financial freedom to say goodbye to his employer, if warranted.  Much the same, when it comes to social media, one has the right to say “F*** You” to those who would even suggest that one should “stick to” some predefined topic that they approve of.  In the case of social media, that means an unconditional policy of blocking any and all such “critics”, to say nothing of the many who would threaten or engage in personal attacks with knowledge of my identity.

Taking the Best, Discarding the Worst

Why does anyone choose to engage with others on social media, particularly strangers, and particularly when there is an asymmetry created by not being anonymous in a sea of anonymity?  Self interest should be the main guiding light.  Disagreements on principle or concepts, as long as they are informed, should be sought out because by doing so we can counteract tendencies to become wedded to our prior beliefs.  Testing ideas can also be beneficial, although I am highly skeptical of the wisdom of widely sharing investment ideas, particularly because of the negative psychological effects this can cause.  But any form of unethical or intellectually devoid discussion, particularly straw man arguments (“You don’t care about the children who were gassed!”, “You must be short that stock”, “You should be running a 7/11 or a Comfort Inn”, “You are a stooge of Putin”, “You must hate puppies”) should immediately result in blocking the individual, no warnings given.

Via Negativa is a good way to view life in general and it seems to have special applicability when it comes to “information” that we are inundated with on a daily basis.  Little additional insight seems to occur when spending two hours with newspapers compared to fifteen to thirty minutes (at the most).  Hardly any loss occurs when eliminating social media interactions entirely.  Turning off the cell phone and taking a walk while actually observing the world is more conductive to thinking about a topic, in some depth, than being constantly connected.  Removing bad elements from your life can be far more conducive to acquisition of wisdom than adding something new.

This is not to say that the acquisition of worldly wisdom is not important.  It is vitally important, particularly to venture beyond one’s narrow discipline in order to acquire the best knowledge from other fields.  However, Via Negativa applies when venturing into new territory as well.  Taking the best from the field, preferably focusing on old sources that have stood the test of time, is preferable to reading blog posts or new bestsellers in the field.

Lest we skip an obvious point, only the reader can decide whether this article in particular or the website in general is additive to his or her knowledge.  It is perfectly possible that this content is a net negative – “information” that is not helpful and should be eliminated from your information diet.

Book Review: A Man For All Markets

The team of six, three men and three women, pretended not to know each other and made their way to the baccarat tables at the Dunes casino in Las Vegas.  It was the spring of 1963 and Las Vegas was still controlled by shady characters connected to the mafia.  It was the fourth night at the tables and the pit boss and casino management had taken note of the lead player’s wins and were not happy.  However, on this night, the pit boss was smiling and offered the player coffee with cream and sugar “just the way you like it”.  Shortly into the first round, the player sips his coffee and suddenly couldn’t think! He had been drugged.  A few days later, as the team of six left Las Vegas, their car’s accelerator suddenly stuck as they traveled down a mountain road.  A terrible “accident” was narrowly averted through use of the emergency brakes.

As Nassim Nicholas Taleb points out in the forward to A Man For All MarketsEdward Thorp has written a book that, at times, reads more like a James Bond thriller than the memoir of a mathematician who ventured outside his academic field to beat casinos, both in Las Vegas and on Wall Street.  Conventional wisdom in the 1950s held that it is impossible for players to gain a consistent edge in games such as blackjack, baccarat and roulette.  Driven by an innate sense of curiosity and powered by raw intellect, combined with some help from early computer technology, Ed Thorp demonstrated that players could gain an edge in blackjack through straight forward card counting methods.  After proving the theory through hands-on testing at the casino tables in Reno, Mr. Thorp published his findings in academic journals as well as in Beat the Dealera book that made card counting accessible to the non-technical reader and remains relevant to gamblers today.

While the methods for gaining an edge in baccarat were similar to those used in blackjack and could be pursued through human intellect alone, the challenge facing the roulette player was far more complicated.  The nature of roulette implies a built-in advantage for the casino and casts doubt on the wisdom of participating at all since the expected value of a large number of bets will be negative for the gambler.  However, the fact that many roulette wheels are not perfectly aligned and maintained implies that a gambler could gain an edge by waiting until the wheel and ball is in motion and betting based on minor flaws in the wheel.  Of course, the human eye is not sensitive enough to detect imprecision in the wheel without the aid of technology.  Mr. Thorp, in collaboration with Claude Shannon, developed the first wearable computer which was intended to provide the gambler with an edge in roulette.  The computer was first conceived in 1955 and was tested in Las Vegas in 1961.  It provided the gambler with an expected gain of 44 percent but minor hardware problems prevented serious betting and the technology was unveiled to the public in 1966.

From Casinos to Wall Street

Perhaps the stock market was a natural and inevitable next step for Mr. Thorp after achieving success in casino gambling.  The problem with Mr. Thorp’s methods for beating the dealer is that it attracted attention from unsavory characters associated with the casino industry, as the adventures of 1963 at the baccarat tables of Las Vegas demonstrated.  Surely, the life expectancy of someone gambling in the greatest casino of them all — the stock market — would be far greater than someone confining himself to the smoky casino halls of the 1960s.

In the idealistic view of economics, the stock market is a venue for providers of capital to invest in promising businesses that have the ability to generate attractive returns on capital.  Of course, there is an element of truth in this sentiment since capital is indeed provided to business via the stock market.  However, the volume of trading in the stock market makes it clear that the majority of activity has little to do with providing capital to business or allocating capital to its best and highest use.  Instead, in the short run, the stock market more closely resembles a casino with players who are interested in making quick gains.  The debate over whether the stock market is “efficient” has been raging for decades with academic theorists insisting that there are no systematic ways to outperform market averages without assuming proportionally more “risk”, as defined by the volatility of an individual stock relative to the overall market.

Mr. Thorp naturally was attracted to this giant casino which lacked the shady characters and dangers of Las Vegas, imposed no “table limits” that constrained the capital he could deploy, and had rules that did not change suddenly in the middle of play just as the player was on a winning streak.  Lacking any background related to investing, Mr. Thorp spent the summer of 1964 educating himself, as he had on many other subjects earlier in life.  He included Graham and Dodd’s Security Analysis in his reading but also went further into scores of other books including the study of technical analysis.  Early forays into investing in the silver market produced unsatisfactory results but Mr. Thorp’s self education continued, eventually reaching the subject of common stock warrants.

Warrants and Arbitrage

The value of a warrant on a common stock is derived based the difference between the current stock price and the exercise price of the warrant as well as the amount of time before the warrant expires.  A warrant will always have a positive value prior to expiration even if it cannot be exercised immediately at a profit because the possibility exists that it will become profitable to exercise prior to expiration.  Mr. Thorp came up with the idea of developing mathematical models to determine whether warrants are mispriced relative to the price of the common stock.  By purchasing the relatively underpriced security and shorting the overpriced security, one can exploit the market’s mistake without necessarily expressing an opinion on the merits of investing or shorting the underlying business.

Through collaboration with a colleague in U.C. Irvine’s economics department, Mr. Thorp came up with a system for capitalizing on mispriced warrants and published the results in Beat the Market which was released in 1967.  One might ask why Mr. Thorp was willing to share his discoveries with the public, first with his technique for winning in blackjack and again with warrant mispricing.  Obviously, the more people who are employing a strategy, the less likely it will continue working as envisioned.  The casinos would become aware of card counting and take countermeasures to deal with it, some of which proved to be physically dangerous.  Stock market participants wouldn’t break your legs but would exploit a published strategy.  As underpriced securities are purchased, they become less inexpensive and as overpriced securities are sold, they become less overpriced.  Why give away the secrets?

Mr. Thorp’s ambition early in life was to excel in academia and he appears to have embraced the ethos of viewing scientific research as a public good.  He was also confident that he would have more ideas that could be exploited for monetary gain.  Shortly after publishing Beat the Market, Mr. Thorp independently came up with the formula that would later become known as the Black-Scholes pricing model for options.  Academics Fischer Black and Myron Scholes, who were partly motivated by Beat the Market, came up with their famous formula and published the findings in 1972 and 1973.  It appears that the formula should be known as Thorp-Black-Scholes, if not attributed entirely to Mr. Thorp.

Meeting Warren Buffett

The story takes a very interesting turn when Mr. Thorp is invited to meet Warren Buffett in 1969.  Mr. Thorp had started to manage accounts for clients, one of whom was the dean of the graduate school at U.C. Irvine, Ralph Waldo Gerard.  Mr. Gerard had been a limited partner in the famous Buffett Partnership which was in the process of winding down at the time.  Investors in the Buffett Partnership would be receiving cash plus the option to receive shares in Diversified Retailing and Berkshire Hathaway.  In retrospect, we can say that people who took cash rather than shares were crazy but virtually no one at the time thought that Berkshire would become Mr. Buffett’s investment vehicle for the next half century.

Mr. Gerard was planning to take cash and wanted Mr. Buffett’s opinion regarding Mr. Thorp.  Both men had employed warrant hedging and merger arbitrage strategies and spoke about it during a lunch arranged by Mr. Gerard.  Although Mr. Buffett’s style of investing extended far beyond Mr. Thorp’s activities, he apparently had a positive overall assessment since Mr. Gerard ended up investing additional funds with Mr. Thorp.

Princeton Newport Partners

At the time, Mr. Thorp was managing about $400,000 and the accounts were grossing about 25 percent a year, with 20 percent of profits payable to the general partner.  Mr. Thorp’s $20,000 income from the partnership was equivalent to his salary as a professor and would only accelerate in the coming years as Princeton Newport Partners attracted additional assets and enjoyed steady success.  Mr. Thorp retained his professorship for several years before finally dedicating all of his time toward investing in the early 1980s.

Princeton Newport employed a true “hedge fund” strategy, meaning that it was designed to be market neutral and profitable regardless of the movement in the overall stock market.  Today, what we call “hedge funds” are usually not market neutral funds of the type Mr. Thorp ran but are instead usually net long or net short, meaning that managers are taking a directional view of their holdings or the market as a whole.  Mr. Thorp focused on identifying opportunities that could be hedged in a way that did not depend on the movements of the overall market.  This resulted in a nearly twenty year track record in which the fund never posted a loss over a single calendar quarter.  From November 1, 1969 through the end of 1988, Princeton Newport Partners posted an annual compound return of 19.1 percent before fees, and 15.1 percent after fees.  This compared favorably to the S&P 500 annual return of 10.2 percent, but more importantly, it was accomplished with a small fraction of the volatility of the overall market.

Princeton Newport ran into trouble in late 1987 when the IRS and FBI raided the firm’s Princeton headquarters which housed the trading operations.  Rudolph Giuliani, who was then a politically ambitious U.S. Attorney, was on a campaign to prosecute suspected Wall Street criminals and was looking for information to bolster his case against Michael Milken at Drexel Burnham and Robert Freeman at Goldman Sachs.  Several employees of the Princeton office ended up facing charges but no one in the Newport office, run by Mr. Thorp, were ever implicated.  However, the damage had been done.  Returns in 1988 were only 4 percent as the firm was distracted by the investigation and Mr. Thorp decided to leave at the end of 1988, after which point the partnership eventually wound down.

Bernie Madoff

Mr. Thorp was already a very wealthy man as Princeton Newport liquidated.  Rather than immediately starting another large fund, he stepped back for a while but still provided consulting services related to hedge fund selection.  It was in this context that he encountered the Bernie Madoff fraud seventeen years before it ultimately collapsed.  The first warning sign was the evasive behavior of Peter Madoff who was filling in for Bernie during Mr. Thorp’s planned office visit.  Peter made it clear that Mr. Thorp would not even be allowed through the front door.

Mr. Thorp was not deterred and went on to examine the accounting records that the Madoff firm had provided to his client.  These records conclusively proved that the Madoff operation was a scam:

“After analyzing about 160 individual options trades, we found that for half of them no trades occurred on the exchange where Madoff said that they supposedly took place.  For many of the remaining half that did trade, the quantity reported by Madoff just for my client’s two accounts exceeded the entire volume reported for everyone.  To check the minority of remaining trades, those that did not conflict with the prices and volumes reported by the exchanges, I asked an official at Bear Stearns to find out in confidence who all the buyers and sellers of the options were.  We could not connect any of them to Madoff’s firm.”

The result of Mr. Thorp’s investigation saved his client from continued participation in the fraud.  The client closed his accounts.  Mr. Thorp made it known within his network that the Madoff operation was a Ponzi scheme.  The establishment at the time would not have believed that Bernie Madoff could be a fraud.  He was a major figure in the securities industry and other attempts to unmask his operation were ignored as well.  It is amazing that the Securities and Exchange Commission never uncovered this fraud.  At the end, Bernie Madoff turned himself in when it became obvious that the game was over in December 2008.

Personal Finance 101

The last few chapters of the book delve into a number of personal finance topics that, while perhaps unexpected in a memoir, provide many good insights for both beginning and experienced investors.  Mr. Thorp goes through the facts and figures associated with wealth in the United States, explains the power of compound growth, examines whether one can beat the market today, looks as indexing strategies as a potential passive approach, and then considers how investors should allocate their wealth between asset classes.

The fact that Mr. Thorp dedicates this much space in his memoir to personal finance indicates that he believes lack of education in this area is a serious impediment to the well being of the public.  He believes that personal finance should be taught in elementary and secondary schools, noting that most people seem to not understand basic probability and statistics.  Clearly, if more Americans understood the power of compound growth when leaving high school, there would be far fewer cases of misery caused by mistaken accumulation of debt and lack of savings.

Although not the focus of the book, many readers will find Mr. Thorp’s treatment of personal finance worthwhile.  The question of whether to attempt to beat the market or not is ultimately a personal decision.  Those who wish to make the attempt must choose between finding managers who can hopefully outperform the market after taking into consideration their fees or must do the work required to personally manage the account.  Indexing seems to be the right choice for the vast majority of people.

Conclusion

Mr. Thorp concludes with a compelling account of the causes and aftermath of the financial crisis.  The follies described may be familiar to most readers but will be an eye opener for some.  Although it would be comforting to believe that a similar crisis will not occur in the future due to wise regulatory changes, Mr. Thorp seems rather pessimistic regarding the efficacy of the reforms put in place after the crisis.  Perhaps his strongest indictment involves the corrupt corporate governance that insulated management at the expense of shareholders and continues to this day.  The incentive structures prevalent in corporate America today are largely unchanged and destined to cause trouble in the future.

Warren Buffett reappears toward the end of the book as Mr. Thorp notes his use of Berkshire Hathaway shares to endow a chair in mathematics at U.C. Irvine.  In a move similar to Warren Buffett’s gift to the Bill and Melinda Gates Foundation (but predating it), Mr. Thorp donated Class A Berkshire stock to the university and directed that shares should be converted to Class B stock and sold slowly in order to fund the endowment.  Like Mr. Buffett’s instructions to the Gates Foundation, Mr. Thorp insisted that his gift would result in funding for additional research that would not otherwise have been funded through existing financial resources of the university.  Unlike Mr. Buffett’s intention for his gift to the Gates Foundation, Mr. Thorp would like his gift to continue to provide funding for the chair in perpetuity.  As such, he limited the annual draw from the endowment to only 2 percent. Since 2003, size of the endowment has more than doubled after accounting for yearly spending.

Mr. Thorp’s memoir is likely to be appreciated by more than one type of reader.  Gamblers and investors will naturally be fascinated by the detail he provides, but those focused on public policy will find his views on the financial crisis compelling and readers less familiar with personal finance will have the bonus of a brief lesson and some actionable advice.  Perhaps the most important lesson to take away from this book is that intellectual curiosity combined with a refusal to blindly accept conventional wisdom is almost always required to advance human knowledge and, in some cases, achieve great wealth.

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