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.

The Autonomous Vehicle Revolution

It is no accident that the rapid rise in living standards over the past century has coincided with tremendous technological progress throughout the economy.  At a fundamental level, rising living standards require the economy to generate an ever-increasing supply of goods and services through intelligent utilization of the fundamental factors of production:  land, labor, and capital.  Improvements in technology are reflected in the quality of capital goods, the ability of individuals to be more productive through enhancements in human capital, and better uses of limited natural resources.  Progress on a per-capita basis is required for individuals, on average, to see growth in the economy translate into a higher standard of living.

Given the importance of technology in the economy, it is interesting to read Warren Buffett’s frequent statements regarding “not understanding” technology.  He has expressed this sentiment in Berkshire Hathaway annual reports for many years as part of a discussion of the company’s acquisition criteria.  However, what he appears to be saying is that Berkshire does not have a competitive edge when it comes to acquiring technology companies, not that Berkshire itself is somehow immune to technology or does not seek to adapt to technological progress.  This reality seems to have gone unnoticed among some value investors who repeat Mr. Buffett’s assertion regarding technology and take it as a license to totally ignore the impact of technology on the economy in general and on their investments in particular.

The Opportunity

According to the Bureau of Transportation Statistics, there were over 260 million registered vehicles on the road in 2014.  Currently, almost all of these vehicles have no autonomous features and are controlled by human drivers.  The amount of time and energy spent controlling vehicles on the road is obviously very significant.  According to the U.S. Census Bureau, it takes the average worker 26 minutes to commute to and from work which implies that the 139 million workers in the United States collectively spent 29.6 billion hours traveling to and from work, the vast majority in a private automobile controlled by a human driver.

Driving a two ton vehicle on public roads is something that does not lend itself to multitasking, at least not safely.  Fully autonomous vehicles adopted throughout the economy would free up all of this time for other endeavors, including work, and would very likely cut the amount of time spent actually commuting because roads could be optimized more intelligently.  In addition, the number of accidents on the road would theoretically plummet due to the decline of unpredictable human drivers.  This could easily save thousands of lives annually along with significant monetary savings due to decreased frequency of property damage and bodily injury.

Elon Musk’s Tesla Motors is the most visible proponent of automation, although many other manufacturers and technology companies are also investing heavily in research and development.  In 2016, the number of S.E.C. filings mentioning autonomous vehicles surged dramatically.  Many of these filings are from automobile manufacturers but there is also increasing awareness of the benefits and risks of automation in other industries such as automobile insurance.  Is this increased interest just hype or does it reflect reality?

A Question of Timing

If we fast forward fifty years to the mid 2060s, it seems almost inevitable that the United States economy will have fully transitioned to autonomous vehicles and reaped countless productivity benefits.  This might seem like a bold assertion.  Is this science fiction similar to the vision of the future from a 1960s Jetson’s cartoon?  Even George Jetson’s flying car was not fully autonomous, although it did compress to the size of a briefcase.

Warren Buffett recently predicted that autonomous vehicles will eventually dominate the market but was skeptical regarding some of the more aggressive claims on timing.  In particular, he was doubtful that even ten percent of the automobiles in the United States would be self-driving within ten years.  Of course, the timing will be very important for GEICO as well as for other auto insurers.  A much safer fleet of vehicles will reduce the rate of accidents resulting in less damage to property as well as bodily injury.  This will cause insurance rates to fall significantly.

Even if we assume that a fully autonomous vehicle will be released imminently, it could take many years for the technology to become mainstream.  The average age of light vehicles in the United States rose to 11.6 years in 2016.  Furthermore, vehicles sixteen years and older are expected to grow from 62 million units on the road today to 81 million in 2021.  Vehicle reliability has been increasing in recent years allowing consumers to keep older cars on the road without incurring major expenses.

The counterpoint is that perceived vehicle obsolescence will dramatically increase as soon as a fully autonomous vehicle is introduced.  In fact, the comparison between the existing fleet and fully autonomous vehicles might be completely invalid.  While the older vehicles will still get drivers from point A to point B, they will always require human control.  The perceived difference could eventually be as great as the difference between a horse drawn carriage and an early automobile.

Flashback to the 1990s

Anyone who lived through the early days of the internet will recall the lofty predictions regarding how the technology would completely change our lives within a few years.  These predictions were necessary to sustain the dot com bubble in which all sorts of dubious business models attracted capital, both from the unsophisticated and gullible and from those hoping to take advantage of the “greater fool” theory.  Bricks-and-mortar retailing would soon be dead, we would all order products from our living rooms using computers, and everything under the sun would be handled online.  These were just some of the more common predictions.

What ended up happening?  Almost all of these predictions eventually came true!  The only issue is that it took an additional ten to twenty years before technology and infrastructure reached the point where a critical mass arrived and existing business models could be seriously disrupted.

From an infrastructure perspective, we needed much faster internet connections than we had access to in the 1990s.  Amazon.com perfected the logistics and infrastructure associated with massive automated warehousing and distribution.  The smartphone revolution put miniature computers in the hands of nearly everyone along with software that increased price transparency and exposed retailers that were not offering good value propositions.  Finally, consumers had to slowly get used to the concept of shifting more and more of their lives online.  We are now at the point where an entire generation has grown up in a connected world and, of course, older generations eventually go along for the ride.

Change is Slow and then Fast

The impact of the dot com bubble on retail took a very long time to fully develop but it seems like we have recently arrived at a tipping point where the predictions of twenty years ago are about to come true.  Malls have been in long-term decline but are now increasingly being razed and redeveloped.  Sears Holdings has been declining for years and recently added “going concern” language to the company’s S.E.C. filings reviving concerns of near-term bankruptcy.  Smaller retailers are often in even worse shape and quarterly earnings disappointments are common.  It is still premature to suggest that bricks and mortar retail is dead but companies without pricing advantages or differentiation seem destined to fall victim to Amazon.com and others operating online.

Could we see a similar outcome for automated vehicle technology?  The hype over vehicle automation is currently reminiscent of the online shopping chatter prevalent in the late 1990s yet we face significant technological and infrastructure challenges that will impede adoption in the near term.  The technology required to safely automate a vehicle is still very much in development and unproven.  The physical infrastructure of the United States is in poor shape, although the Trump administration claims to have plans to significantly boost infrastructure investment.  Perhaps most importantly, people are used to controlling their vehicles directly and most people believe that they are “above average” drivers.  Some people even enjoy driving.

In 2016, a high profile fatality in a Tesla vehicle resulted in a great deal of media coverage.  Even though the ensuing investigation revealed no safety defects in Tesla’s autopilot technology, this incident and similar future incidents will slow down the shift toward automation both from a regulatory and consumer acceptance standpoint.  As flawed as human drivers are, most of us feel like we are “in control” when driving.  Handing over control to technology is a major shift that many people will resist.  There will be a transition period when some vehicles are automated while others are human controlled.  The interaction between autonomous and human drivers will also cause controversy, regulatory review, and impact consumer acceptance.

Conclusion

We have no way of knowing how the shift toward vehicle automation will evolve over time but the end result is easier to forecast.  At some point, all vehicles are likely to be automated and will interact with each other in predictable ways.  This will reduce the rate of accidents and boost human productivity as the time spent driving cars will be redirected to higher value pursuits.  The benefits are likely to be immense but certain industries such as auto insurance will be much smaller as a result.  As is the case with most technological change, there will be clear winners and losers.

What we cannot know at this point is whether the shift to automation will be largely complete by 2030 or if 2050 is a more realistic target.  This has important implications for a business like GEICO or Progressive.  The intrinsic value of a company is the analyst’s best estimate of the present value of all future cash flows from the business.  If the decline of auto insurance is 30 to 40 years in the future, current valuations will be far less impacted than if the decline occurs in 10 to 20 years.

GEICO and Progressive have been growth companies for a long time as they took market share from competitors and benefited from the overall growth of cars on the road.  At some unknown point, this virtuous cycle will reverse.  Premium volume and float will decline.  Companies will compete fiercely over the remaining business.  Auto insurance companies will be valued as melting ice cubes rather than growth companies.  Fifty years from now, we will know how everything turned out.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway, the parent company of GEICO. 

Highlights from Markel’s 2016 Annual Letter

Intelligent investors should be skeptical when reading about companies that could be the “next Berkshire Hathaway” or executives who resemble a “younger Warren Buffett”.  The reality is that very few companies have even a remote chance of replicating Berkshire’s 20.8 percent compound annual gain in per-share market value over past 52 years.  Furthermore, companies that meet or exceed that track record in the future will have to adapt to the conditions that prevail during their time.  Mr. Buffett’s value investing principles are timeless but the application of those principles will not remain static.  The idea that mimicking the style of Berkshire Hathaway’s website or shareholder communications brings one closer to achieving Mr. Buffett’s performance confuses style for substance.

Markel Corporation has been discussed frequently on this website not because the company might be the “next Berkshire Hathaway” but because management has consistently adopted many of Mr. Buffett’s principles in substance while retaining their own unique style of operations.  As the management team notes in the company’s recently released 2016 annual report, the long term record has been strong with compound annual growth in book value per share of 19 percent over the thirty years since the company’s initial public offering.

Is Markel the “next Berkshire Hathaway”? We would not presume to know the answer, but should management be able to continue compounding book value at 19 percent over the next 22 years and maintains the current price-to-book ratio and share count, the company’s current $13.5 billion market capitalization would rise to over $600 billion.  This is almost certainly far in excess of the results one can reasonably expect but falls into the category of an interesting thought experiment.

Time Frames Guiding Management

One year is not a very long period of time and typically an insufficient time period to measure management’s effectiveness.  Yet how many times do we hear managers make excuses for poor decisions by saying that they should not be judged over one year periods … and similar excuses come up every year?  A series of short-runs eventually becomes the long-run, so it is interesting to see how Markel’s managers view this reality:

“While we necessarily break down our results in the normal pattern of yearly increments, we don’t think about Markel in annual terms.  We think about your company in two distinct yet completely connected time horizons, namely forever and right now.  

These two time frames guide our actions.  We believe that Markel remains unique among most publicly traded companies in emphasizing the forever time horizon as much as we do.  That is an immense competitive advantage for us as we continue to navigate into an always uncertain future that continues to change at faster and faster rates.”

Management seems committed to adapting to rapid changes, especially those brought about by technology, and doing so in a timely fashion rather than using the tired excuse of having a “long term outlook” to explain away short term deficiencies.  With many companies, it seems like there are always short-term excuses for poor performance that tend to recur every year.  However, a moderately long time horizon, such as five years, is obviously made up of a series of five one year periods.  In order to produce good long term outcomes, managers have to show up every day with that goal in mind.

Three Engines of Activity

Management characterizes the company as having three “engines of activity”: Insurance, Investments, and Industrials.  Markel’s roots as an insurance company account for the first two engines.  Insurance underwriting profitability is an essential ingredient for success and provides management with low or no-cost funds to invest in fixed income securities.  Markel historically invested shareholders’ equity in common stocks but over the past decade has increasingly directed funds to majority or wholly controlled companies under the umbrella of Markel Ventures, characterized in the letter as “Industrials”.

Insurance

The insurance market is characterized as “brutally competitive” in the letter indicating that pricing pressure is significant and that the market is soft, at least in the niche segments in which Markel typically competes.  Nevertheless, total insurance premiums written increased 4 percent to $4.8 billion in 2016 and the combined ratio was 92 percent indicating underwriting profitability:

“Conditions across the insurance market worldwide remained brutally competitive.  That is true in every product across the board.  Despite the ongoing competitive nature of insurance markets we produced an underwriting profit as demonstrated by the combined ratio of 92%.  We’ve been profitable on an underwriting basis in 15 of the 21 years shown on this chart [the letter includes a 21-year summary of financial data] and we hope that provides you with a tangible sense of how much we mean it when we say that we are dedicated to making an underwriting profit.  We will continue to exercise discipline, and walk away from insurance risks that in our opinion carry a likelihood of underwriting losses.”

Anyone who follows the insurance industry knows that, without exception, managers talk about achieving underwriting profitability and rejecting poorly priced business even if that means a loss of market share.  In reality, most managers fall well short of this objective.  We can see Markel’s track graphically in the following exhibit:

The early years on the chart show that no management team is immune from mistakes.  Markel had some trouble initially with the acquisition of Terra Nova which impacted 2000 results and 2001 was impacted by adverse development that required an increase in reserves as well as the September 11 terrorist attacks.  Since then, results have been much more consistently positive.  Although the nature of insurance makes terrible results in some future year nearly inevitable, management has credibility when it comes to underwriting discipline. Credibility is important because sometimes negative results will be surprising as was the case recently with an $85 million reserve increase that will impact Q1 2017.

Investing

Markel traditionally invested policyholder float in fixed income securities with a duration intended to match policyholder liabilities while investing shareholders’ equity in common stocks.  In 2016, Markel reported a total return of 4.4 percent from its publicly traded securities portfolio, comprised of a total return of 13.5 percent from equity securities and 2.4 percent from fixed income securities.  Here again, management makes a distinction between the short run and long run when it comes to evaluating results:

“We specifically use the term “reported” for the one year number and “earned” for the 5 year term.  Those words describe two different, yet related things, and we think it is important to conceptually discuss the nuance meant by using those two different words.”

The term “reported” is the simple arithmetic stating the return Markel achieved on securities during the given year but, in the short run, these results might differ from changes in intrinsic value of the securities.  This appears to be the case for both equity and fixed income returns for 2016:

“In our opinion, while the equity portfolio enjoyed a reported return of 13.5% for the year, we believe that the underlying economic performance of the businesses we own in that portfolio was probably slightly less than that reported return.  Some individual companies performed meaningfully better than what the change in stock prices would suggest, and some performed less well than you might think at first glance.  Additionally, the dispersion of economic performance between individual companies, and one industry as compared to another, seems to be getting wider in our opinion.  In aggregate, the overall equity portfolio return of 13.5% remains directionally correct in describing the underlying business performance of our investees, but that number is not precise in describing their aggregate economic progress, and we believe it might be just a touch high.”

Management is more confident that the 15.9 percent annualized five year reported return on the equity portfolio more accurately describes what Markel “earned” in terms of advances in the intrinsic value of the underlying companies.  The passage of time tends to eliminate the differences between what is “earned” and what is “reported” – meaning that in the long run, changes in quoted values reflect underlying intrinsic value.  This is identical in substance to Benjamin Graham’s analogy of the stock market being a voting machine in the short run but a weighing machine in the long run.

The duration of Markel’s fixed income portfolio has been rising in recent years.  Management has stated a goal of keeping a relatively constant duration of between four and five years in the fixed income portfolio in order to match the expected timeframe in which policyholder claims will be paid out.  However, in the short run, the longer duration led to the fixed income portfolio falling in quoted value in the fourth quarter of 2016 as interest rates rose.  The present value of Markel’s insurance liabilities also fell in theory but were not repriced on the balance sheet:

“The rise in interest rates in 2016 means that our “reported” returns from the fixed income portfolio were lower than our economic returns from owning those securities.  U.S. GAAP accounting recognizes that mark to market change of the fixed income portfolio but it doesn’t recognize that the net present value of our insurance liabilities decreased economically by a similar amount.

Over five years, these sorts of timing and reporting differences resolve nearly completely, which is why we pay attention to the 5 year number much more than the annual amounts.”

Overall, Markel’s investment results have been very good in recent years as we summarize in the exhibit below (click on the image for a larger view):

Industrials (Markel Ventures)

Many of the comparisons between Markel and Berkshire Hathaway are driven by Markel’s recent entry into non-insurance businesses which has made the company into something of a mini-conglomerate.  The history of Markel Ventures makes for interesting reading and shows how management has gone about this transformation since 2005.  In addition to diversification, Markel believes that these businesses add resiliency to the overall corporation:

“Markel Ventures continues to grow as a positive factor within your company.  This collection of businesses provides a diversified stream of cash flow for Markel that is not tied completely to the economic fates or regulatory forces affecting our insurance operations.  

As such, these cash flows provide resiliency for the company as a whole and allow us more options to consider when we make capital allocation decisions.  

Resiliency is a much more important concept than diversification.  Diversification is a necessary condition to obtain resiliency, but it is not in and of itself sufficient to achieve that goal.  Resiliency means so much more.  Our goal is to continue to build resiliency at Markel.  Resiliency means that whatever the markets, and technology, and change, throws at us, we’ll be able to rise to those new challenges and circumstances.”

Results at Markel Ventures continue to require additional explanations beyond the raw numbers.  This is primarily due to the impact of accounting conventions, specifically the manner in which goodwill is evaluated on an annual basis.  When an acquisition is made, the consideration paid to the seller in excess of identifiable assets is recorded as goodwill.  The goodwill of each individual business unit is evaluated for impairment each year and written down if needed.  However, because this is done at each individual business unit rather than in aggregate, the overall economic goodwill of the Ventures businesses could be rising even as a goodwill write-down is taken at one unit.  Management believes that the $18.7 million write-down in 2016 does not reflect fundamental impairment of the goodwill of Ventures as a whole:

“Neither we nor anyone else knows when or if energy prices will rise or to what degree.  That said, the carrying value of this cyclical business has been reduced substantially through this particular goodwill charge.  This creates an asymmetric financial reporting outcome.  The process creates a one way street where only negative events get highlighted and charged off in lumps.  Future good news of better earnings, and the implication of a business that is worth more economically, will never show up in the balance sheet.  You’ll just see those earnings anonymously comingled with all of the other earnings streams in the income statement.”

Of course, there is nothing to prevent management from highlighting these positive developments in the annual letters when warranted or providing more granularity in financial reporting.  Currently, Markel Ventures subsidiaries are presented in a non-granular manner which could partly be due to a desire to conceal information from the competitors of individual subsidiaries but also makes it more difficult for shareholders to evaluate results.

Capital Allocation

Markel restated the principles of capital allocation that were presented a few years ago in the 2013 annual report:

“We will continue to use our capital with the same priorities.  As we wrote in the 2013 annual report, “Our first and favorite option is to fund organic growth opportunities within our proven, existing line up of insurance and non-insurance businesses.  Our next choice is to buy new businesses. Our third choice is to allocate capital to publicly traded equity and fixed income securities, and our final choice is to repurchase shares of our own stock when it is attractively priced and increases the value of each remaining outstanding share.”

It is interesting that repurchases are listed as the last choice in the list, but perhaps not surprising given that Markel has not historically repurchased a meaningful number of shares.  Repurchase activity in recent years seems more related to a desire to keep the share count constant as new shares are issued as part of the company’s stock incentive programs and has not varied much based on Markel’s valuation.  As an example, Markel’s stock price traded at only a modest premium to book value for much of 2013 yet repurchases for the year were only $57 million, as compared to $51 million in 2016 when shares traded at a much more significant premium.

Overall, however, management should be evaluated based on progress in intrinsic value per share and Markel has posted good results in recent years with compound growth in book value per share of 11.5 percent over the past five years and 10.2 percent over the past decade.  Management has reason to be confident in their ability to compound intrinsic value at satisfactory rates far into the future and shareholders seem willing to allow for retention of capital in order to fund that growth.

Conclusion

The exhibit below shows Markel’s track record from the turn of the century through earlier this month, with the top chart showing the movement of the company’s stock price, book value, and tangible book value per share and the bottom chart showing the company’s price-to-book ratio:

As Markel’s stock price advances to near the psychologically meaningful (but substantively meaningless) $1,000 per share level, it is notable that the price-to-book ratio is only now reaching levels that prevailed before the financial crisis.  Markel is still primarily an insurance company, albeit with a growing collection of non-insurance subsidiaries, so price-to-book remains a meaningful but understated measure of intrinsic value.

The bottom line is that we have no way of knowing whether Markel is the “next Berkshire Hathaway” but the track record since the company’s IPO thirty years ago gives us reason to at least watch closely in the coming years.  Substance matters much more than style.  Markel’s management is very different from Berkshire’s in style but has adopted much of the substance that resulted in Berkshire’s unusual success.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway and Markel Corporation. 

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