Book Review: Intelligent Fanatics Project

Is it possible to reliably identify great managers and their companies at an early stage and enjoy compound annual returns of twenty or even thirty percent over many decades?  We recently explored this subject in some detail using Berkshire Hathaway and Markel Corporation as relevant examples and concluded that it would have been very unlikely for an enterprising investor to have identified these companies at early stages of development:

In 2016, there is no doubt that there are companies one could invest in on the ground floor that will become phenomenal success stories in the decades to come.  There is substantial doubt that investors will be able to identify those companies.  However, today there are many candidates for investment where the companies are already well under construction and we can get in on a higher floor.  Markel is just one possible example.  Such investments may not realize 20 percent compound annual returns over 50 years but, for most people, far more modest compound returns are perfectly adequate to meet personal objectives.

This attitude might strike some readers as somewhat defeatist.  After all, even if getting in at a “higher floor” is a more reliable way to compound wealth at “reasonable rates of return”, those who can get in on the “ground floor” of truly outstanding companies have the opportunity to amass enormous fortunes at “unreasonable rates of return”.  Even those who are not attracted to the idea of an enormous fortune to facilitate personal consumption might be motivated by opportunities to leave a legacy to loved ones or to fund charitable causes.  Why not endeavor to find the truly outstanding opportunities if there are reliable ways to identify such companies in advance?

intelligentfanaticsCharlie Munger came up with the term “intelligent fanatic” to describe individuals with large ideas and a fanatical drive to build sustainable competitive advantages over time.  These are precisely the type of individuals most likely to found companies that deliver amazing results over many decades.  Ian Cassel, founder of MicroCapClub, seeks to find great companies at an early stage of development.  Mr. Cassel, along with co-author Sean Iddings, recently published Intelligent Fanatics Projecta book that attempts to help readers find intelligent fanatics at an early stage by providing case studies of known intelligent fanatics who have already succeeded in compounding wealth at high rates over many decades.  By studying the past and the common elements and themes that have helped these intelligent fanatics succeed, investors may be able to spot the next big thing and get in on the “ground floor”.

The case study format of the book is quite similar to William Thorndike’s The Outsiders which has quickly become a must-read for investors. Both Intelligent Fanatics and The Outsiders present a number of CEOs and companies that have already made their marks on business and compiled great track records.  The case studies presented in Intelligent Fanatics are:

  • John H. Patterson – National Cash Register
  • Simon Marks – Marks & Spencer
  • Sol Price – Fed Mart and Price Club
  • Les Schwab – Les Schwab Tire Centers
  • Herb Kelleher – Southwest Airlines
  • Chester Cadieux – QuikTrip
  • F. Kenneth Iverson – Nucor
  • Jorge Paulo Lemann, Carlos Sicupira, and Marcel Herrmann Telles – 3G Partners

Obviously, these case studies represent a wide range of industries and date from the 19th century to the present day.  Several of the cases involve individuals who are probably not as well known to investors today compared to the case studies in The Outsiders.  In particular, many readers will not be familiar with John Patterson, Simon Marks, and Chester Cadieux and will learn quite a bit from these profiles.  The profiles are not necessarily restricted to companies that were publicly traded, at least not for the entire career of the executive, and in many cases make certain inferences regarding returns to shareholders based on the information that is available.

The example that is probably most interesting to many readers is the chapter on 3G Partners because the formula for success developed by Jorge Paulo Lemann is currently being used to generate value in partnership with Warren Buffett’s Berkshire Hathaway.  Furthermore, the approach used by 3G is quite different from the more organic growth model used by the other intelligent fanatics.  Specifically, 3G seeks to acquire businesses that are either poorly managed or at least sub-optimally managed, and to then put in their system to extract value:

” … most intelligent fanatics would never attempt to acquire a large, bureaucratic competitor.  For instance, when Ken Iverson was asked, “If you were put in charge of U.S. Steel, what would you do?,” he answered, “I’d put a bullet in my head.”

The opposite has been true with the 3G partners, who purposely seek out poorly managed businesses with established brands and market presence.  They incorporate their tried-and-true leadership system, using an internally developed manager, to create a high-performance culture.  For instance, 3G partner Marcel Telles left his position at Garantia to become CEO of Brahma.  The first piece of advice that he received was from a friend, who said, “Marcel, congratulations! Now buy the aspirin factory, too, because Brahma causes huge headaches.”  But Marcel was looking for the opportunity to inject the Garantia model into the sleeping giant.”

Does this sound at all like Warren Buffett’s method of operation?  Of course not!  Mr. Buffett only acquires businesses where excellent economics and management are already in place and loathes cases where he must replace existing management or interfere in any way.  Yet Mr. Buffett has made a very significant bet on partnering with 3G as operating managers for Kraft Heinz.

Readers will be interested in the history behind Jorge Paulo Lemann’s founding of Garantia, a brokerage firm modeled after Goldman Sachs’s meritocratic culture.  Garantia was extremely successful in Brazil and eventually produced so much cash that, if distributed, would likely have removed incentives for partners to continue working.  Mr. Lemann instead began investing Garantia’s cash in other businesses.  The second business he took control of was Brahma, a brewer which morphed into AmBev with the acquisition of Antarctica in 1999, into InBev with the acquisition of Interbrew in 2004, and finally into AB InBev with the mammoth acquisition of Anheuser-Busch in 2008. The amazing story behind how Brazil’s number two beer company transformed into the largest beer company in the world is alone worth the price of the book.

Ultimately, the real question for investors is whether intelligent fanatics can be identified in advance, not years after their outstanding records have already been established.  One can achieve satisfactory results by getting on board at a more mature phase of a company’s development but it is the early years that usually provide the lollapalooza effect often discussed by Charlie Munger.  The authors believe that intelligent fanatics can be identified in advance and they make claims in each of the case studies regarding when it would have been clear that a manager is unique and what kind of returns investors could have achieved since that clarity became apparent.  They also include a final chapter describing the characteristics one should look for when searching for intelligent fanatics at an early stage.

All of this is very interesting and, in many ways, highly compelling.  We all want to find ways to compound wealth rapidly and the outstanding track records achieved in the past taunt those of us who have purposely settled for less by getting on board with companies at later stages of development.  One of the persistent issues and criticism facing books like The Outsiders and Intelligent Fanatics Project is that there is an inevitable degree of survivorship bias at work when we study those who have been successful but do not examine, with equal intensity, those who appeared to share the same characteristics but subsequently failed.  Is it not possible that there were many managers who initially succeeded and shared many of the same attributes of those in these books but ended up either failing completely or falling into mediocrity?  Books of this type would be strengthened by examining such examples in some detail and trying to identify what might have been different in cases of failure, even when the conditions and personalities necessary for success appeared to be in place.

There is never any harm in studying business success and Intelligent Fanatics Project certainly delivers in its attempt to provide interesting examples and to inspire readers to aim high when looking for new opportunities.  Enterprising investors will want to pay close attention to what has worked, even as they also invert and study what has failed to work.

Disclosure:  A review copy of the book was provided to The Rational Walk LLC free of charge by the authors.

Interesting Reading – November 25, 2016

In this series, we suggest worthwhile reading material on a variety of topics, not all of which are directly related to investing.  

The Big Short: Is the next financial crisis on its way? – The Guardian, November 19, 2016.  Steve Eisman is best known for his correct bets against the subprime housing bubble leading up to the financial crisis.  He now believes that European banks, particularly in Italy, are in big trouble.  “Europe is screwed. You guys are still screwed,” says Eisman. “In the Italian system, the banks say they are worth 45-50 cents in the dollar. But the bid price is 20 cents. If they were to mark them down, they would be insolvent.”

Is Indexing Worse Than Marxism? – The Wall Street Journal, November 24, 2016.  Burton G. Malkiel, who is very well known for his book, A Random Walk Down Wall Street, takes on critics who are claiming that index funds pose grave dangers to the stock market, the overall economy, and perhaps to capitalism itself.  Mr. Malkiel acknowledges that an efficient market requires some active traders who analyze and act on new information but suggests that the proportion of active managers could shrink to as little as 5-10 percent of the total and still provide sufficient efficiency.

Faith, Feedback and Fear:  Ready for the Valeant Test? – Musings on Markets, November 22, 2016.  NYU Professor Aswath Damodaran recaps the past several months at Valeant and revisits his investment thesis that led him to purchase shares at $27 in May 2016, a time when his analysis led him to believe that the intrinsic value of shares was $44.  Although recent events have reduced his intrinsic value estimate to $32.50, the share price has also declined.  This led Prof. Damodaran to double his Valeant holdings at $15.  His article follows news of Lou Simpson’s exit from Valeant in the third quarter.

How Two Trailblazing Psychologists Turned The World of Decision Science Upside Down – Vanity Fair, November 14, 2016.  Amos Tversky and Daniel Kahneman are best known for their groundbreaking research in the field of behavioral economics, much of which was set forth for popular audiences in Daniel Kahneman’s recent book, Thinking, Fast and SlowIn this article, adapted from The Undoing Project:  A Friendship That Changed Our Minds, Michael Lewis discusses the evolution of thought, research, and experience that led to breakthroughs that would forever change how economists view real world decision making.

William Ackman’s 2016 Fortune:  Down, but Far From Out – The New York Times, November 15, 2016.  Bill Ackman’s Pershing Square is on course for a second year of double-digit annual losses, but many big investors believe that his firm will turn the corner.  Mr. Ackman’s most prominent mistake has been Valeant Pharmaceuticals which has plunged over 90 percent from the average of $190 that Pershing Square paid to acquire a big stake in 2015.  Mr. Ackman has secured two board seats to influence a turnaround strategy.  More recently, Mr. Ackman has acquired a significant stake in Chipotle Mexican Grill (see also New York Times article on November 18 and The Rational Walk’s recent coverage of Chipotle).

Bonds Down, Stocks Up! – The Brooklyn Investor, November 22, 2016.  The Brooklyn Investor explores the relationship between interest rates and equity prices over many decades along with the implications for equity valuations in periods of rising interest rates.  Since the presidential election on November 8, interest rates have risen quite sharply while stock prices have also rallied.  In theory, higher interest rates should act as a downward pressure on equity valuations, but this relationship is not precise and also depends on whether the stock market ever completely “priced in” the period of abnormally low interest rates that have prevailed since the financial crisis.

Warren Buffett’s Meeting with University of Maryland Students – By Dr. David Kass, November 20, 2016.  Warren Buffett met with twenty students from each of eight universities on November 18.  During the session, he responded to twenty student questions over a period of 2 1/2 hours.  The questions range from politics to economics to questions about specific investments such as Berkshire’s recent foray into airline stocks.

The Money Management Gospel of Yale’s Endowment Guru – The New York Times, November 5, 2016.  David Swensen runs the $25.4 billion Yale endowment which is one of the largest in the country.  Mr. Swensen is best known for pioneering an investment strategy that includes holdings in real estate, private equity, and venture capital along with other alternative investments.  This is in contrast to the more typical stock and bond allocations common in endowment fund management.  Mr. Swensen took over management of the $1 billion endowment in 1985 at a time when it provided 10 percent of Yale’s annual budget.  The endowment provides 33 percent of the budget today.  In this article resulting from a series of interviews, Mr. Swensen provides insights on active vs. passive management, activist investors, and his experiences during the financial crisis, as well as many other topics.

Like Buffett, Another Folksy Investor Turns Patience Into Profit – The Wall Street Journal, May 22, 2015.  Jason Zweig shares his experiences covering the 2015 Markel Corporation annual meeting in Richmond, Virginia.  This article, focusing on Markel’s co-CEO Tom Gayner, might be of interest to readers who have been following The Rational Walk’s recent coverage of Markel.

Quit Social Media.  Your Career May Depend on It – The New York Times, November 19, 2016.  Cal Newport, who describes himself as a “millennial computer scientist” and author makes the case against the use of social media.  Although his complete absence from social media may be considered extreme, the author’s warning regarding the risk of distraction warrants consideration:  “Consider that the ability to concentrate without distraction on hard tasks is becoming increasingly valuable in an increasingly complicated economy. Social media weakens this skill because it’s engineered to be addictive. The more you use social media in the way it’s designed to be used — persistently throughout your waking hours — the more your brain learns to crave a quick hit of stimulus at the slightest hint of boredom.”

Alfred P. Sloan on Automobile Distribution

Despite rapid advances in automobile technology in recent decades, the manner in which manufacturers distribute their products to the end customer has remained relatively unchanged for nearly one hundred years.  New vehicles in the United States are almost exclusively distributed through a vast network of franchised dealerships.  According to the National Automobile Dealers Association, there were 16,545 new car dealerships operating in the United States in 2015.  These dealerships registered total sales of $862.7 billion and generated $63 billion in payroll.  Nearly 1.1 million people were directly employed by dealerships with an additional 1.2 million jobs supported indirectly.

Automobile distribution is clearly very important to the overall economy and many dealerships are an important source of jobs in local communities.  Over the years, most states have put in place regulations that attempt to protect franchised dealerships from potential competition with manufacturers wishing to sell directly to consumers. For the most part, this was not particularly controversial in the past because all major manufacturers thought it in their best interests to use a franchised distribution model.

The automobile market is currently going through a period of rapid change that threatens to upend the familiar business models that have long characterized the industry.  Telsa Motors, under the leadership of its charismatic founder Elon Musk, has introduced a line of luxury electric vehicles with ranges in excess of 200 miles.  Tesla vehicles also have autonomous features that, while currently controversial, hold the promise of eventual full automation in the coming years.  In addition to all of this, Tesla has put in place a direct sales model that is quite different from the traditional franchised dealership model.  Customers visit a Tesla run “gallery” where one can view vehicles in a no-pressure environment because salespeople are not paid on commission.  The customer then orders a vehicle directly from Tesla for delivery at a later date, sometimes several months in the future.

Development of the Franchised Dealership Model

My Years with General MotorsAlfred P. Sloan joined General Motors in 1918 at a time when the company was in turmoil and its future was in no way secure.  Under his leadership over the next four decades, General Motors grew into the dominant manufacturer of automobiles in the United States.  In My Years with General Motors, published in 1963, Mr. Sloan describes the history of General Motors and the overall automobile market from its infancy to a very mature industry.  The structure of the industry has been buffeted by foreign competition and new technology in the years since Mr. Sloan left the scene.  However, many aspects of the industry that he describes are familiar to modern readers.  We still have the annual model year change that usually goes along with periodic styling changes and is a key component of inducing customers to trade in for new models.  Additionally, the distribution model, and the logic behind it, has remained relatively unchanged.

Mr. Sloan believed that a stable dealer organization is a necessary condition for the ongoing prosperity of a manufacturer.  He noted that the automobile is not a typical “off the shelf” product that consumers buy every day.  It represents a highly complex and expensive “investment” that the buyer expects to operate on a frequent basis without personal knowledge of the mechanical complexity.  Especially in the early days of the automobile, frequent service was a necessity and only a local network of skilled technicians employed by dealers could provide it.

The franchised dealer and the manufacturer are essentially “partners” that have taken on different roles and assumed different levels of investment:

“Both the manufacturer and the franchised dealer undertake normal and related business risks, the dealer in his investment in selling and service facilities, the manufacturer in his investment in producing facilities, including engineering development and high annual tooling costs.  Both depend upon the appeal the manufacturer gives to the product and the ability of the franchised dealer efficiently to sell and service the product.”

Ultimately, any lasting business relationship has to be a “win-win” in terms of being mutually beneficial.  In response to difficulties in the dealer network in the 1920s, Mr. Sloan made it a practice to make personal visits to dealers.  Traveling in a private railroad car, he and several associates went to nearly every city in the United States and visited five to ten dealers a day.

“I made careful notes of all the points that came up, and when I got back home I studied them.  I did this because I realized that, irrespective of how efficient our regular organization might be, there is a special value in personal contact, and furthermore, as chief executive officer of the corporation, my interest was primarily in general policies.  This time-and-effort-consuming approach to the problem was particularly effective under the circumstances existing at that time, when we knew so little about the facts of distribution in the field.  Many things that we learned were subsequently reflected in our dealer selling agreements, and communications in particular were put on an established basis through councils and in other ways which at least in part served to meet the same need.”

There were a number of problems that General Motors faced in subsequent years that required modifying the relationship with the dealers.  In particular, there were issues that had to be dealt with in terms of ensuring that dealerships had adequate capital to carry necessary inventory.  There were also challenges related to assisting dealers with liquidation of an old model in order to make room for new models while keeping inventory losses as low as possible.  These are problems that still impact dealerships today and the reason behind periodic clearances and sales incentives designed to move prior year models in a timely manner.  The sharing of responsibility between the franchised dealer and the manufacturer is a question that still faces industry players today.

Was a Direct Sales Model Possible?

The main alternative to a franchised dealership model is for manufacturers to directly sell vehicles to the end customer.  Why was this option not pursued in the early days of the automobile industry?

“The question might arise why the automobile industry adopted this form of distribution [franchised dealerships].  The answer, I think, in part is that automobile manufacturers could not without great difficulty have undertaken to merchandise their own product.  When the used car came into the picture in a big way in the 1920s as a trade-in on a new car, the merchandising of automobiles became more a trading proposition than an ordinary selling proposition.  Organizing and supervising the necessary thousands of complex trading institutions would have been difficult for the manufacturer;  trading is a knack not easy to fit into the conventional type of a managerially controlled scheme of organization.  So the retail automobile business grew up with the franchised-dealer type of organization.”

To a large degree, the function of a dealership today is similar to what Mr. Sloan described as being the case in the 1920s.  A customer will show up with his or her current vehicle and use it as a trade-in for a new model.  The function of the dealership is to negotiate with the customer on the terms of the trade in, usually in conjunction with the terms of sale for the new model.  Of course, this is the type of negotiation that is fraught with stress and can be quite opaque in many ways for the customer.

In contrast with the 1920s, customers today have access to a wide array of pricing information and are much more aware of the value of their trade in as well as the going price for new models.  Customers also have many more options for selling their existing vehicle privately than they did even a couple of decades ago.  The internet, of course, has changed the situation dramatically both in terms of provision of pricing information and the ease of which sellers and buyers can get together directly.  This has clearly reduced, but not eliminated entirely, the advantage of a dealer when it comes to liquidating a used vehicle in order to facilitate a new vehicle sale.

Changing Business Models for Changing Times

One aspect of My Years with General Motors that modern readers will no doubt take away from the book is that the underlying principles described by Mr. Sloan are timeless and he recognizes that change is a constant that future executives would have to deal with.  Ultimately, the goal of a distribution network is to best serve the end customer.  This can change over time:

“The achievement of our two goals in distribution – namely, the economic movement of the product, and a stable network of franchised dealers who move the product – has taken much thought and work over many years, for the problems are complicated, they change to some extent with changing circumstances, and the solutions have not always immediately presented themselves.  Policies and practices that were satisfactory at one time may not be best suited to later conditions.  A “new model”, so to speak, in dealer relations may be needed from time to time.”

Industry observers today must evaluate the degree to which technology has the potential to upend the century-old franchised dealership model.  From an information asymmetry standpoint, dealerships have lost much of their historical advantage because pricing information for both new and used vehicles has become much more transparent.  The internet also has allowed manufacturers to have a direct relationship with end customers, as Tesla has shown with their direct sales model.

What has not changed is the fact that automobiles are very complex and expensive purchases that require maintenance.  Customer satisfaction depends on ensuring that maintenance and support is available long after the initial sale.  Although electric vehicles are less complex in some ways than gasoline powered vehicles, they are effectively complicated computers on wheels.  Some aspects of maintenance can now be handled through software updates provided through internet connections.  But clearly mechanical service is not obsolete.  Tesla obviously recognizes this and has built up a network of service centers.

Conclusion

We can often benefit from an understanding of history when looking at current controversies.  My Years with General Motors is a business classic and conveys much wisdom aside from the topic of automobile distribution discussed in this article.  However, Mr. Sloan’s observations on distribution are particularly interesting given Tesla’s current approach and the changing dynamics of the industry in general.

In 2015, Berkshire Hathaway acquired Van Tuyl Group, the largest privately-owned auto dealership group in the United States.  The group has been renamed as Berkshire Hathaway Automotive and now operates 81 dealerships with over 100 franchises in 10 states.  Obviously, Warren Buffett has made a significant bet on the continuation of the franchised dealership model that was developed by Alfred P. Sloan and his contemporaries nearly a century ago.  It will be interesting to see whether the significant technological disruption in the automobile industry causes a shift in the overall distribution model or whether the franchised dealer distribution model will endure for decades to come.

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

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