Book Review: Early Bird – The Power of Investing Young

“Compound interest is the 8th wonder of the world.  He who understands it earns it.  He who doesn’t pays it.”

— Attributed to Albert Einstein

The quote above has often been attributed to Albert Einstein although there is some controversy regarding whether he ever actually made this statement.  However, regardless of the historical accuracy of the quote, it is undeniable that a solid understanding of compound interest is a requirement for basic financial literacy.  Exponential functions like compound interest are not automatically intuitive for most people, especially when interest rates are microscopic, as they have been in recent years.  Yet the principle is relatively simple and should be a requirement for high school graduation.

Relatively few young people have a natural inclination to plan ahead, a tendency that our consumer oriented culture does nothing to discourage.  Without a solid understanding of the power of savings and compound interest, there is no counter-balance to the natural impulse to prefer consumption right now to potentially greater consumption at some point far in the future.  An understanding of compounding can be thought of as a partial immunization to falling into destructive spending habits.  Early Bird: The Power of Investing Young is a new book intended to introduce young people to the exciting world of investing.  Maya Peterson is only fifteen years old and started investing at the age of nine with $100 raised from the sale of her American Girl dolls.  As Maya says “Teenagers, more than anyone, should be educated in this field.  Why?  Because they have the power of time!”

The book is primarily intended to encourage young people to harness the power of time to create investing “snowballs” – a term associated with Warren Buffett’s life story of starting with small amounts of capital and watching it snowball into tens of billions of dollars.  A refreshing aspect of the book is that Maya understands that buying a stock is more than simply buying a virtual “piece of paper” with quotes that squiggle around every day.  She clearly understands that ownership of stocks is simply a proxy for ownership of the underlying business.  Furthermore, she seems to like the process:  “The world gives you clues and an investor is like a detective who has an endless series of mysteries to try and solve.”  This is precisely the task of an intelligent investor.  Investors take the accumulated worldly wisdom they have obtained in life and apply that to the analysis of companies within their individual circles of competence, and then make judgments regarding the relative attractiveness of businesses they can understand.

One of the best ways to get young people interested in investing is obviously to focus on companies that they personally are familiar with and understand.  All teenagers are familiar with companies such as Disney, Coca Cola, Starbucks, Amazon, McDonalds, Wal-Mart and many more.  Maya advocates something along the lines of the classic “Peter Lynch” approach of buying what you personally know, with the caveat of digging into the fundamentals.  The book covers some basic financial concepts and primarily relies on the use of tools such as The Motley Fool and Morningstar websites rather than going directly to the SEC filings.  This seems understandable especially for younger investors, but teenagers approaching the end of high school who are serious about investing should begin to delve into primary sources such as SEC filings in addition to information services like Morningstar.

The book also contains interesting interviews with established professional investors as well as individual investors with many years of experience.  This is important because the life experience of a fifteen year old author is inevitably going to be limited.  By going to individuals with many decades of experience, Maya gives the reader a sense of the process serious investors go through when selecting specific investments.  She also spends some time discussing socially responsible investing, a topic likely to resonate with idealistic young people who wish to invest their money only with companies that share their values.

Although only a certain percentage of young people are going to be interested enough in business to delve into the details required to make investments in specific companies, all teenagers could greatly benefit from the fundamentals presented in this book.  There is nothing wrong with investing money passively in broad based index funds over a long period of time.  Although stock valuations are quite high today, someone just starting has the advantage of time and should view any temporary declines as buying opportunities since they have the majority of their life (and earnings potential) ahead of them.

Perhaps the best way to help a young person start to invest is to fund a Roth IRA account when they begin earning their own money.  Most teenagers are unlikely to want to plow all of their earnings into investments but suppose that a teenager earns $5,000 over the course of a year in part time jobs.  If the teen can be persuaded to save perhaps half of this amount, or $2,500, his or her parents could match that amount and invest a total of $5,000 in a Roth IRA account.  Roth IRAs are ideal for those who have many decades ahead of them.  If a fifteen year old invests $5,000 this year and achieves a real compounded return of 5 percent, that $5,000 will grow into purchasing power of over $57,000 in 2018 dollars by age 65 in fifty years, and no taxes will be owed when these funds are withdrawn in retirement.

Early Bird is an impressive achievement and would make a good gift for a young person who is interested in investing.

Disclosure:  The Rational Walk received a review copy of the book.  

Tax The Small Investor Behind The Tree

“Don’t tax you, don’t tax me, tax that fellow behind the tree!”

— Senator Russell B. Long

“No one should see how laws or sausages are made. To retain respect for sausages and laws, one must not watch them in the making. The making of laws like the making of sausages, is not a pretty sight.”

— Source uncertain but often attributed to Otto von Bismarck

As much as value focused investors might prefer to be reading annual reports and conducting other fundamental research, it has been difficult in recent months to ignore the various permutations of “tax reform” that have been taking shape in Washington.  Even Warren Buffett, someone who is known for his aversion to political distractions, has admitted that tax reform is a big factor in his decision making this year.

After failing to repeal and replace the Affordable Care Act, Republican politicians are desperate to deliver on at least some of their campaign promises.  The House of Representatives has already passed tax reform legislation and the Senate is very close to voting on their own tax package.  Assuming passage of a tax bill in the Senate, the House and Senate will enter reconciliation discussions before attempting to pass a final bill that the President will sign into law.  The goal is for legislation to be signed into law by the end of the year.

While there are many aspects of tax reform that will have major impacts on business conditions and the investment climate, one specific proposal has made its way into Senate legislation that appears to specifically target individual investors.  The change has to do with how investors calculate the cost basis of shares at the time shares are sold.  Currently, investors are able to specify the specific shares that are being sold which makes it possible to minimize capital gains taxes when part of a position is being sold.  Under the Senate proposal, investors would have to dispose of shares on a “first-in-first-out”, or FIFO, basis.

Obscure Accounting –> Real Life Impacts

This change might seem technical and obscure but it has powerful real impacts on small investors who have steadily purchased shares of companies over long periods of time.  In contrast, it has virtually no impact on traders who turn over their portfolios several times per year.

Let’s take a look at a hypothetical example that demonstrates the real life impact of the Senate’s proposal on a small investor.  James is a 65 year old pharmacist who plans to retire on January 1, 2018.  Over the past twenty years, James has invested in Berkshire Hathaway B shares on the first trading day of each year.  He started in 1998 with a $10,000 investment that purchased 327 Berkshire Hathaway B shares (split adjusted – assume for this example that purchasing fractional pre-split shares would have been possible).  Every year, he increased his investment by approximately 3 percent which roughly mirrored increases in his paycheck.  Today he owns 3,962 shares of Berkshire Class B worth slightly more than $717,000.  Of this amount, over $448,000 represents capital gains.  The exhibit below illustrates the annual purchases and the capital gain attributed to each purchase:

So the time has come for James to retire and he plans to draw down his portfolio of Berkshire shares at a rate of 4 percent per year to fund part of his retirement expenses.  This drawdown will start on the first trading day of 2018 and will involve a sale of 158 shares.  If Berkshire’s class B shares are trading at around today’s level of $181 at the beginning of 2018, the sale of 158 shares will result in proceeds of roughly $28,600.  (For purposes of this discussion, we will ignore commissions which are so low these days as to be nearly immaterial).

James has always expected to pay capital gains taxes when he started selling shares in retirement.  However, his accumulation of shares over the years was based on the understanding that he would be able to select the specific shares that were being sold.  Under current law prevailing in 2017, he would select the entire 2017 lot of 107 shares as well as 51 shares out of the 2015 lot of shares.  Here is what the capital gain would be under current law:

  • 2017 Lot:  107 shares sold at $181 (basis: $163.83) for proceeds of $19,367 with a gain of $1,837.
  • 2015 Lot:  51 shares sold at $181 (basis: $149.17) for proceeds of $9,231 with a gain of $1,623.
  • Total Proceeds:  158 shares sold at $181 for proceeds of $28,598.
  • Total Capital Gain:  $3,460

Under the Senate proposal, James would not have the ability to specify the shares that he is selling.  The assumption would be that the 158 shares being sold are from his first tax lot, that is, the shares that he purchased back at the beginning of 1998.  So, under the proposed law, here is what the capital gain would look like:

  • 1998 Lot:  158 shares sold at $181 (basis: $30.58) for proceeds of $28,598 with a gain of $23,766.

Assuming that James is in the 25 percent tax bracket for ordinary income, he would pay Federal capital gains taxes at the 15 percent rate:

  • Federal tax due under current law:  0.15 x 3,460 = $519
  • Federal tax due under proposed law:  0.15 x 23,766 = $3,565

Granted, it is true that James may benefit from other aspects of the tax reform legislation that could blunt the impact of this increase in capital gains taxes, but it would take a significant offset elsewhere to recover from a ~$3,000 capital gains tax hike due to the Senate’s tax proposal.  On capital gains, at least, James feels somewhat like Charlie Brown when Lucy pulls away the football.  His careful strategy of accumulating shares over two decades and intent to liquidate the highest cost basis shares first has been thwarted by an obscure provision motivated primarily by Senators desperately trying to get the bill to “score” more favorably.  The change is intended to raise revenue.  When Fidelity, Vanguard and other mutual fund firms objected, the Senators answered the phone and exempted fund companies.  Will they even answer a call from James?

Broader Effects

The impact on individual investors facing near term tax hikes should be clear but there are also broader effects that may or may not have been discussed by the politicians.  One clear impact will involve estate planning.  Shares that are left to heirs receive a “step-up” in cost basis coinciding with the date of death.  In other words, when James passes away, his low cost basis shares will “step up” to the current stock price so that his heirs will only owe capital gains taxes on further appreciation.  By being forced to liquidate lower cost basis shares, James will be less able to pass on low cost basis shares to his heirs.

The proposed change will also impact investors still in their accumulating years.  Let’s say that James is not retiring next year but in ten years.  Will he still want to put new savings each year into Berkshire Class B shares knowing that these specific shares cannot be “sold” under all of the lower cost basis shares in his portfolio are disposed of?  Effectively, recent lots of stock are “trapped” in the sense that they can only be liquidated after all of the earlier shares are sold.  James might well decide to put his funds into another company instead knowing that he can liquidate those shares at a relatively high cost basis, if desired.  Some might say he should be diversifying anyway, but isn’t that a decision that should be made based on the merits of investment choices and an individual’s personal view of the best place to invest his or her funds?

Any tax policy that causes investors to depart from acting based on fundamentals is bound to cause inefficiency in allocation of capital.  At the micro level, as with James, this has no discernible macroeconomic impact.  But when millions of potentially suboptimal tax driven decisions are aggregated, it could well have an impact on how capital is allocated economy-wide.

Tax reform was supposed to simplify the overall system, raise the funds necessary to run the government, and allow decision making to be based on business merits rather than playing tax games.  While there is always going to be a certain amount of lobbying and sausage making in Washington, it is disappointing that a supposedly “pro-business” party has presided over reform proposals that not only fail to achieve the stated objectives but might actually further distort economic incentives and decision making.

UPDATE:  The final tax legislation passed by Congress in late December 2017 did not include the FIFO changes discussed in this article.  However, it is quite possible that this provision could be included in future tax law changes now that it has been brought up as a revenue raising idea.

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.


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