The Sage of Baltimore

“The real fortunes in this country have been made by the people who put their capital into a business that had a future, worked hard, invested more capital, and stayed with their investment throughout the years — depression and boom alike. Such names as Ford, DuPont, Rockefeller, Duke, Carnegie, Woolworth and many others that are well known to all. These names are legend. Fortunes are still being made this way and you and I can participate in their continued growth as their shares are available in the market.”

— Thomas Rowe Price, Jr, “What is a Share in a Business Worth?”, October 25, 1947

Many things in life are completely out of our control. Most fundamentally, the year of our birth is something that none of us had any control over, yet this biographical detail has an enormous impact on our lives. Those who enter the labor force in a robust economy do so with more ease. Even individuals with marginal skills and work ethic can find employment. Coming of age in a period of stagnation creates headwinds that only the determined will overcome. Just as importantly, the baseline psychology of an individual is drastically affected by the environment in which he or she is raised and gets started in life.

Warren Buffett often says that he won the “genetic lottery” of life in terms of being born in 1930 and brought up in a relatively affluent environment. Coming of age right as the post-World War II boom was getting underway clearly shaped his outlook and opportunity set. What if Mr. Buffett had been born thirty years earlier instead, right at the turn of the twentieth century? If he had been born around 1900, he would have come of age in the aftermath of World War I, experienced the roaring 20s as a young man, and then suffered through the subsequent crash and depression. One can argue that the generation of investors that came before Mr. Buffett had more headwinds to deal with and certainly lived through more challenging macroeconomic environments as they were getting started.

Most modern-day investors are familiar with Benjamin Graham and Phil Fisher, both of whom were born within a few years of the turn of the century. However, relatively few investors are familiar with the life of Thomas Rowe Price, Jr, who in his later years was recognized as one of the best investors of the century and known as the “Sage of Baltimore”. T. Rowe Price: The Man, The Company, and The Investment Philosophy by Cornelius Bond is the first-ever biography of Price and provides readers with a comprehensive understanding of the man and his investment approach. Bond worked directly under Price for nearly a decade during the 1960s, relatively late in Price’s career. From this vantage point, Bond provides his recollections and insights regarding Price coupled with the findings of research into Price’s earlier years. Although Bond shows a deep level of respect and admiration for Price, he manages to avoid veering into hagiography and presents a balanced and worthwhile view of Price’s life and his times.

Early Years Shape The Man

Benjamin Graham and T. Rowe Price were born within a few years of each other in the final years of the nineteenth century and both came of age around the same time, with the main difference being that Graham started on Wall Street in the midst of World War I while Price was still a student. Neither Graham nor Price chose to study business in college. Graham was such a gifted student at Columbia University that he was offered teaching positions in English, Philosophy, and Mathematics upon graduation. Price entered college intending to pursue a pre-med program but ended up earning a Chemistry degree from Swarthmore where he did not take a single class in business or economics.

While Graham turned down his academic job offers and opted to start a career on Wall Street, Price initially had no intention of pursuing a career in business. He initially obtained jobs in his field of study but soon became fascinated with finance while working for DuPont. Price found that he could pursue a career in a field that offered solid remuneration while also enjoying what he was doing. He entered the field of investing in 1921 at the age of 23 and witnessed the roaring 20s firsthand, albeit from the vantage point of Baltimore rather than Wall Street.

In 1925, Price joined Mackubin, Goodrich & Co, a small financial firm in Baltimore where he would spend the next twelve years of his career as market euphoria peaked in the late 1920s and then crashed in the 1930s. Unlike Graham, who lost most of his investments in the early Depression years, Price was at an earlier stage of his career and, fortunately, was not a partner in his firm.

In 1930, Mackubin, Goodrich & Co had significant cash flow issues that forced partners to liquidate securities to raise cash in order to keep the firm afloat. Price obviously observed this turmoil but was not forced to liquidate his investments. Price appears to have taken this as a lesson to avoid leverage based on a journal entry at the time:

“When once again we are in good times with rising prices and the public is clamoring for profits, BE SURE to point out the horror of a depression and BE SURE to state that the worst depressions come when least expected. If you are buying something which you cannot pay for in cash, you must be prepared to take losses.”

T. Rowe Price, p. 54

Although Price took losses on his holdings during the early 1930s, he does not appear to have fallen into financial distress to the same degree that many of his contemporaries suffered. He also was able to hone his own investment approach and came to the conclusion that starting his own firm was the only way to pursue his passion for research and providing investment council.

Price came out of the depression without a gloomy outlook. He remained an optimist and this was a key factor that allowed him to pursue his approach to growth stock investing. Benjamin Graham emerged from the Depression to establish the school of value investing with its focus on the balance sheet and downside protection. Both men ended up posting excellent investment track records in the post-World War II years, albeit with diametrically opposed approaches.

The Growth Stock Philosophy

Price developed his growth stock philosophy over a period of nearly a half century starting in 1934 when he created a model portfolio while still working for Mackubin, Goodrich & Co. The idea of investing for growth in the midst of the Great Depression was a novel one, to say the least. At the time, investors were more interested in the return of their principal rather than the return on their principal. Price refined his philosophy over the years and published the following summary in 1973:

“A growth stock is defined as a share in a business enterprise which has demonstrated long-term growth of earnings, reaching a new high level per share at the peak of each succeeding business cycle, and which gives indications of reaching new high earnings at the peaks of future business cycles. Earnings growth per share should be at a faster rate than the rise in the cost of living, to offset the expected erosion in the purchasing power of the dollar. The goal is a portfolio of companies that will double earnings over a 10-year period. It is believed that dividends and market value would do the same.”

T. Rowe Price, p. 97

The goal of holding a portfolio of companies that will double earnings every decade might seem rather modest to the modern reader but being able to compound at a rate of 7 percent is not a shabby result whatsoever. When combined with dividends, it is likely that such a portfolio would approach 10 percent annualized returns which is more than adequate for the success of any long-term investment program.

When one reads Bond’s chapter describing Price’s Growth Stock Philosophy, it is clear that elements of it closely parallel Phil Fisher’s approach. Price emphasized careful research including the type of “scuttlebutt” techniques that Fisher advocated. Price was a big believer in talking to management and making frequent visits to gain an appreciation for what makes a company and its leaders tick. He looked for managers who prioritized intelligent research that would foster a differentiated product strategy commanding higher than average margins. And although Price always kept his focus on growth, he did not ignore downside protection either. He insisted on strong finances that would allow a growth business to survive business downturns.

Once growth companies are found, Price believed in holding them for a very long period of time, often measured in multiple decades. Like all intelligent investors, Price did not view market fluctuations as “risk” but instead knew that the only risk that counts is permanent loss of capital which is usually driven by weak finances.

Price’s growth stock philosophy worked very well, allowing him to generate an enviable track record over a long period of time. From inception of the strategy in 1934 to the end of 1972, the growth stock strategy returned 2,600 percent, assuming reinvestment of dividends, compared to a 600 percent gain for the Dow Jones Industrial Average. The CPI rose 205 percent over this timeframe.

House Money?

When to sell is a dilemma facing all investors, but particularly those who focus on growth stocks. Many of the greatest growth stocks always appear to be “expensive” based on traditional metrics used by value investors such as the price-to-earnings ratio or price-to-book value. Price believed in holding his companies for decades but also had an interesting policy that recovered his cost basis in a company while letting his profits ride:

“Once a position is established, if a stock then moved to a significant premium over what it is deemed to be worth, he suggested that the stock be sold until the total cost of the stock position, plus capital gains taxes, is realized. The profit, he believed should be reinvested in long-term government bonds, or good-quality corporate bonds for safety and income. The profit represented by the shares left in the portfolio should be allowed to continue to grow in value until the company matures and is no longer considered to be a growth company. These shares effectively have no cost.”

T. Rowe Price, p. 106

On its face, this approach is not a rational one. If one deems a security to be overvalued, which implies that future returns will be sub-par and fail to approach returns achievable in other investments (or an index fund), one should logically sell the entire position. However, human beings have to grapple with our psychology and the fallibility of our analysis. We could be wrong about a company being overvalued. Many great growth companies are “overvalued” for their entire history by conventional metrics. A growth stock investor who adopts Price’s approach of getting their cost basis back might be able to psychologically handle leaving the remaining “house money” invested because it has “no cost”.

Of course, this type of mental accounting is not strictly rational. The remaining shares in the portfolio most certainly have an opportunity cost. They could be sold and reinvested. The market doesn’t “know” that you have retrieved your cost basis and are playing with house money. Yet, if this type of approach helps a growth stock investor to stay the course in promising companies through periods of transient overvaluation, perhaps that is a psychological trick that has some merit. Those of us who fall into the value investing camp are not likely to be comfortable with the house money concept but we should not easily dismiss its utility from a psychological perspective, especially for those with a focus on growth stocks.

A Different Era

It is impossible to read this biography without noting that Price and others during his lifetime operated by very different ethical standards compared to modern day Wall Street. The reason Price started his own firm in 1937 was primarily because he did not believe that the firm he was working for was focused entirely on providing investment council to clients but was instead always likely to view the world from a transactional perspective of a broker. Price wanted to forge long-term relationships with clients and had a higher sense of fiduciary duty.

The modest salaries taken by Price and others in his firm illustrate an ethos from an earlier time. In 1947, as his firm was regaining its footing after the war, Price paid himself an annual salary of just $12,000. According to the Bureau of Labor Statistics, this is equivalent to $134,000 in 2019 dollars. The other founding members of the firm earned just half of Price’s salary. By 1950, Price was earning nearly $23,000 in taxable income, or the equivalent of $241,000 in current dollars, a year that he referred to as “the most successful year in my business career from every angle.” At this point, Price was in his early 50s and at the start of an incredible run building his mutual fund business.

Until the early 1950s, T. Rowe Price & Associates was primarily focused on managing separate accounts for wealthy individuals and institutions. Several tailwinds in the 1950s, principally the fact that institutions started investing their pension funds in stocks, led to massive growth in the mutual fund industry. T. Rowe Price initially created its Growth Stock Fund as an ancillary service for existing clients and made it a no-load fund. Most funds at the time charged sales loads of five percent or more. Assets under management catapulted from $152 million in 1954 to over $1 billion by 1965 when Price began the process of selling his interest in the firm.

By modern standards, the $720,000 Price received for his interest in T. Rowe Price & Associates in 1966 seems microscopically tiny for a controlling interest in a successful asset management company. This amounts to only $5.6 million in 2019 dollars. Two years later, he sold his interest in Rowe Price Management, a firm that he established to manage portfolios of small growth stocks, for just $1.5 million, or $10.9 million in current dollars. Price earned significant wealth in his lifetime, but nothing like what modern executives in finance, many with no real skin in the game, earn in just a single year!

Lessons Learned

The life of Thomas Rowe Price, Jr. is well worth serious study and it is somewhat surprising that his first biography was written in 2019, 36 years after his death in 1983 at the age of 85. During his later years, he received the professional recognition that he always craved and was well known in the investment community as the Sage of Baltimore but in recent years his name is more likely to bring to mind the firm he founded rather than his growth stock philosophy and investment track record. That’s a shame because investors have much to learn from his life and approach to investing.

While none of us had any control over the outcome of the “genetic lottery” and, to a large degree, are products of our times, it is fascinating to read about how different people react to the same circumstances. Much of this, no doubt, has to do with temperament and personality. One gets the sense that Price was an eternal optimist. There is no doubt that this shaped his willingness to seek out investments with multi-decade time horizons even as the world was in the midst of depression and world war. Ben Graham lived through the same period and adopted a radically different, and much more skeptical approach. Yet both men did very well with their different approaches because they adopted styles congruent with their outlooks and personalities.

There are many ways to win in business and in life. Chances are that if you are reading this article, you are already a major winner in the lottery of life. There are truly unfortunate people in the world who have little opportunity based on the luck of the draw. Those of us fortunate enough to have built up capital to invest based on enterprise and hard work should bear in mind that we can pursue our activities through all sorts of economic vicissitudes knowing that following logically consistent and rational approaches will stand the test of time.

Disclosure: The Rational Walk LLC received a review copy of this book from the publisher.

The Aesthetic Tightrope

Dogs do not care what patterns are knitted into their sweaters. They may or may not appreciate the functional warmth provided by their sweaters but only their owners derive any benefit from details such as the color scheme, a Christmas pattern, or the overall quality of the stitching. Most dogs would probably be happier to wear nothing at all, even in the depths of winter.

Human beings are unique creatures in many ways, and probably viewed as somewhat odd by other animals, including our long suffering dogs forced to wear cashmere Christmas sweaters. Ever since the first cave paintings were created over 40,000 years ago, humans have expended time and energy to beautify our surroundings in ways that have little or nothing to do with functional elements of our lives. The quality of our homes and our clothing have been important ways to signal status for thousands of years and people have gone to great lengths to go well beyond functional utility due to the intangible value provided by aesthetics.

Other species may appear to take note of what we call aesthetics, but they do so for functional purposes, such as when a scavenging animal is repulsed by spoiled meat that would be poisonous to eat or when peacocks note the beauty of each other’s tail feathers during mating rituals. Being aware of the aesthetic qualities of food lowers the risk of poisoning and noting which potential mate displays the most impressive physical attributes is a necessary impulse for animals who seek to propagate their genes. In this sense, aesthetics in the non-human animal world have functional purposes. Only a peacock that is healthy, thriving, and likely to pass on strong genetic material will have the ability to dedicate scarce physical resources to growing beautiful tail feathers.

As human civilization progressed over the centuries and societies rose beyond the subsistence level, social stratification allowed a small number of people to dedicate their entire lives to pursuing their notions of aesthetic beauty. Often such artists were sponsored by royal courts that had tremendous resources to dedicate toward the aesthetic ideals prevailing at the time. Any tour through a great art museum leaves a modern visitor in awe of the works of art created by societies in which the vast majority of people were still focused on day-to-day survival.

The importance of aesthetic beauty is now pervasive in all segments of modern society and it would be rare to encounter anyone who has no desire to be near beautiful artwork or pleasing objects, however they choose to define it. At the same time, most of us go through our day-to-day lives with an intent focus on functional utility, whether we are commuting to work, reading the newspaper on our tablets, or preparing dinner at home. Ideally, we would like the functional objects in our lives to also provide aesthetic beauty.

The Intersection of Liberal Arts and Technology

In 1995, I decided to teach myself computer programming and I needed to purchase a computer. The problem was that as a new college graduate, I did not want to spend a lot of money on a pre-built system from a company like Dell or Hewlett-Packard. Fortunately, it was easy to go to Fry’s Electronics and purchase a tower case, a motherboard, CPU, memory, a hard drive, a power supply, and a few other components and plug them all together. Voila! I had a working system with Window 95 installed and I saved some money. The system had no aesthetic beauty. Few thought computers needed to at the time. With one notable exception.

”It is in Apple’s DNA that technology alone is not enough—it’s technology married with liberal arts, married with the humanities, that yields us the results that make our heart sing.” 

Steve Jobs introducing the iPad 2

Computers were thought of as functional objects for a long time. They were purely utilitarian and appearance did not resonate much with corporate or retail consumers, especially for desktop systems that spent their lives under a desk. However, Steve Jobs had long been obsessed with aesthetics. To Jobs, a computer or any other functional technology product had no soul if it did not have aesthetic virtues as well as technical prowess. Jobs famously also obsessed over what the inside of his products looked like even though customers would never see it. It was a matter of principle and pride of craftsmanship — attributes that great artists insist on.

Jobs was decades ahead of his time and suffered greatly for his obsession with the appearance of his products. And his competitors mercilessly ridiculed him for it as well. When Jobs, exiled from Apple in the 1980s, unveiled his first product launch for NeXT, he made the design and appearance of the computer a priority. Bill Gates dismissed not only the technology but the sleek, all black design stating: “If you want black, I’ll get you a can of paint.”1 Two decades later, Steve Ballmer laughed at what he considered the outrageous pricing of the first iPhone — after all, Microsoft had phones that could also “do email and internet”.

Importantly, Jobs was not a starry eyed romantic when it came to aesthetics. He realized that the beauty of the form had to be married to strong functionality to succeed in the marketplace. Additionally, he spotted areas where an aesthetic advance such as eliminating ugly physical phone keyboards could not only provide the same functionality but improve capabilities because virtual keyboards can be designed to adapt to changing contexts based on what the user is doing.

The Tension Between Form and Function

The best of both worlds occurs when an aesthetic advance, such as virtual keyboards on phones, also provides important functional advances. This is a clear win-win proposition. However, in many important design decisions, there is a tension between maximizing functionality and promoting physical beauty. This is true in many areas, but let us stick with technology for now and consider certain other design decisions made by Apple in recent years.

Apple has long been obsessed with making devices thinner and sleeker. Such attributes are prominently featured in all product launch events and the “wow” factor clearly impresses a large segment of consumers. In addition, highly visible changes to the physical appearance of a product, such as the iPhone or iPad, can be important to drive product upgrade cycles. Many customers will upgrade so they can be seen with the latest and greatest device. To drive this impulse that people have to signal status and wealth with technology, products must be visually differentiated from older versions.

The drive to produce thinner and sleeker products has required tighter and tighter construction of the components making up the device to the point where almost no consumer today would have the ability to service their product themselves. In many cases, devices cannot even be serviced by Apple itself. Additionally, the desire for thinner form factors has sometimes involved removing functionality. Such was the case when Apple discontinued a dedicated earphone outlet on new iPhones. Customers must now utilize the power port for wired headphones. And, of course, many have opted to purchase Bluetooth headphones like the AirPod.

The Price Paid for Beauty

The days of ordinary people tinkering with their consumer electronics is long past. When something goes wrong with a device, it typically must be returned to the manufacturer or taken to a third party repair shop for service. Often the cost of service, for devices past warranty periods, is too high to justify repair. The clearances within the device are simply too tight for people without training to replace broken parts or to diagnose problems.

I purchased a new MacBook Pro laptop in mid-2017 and it is both the most powerful and most beautiful computer I have ever owned. And it should be based on the $2,500 price tag! Unfortunately, Apple made a decision to introduce a new type of laptop keyboard using a “butterfly” mechanism in order to allow for a sleeker design. This design backfired:

In a weird way, Apple made a brilliant new laptop keyboard — it was thinner, sleeker, and felt fantastic to type with. Unfortunately, it only worked consistently in controlled environments and ruined one of the most important aspects of any computer.

What the hell is Apple’s butterfly keyboard?

The keyboard did feel fantastic to type with and it looked great as well. Win-win, right? Wrong. A little over two years of daily use resulted in several keys not working properly – either becoming non-responsive or repeating inappropriately. One faulty key was the period, which is probably the worst key to go bad for a user who works with spreadsheets frequently.

After some initial controversy and legal action, Apple did the right thing and created a program to replace all faulty keyboards free of charge. But customers are still being inconvenienced and losing access to their computers for several days while the problem is resolved. Additionally, due to the tight clearances and desire to make everything as compact as possible, Apple must replace not only the keyboard but the battery of affected laptops since both are within a single module that apparently must be replaced as a unit.

Balancing on the Aesthetic Tightrope

What is the right balance between form and function? Who had the “right” approach – Bill Gates or Steve Jobs? Looking at that specific question from the perspective of late 2019, we can note that both Microsoft and Apple have been resounding success stories and both companies now have market capitalizations in excess of $1 trillion.

Microsoft has never been known for the aesthetic beauty of its products, but hardware was not a focus for the company throughout most of its history. Apple, on the other hand, has always been known for the form and function of its products. Both have played to their strengths over the past decade with Apple continuing its innovations in product design while Microsoft made surprising headway in cloud services. There are many ways to win in business.

Apple without a focus on aesthetic beauty would be a company with no soul. It is clearly correct for Tim Cook to dedicate significant resources toward innovations that lead to thinner and sleeker devices that will cause people to line up for product releases. It is also probably correct for Apple to make a conscious decision to accept some functional constraints in the pursuit of aesthetic beauty, including taking risks that sometimes backfire as was the case with the butterfly keyboard issue.

In rare cases, advances in aesthetics and functionality go hand in hand and this is a clear win-win proposition. In most cases, however, there is a natural tension between form and function. Apple has generally managed to walk the aesthetic tightrope skillfully over the years even though the choices they make sometimes backfire and annoy their customers.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway which has a large holding of Apple common stock.

  1. See Loonshots, p. 122, which we reviewed in November. []

Holiday Book Recommendations for 2019

Reading a book can be deceptively expensive. The cost of a new hardcover book on Amazon is usually in the vicinity of twenty dollars, but the real cost of reading any book is the time you spend reading it. If you value your time at fifty dollars per hour and the typical book takes five hours to read, that is a $250 time commitment. And often that commitment is well worth it since you have the ability to absorb the knowledge a writer has poured out onto a page over hundreds or even thousands of hours of effort.

Books can represent a terrific value proposition provided that you avoid the ones that are not worth your time! In addition to hopefully conveying interesting information to readers, writing book reviews helps to synthesize the information and compliments the goal of active reading. Importantly, conveying this type of information does not carry with it the negative aspects of writing about investment ideas. As a result, book reviews have become a more common subject for articles on this website in recent years.

The book recommendations that appear in this article are mostly not related to finance and investing. Although these are all books that I read in 2019, most were not published this year. A similar list of recommendations appeared during the 2018 holiday season and a list specific to investing appeared several years ago. Hopefully these recommendations will provide an interesting starting point for your own holiday season reading or ideas for gifts.

Alexander Hamilton. Ron Chernow’s epic biography of Alexander Hamilton represents the authoritative modern account of the life of one of the most consequential founding fathers. Although often castigated as a monarchist by his rivals, Hamilton had anything but a privileged upbringing. He rose from a position of poverty and family dysfunction in the Caribbean to the heights of American political power in a very short period of time, gaining the trust of George Washington during the Revolution. He parlayed early success into positions of great influence in shaping the Constitution and establishing the foundational elements of American capitalism. Hamilton was a flawed man whose style sometimes led to more antagonism than necessary, but his importance to the success of the American experiment cannot be denied. Chernow has a way of bringing historical figures to life and Hamilton is no exception.

Dignity: Seeking Respect in Back Row America. Chris Arnade left his job as a trader on Wall Street in 2012 to focus on the plight of the poor in America. While still working as a trader, Arnade had a habit of taking long walks through New York City. His willingness to talk to the drug addicts, prostitutes, and homeless people he encountered formed the basis for a more in depth examination of what he calls “the back row” of American society – those left behind in our modern economy. Worse than being left behind, the back row is misunderstood and belittled by the “front row” elites, and this misunderstanding crosses racial, ethnic, political, and geographical lines. Although this isn’t a book about how Donald Trump came to power, it does help to get a sense for the dissatisfaction that makes people willing to make Hail Mary attempts to shake up the system.

The Bed of Procrustes. Nassim Nicholas Taleb is best known for his first book, Fooled by Randomness, which is part of a five volume set called The Incerto. The Bed of Procrustes is probably the least read of Taleb’s work and is also the shortest. As a book of aphorisms, the text is entirely comprised of short statements of a principle or opinion, such as “If you find any reason why you and someone are friends, you are not friends.” Chances are that if you appreciate Taleb’s work in general that you will also enjoy his often witty and profound takes on a variety of subjects from economics to philosophy to practical aspects of life. Taleb is often very polarizing on social media, something that he obviously views as a necessary aspect of his role as a “BS detector”, but the fact is that his insights have proven to be correct and his work extremely valuable even for those who are put off by his often acerbic online persona.

Night. No matter how many Holocaust museums one visits or how many first-hand accounts one reads, it is impossible to fully understand the horror of the crimes of Adolf Hitler’s Third Reich before and during the Second World War. Nevertheless, it is the responsibility of current generations to make an effort to remember what happened as the remaining individuals who witnessed it directly will be gone within the next couple of decades. Elie Wiesel experienced the horror firsthand as a teenager when he and his family were taken to the Auschwitz concentration camp in 1944. His account of the death of his family members and the suffering of countless others has deeply affected readers since the book’s publication over sixty years ago. Wiesel lived until 2016, clearly haunted by his experiences but determined to convey the horror so that such atrocities will not be permitted to happen again. Night can be paired with Dawn which is a story of the moral and ethical choices facing a Holocaust survivor-turned soldier during the war of Israeli Independence.

The Alchemist. Paulo Coelho published The Alchemist in 1988 at the age of 41. Published originally in Portuguese, the book attracted little attention at first and his original publisher cancelled his contract. However, the book went on to achieve great success and has sold over 50 million copies. Coelho did not give up. Like the story of the Andalusian shepherd boy in the book, Coelho had a laser-like focus on his “personal legend”: “It is what you have always wanted to accomplish. Everyone, when they are young, knows what their Personal Legend is.” The shepherd boy in the story had known ever since he was a small child that he wanted to travel in order to see and experience the world. His quest, set in an earlier time, led him from the comfortable pastures of Southern Spain that he had known all his life to the pyramids of Egypt. Along the way, he learned much about himself, human nature, his place in the world, and his ultimate destiny. A grand adventure sure to be appreciated by young and old alike.

Where Are the Customers’ Yachts? Fred Schwed wrote the first edition of this book in 1940 and revised it in 1955, yet far from stodgy and outdated, this book will seem like it was written about investor behavior this year. Contexts and examples change, but the underlying human condition and the follies we encounter never changes. On topics ranging from the investor’s passion for prophesy to inflation to chartists, to economists, to the inability of most people to simply sit and do nothing, Schwed will have you nodding in recognition of some of your own mistakes while bursting into spontaneous laughter. The book is full of gems such as: “When a statistician works up a sufficient reputation for profundity, he is graduated and becomes an economist”. As Jason Zweig notes in his introduction, many investment books can make you think, you can occasionally find something useful, but it is very rare to find an investing book that can make you laugh. Schwed’s classic is such a book.

Walk the Sky. The John Muir Trail in California’s Sierra Nevada mountain range is one of the most scenic pathways in the world. After writing an account of my walk this summer, I received several inquiries regarding the trip. It is difficult to convey the trail in words but, luckily, those with an interest in the scenery can read John Dittli’s Walk the Sky. The book is not a guide for the trail, but instead provides numerous excellent photos of the trail along with accompanying essays. Dittli knows the Sierra Nevada from his decades of exploration and has a unique talent for capturing scenery.

The Prado Guide. Madrid’s Prado Museum is one of the highlights of any trip to the city and is considered by many to be the greatest public collection of paintings in the world. You can easily spend an entire day wandering around the collection. This guide contains full color photos and could be of interest to anyone, but of course is of greatest interest to someone planning to visit the collection. My purpose for including it here is to point out that most people who visit museums either rent audio guides or rely on placards next to artwork. Neither provides a real understanding of what you are actually looking at. It is much more rewarding to invest a few dollars or euros in a proper guidebook and read about what you are looking at in more detail. By doing so, you will also escape the herds of tourists on tours who move from one piece to another with robotically timed precision. Unfortunately, this approach ends up being superficial – a mile wide and an inch deep. Consider investing in a book for your next visit to a great museum.

The Little Book of Valuation. One of the most consistently interesting investment blogs is Aswath Damodaran’s Musings on Markets. Over the past year, Damodaran has made a special effort to examine many of the highly publicized initial public offerings and attempt to provide valuations in cases where most investors would give up in frustration. Most IPOs are priced based on the strength of the narrative presented by the company whereas true investors, as opposed to speculators, care about estimating intrinsic value. Damodaran clearly lays out his assumptions regarding each company and presents valuations for each while fully acknowledging the hazards of doing so in cases where the variables are difficult to forecast. He also provides downloadable spreadsheets so readers can test variances based on their own judgment. The Little Book of Valuation is a 2011 book that lays out Damodaran’s approach to valuation in greater detail.

The Feynman Lectures on Physics. Like many who opted to study business in college, I viewed other subjects mainly as requirements to be met as efficiently as possible. I took science seriously, but only to the point where I needed to in order to secure an A. Information obtained in this superficial manner is usually not retained, and therefore cannot be called upon decades later. If we take Charlie Munger’s advice to learn as many mental models as possible, it is hard to ignore the hard sciences. The Feynman Lectures on Physics, which are also available free of charge, is an excellent way to begin to understand physics, and I have only made modest headway on the first volume this year. Often challenging but never boring, Feynman’s lecture notes are definitely worthwhile for the intellectually curious.

Disclosure:  The Rational Walk participates in the Amazon affiliate program and receives a small commission for all products purchased via links on this site.

Here’s to the Crazy Ones

It is Friday afternoon, around 4:30 pm, and Dan just got back to his desk from a meeting. He sees Janet, his manager’s boss, drinking coffee nearby. Dan’s son goes to the same school as Janet’s daughter and he has chatted with her before. Does Dan take this opportunity to talk to Janet or will he write some code for his project which is already late and might not be complete by its due date next week? The end of the quarter is coming up soon and about ten percent of his compensation is based on a bonus…


Disruption. This single word is among the most overused in the lexicon of business, especially in fields that are related to technology. It seems like every company under the sun hoping for venture capital funding has a hundred page PowerPoint deck ready to demonstrate how their product or service will “disrupt” the old, lazy incumbents in an industry and deliver riches to early stage investors. But actual disruption is rare. Organizations that have all the right ingredients to bring disruption to entrenched industries are very special and uncommon.

Every investor wants to understand disruption, whether from the perspective of the venture capitalist interested in spotting the next unicorn or the conservative investor worried that one of his companies might be on the receiving end of a tectonic industry shift. Safi Bahcall’s new book, Loonshots, is not a study of industry disruption per se, but it is useful for those who have an interest in the development of “crazy new ideas” that often end up being disruptive. He defines a loonshot as “a neglected project, widely dismissed, its champion written off as unhinged.” A moonshot, in contrast, is “an ambitious and expensive goal, widely expected to have great significance”. Loonshots often begin as embryonic ideas or technologies with no resemblance to the product or service that they later evolved into, and the inventors of the loonshot might have never imagined what the ultimate target market would be. Loonshots is a study of the nature of organizations that successfully nurture early “crazy ideas” that later turn out to have far reaching and often surprising implications.

The topic of loonshots can be approached in multiple ways. It is likely that most readers of this book are entrepreneurs or managers who are hoping to build or sustain highly innovative organizations. For these readers, the book offers a number of strategies that should be helpful for building organizational structures conducive to loonshots. Many readers of this article might be looking at the topic from the perspective of outside investors who want to identify companies that have characteristics necessary to nurture loonshots. In either case, a good understanding of the basic premise of the book is a necessary prerequisite.

Phase Transitions

The world is full of complex systems that exhibit sudden changes of behavior in response to slight changes to the variables that affect it. In physics and the hard sciences, a phase transition can refer to the transition point between a solid, liquid, or gaseous state of matter. A very simple example that everyone is familiar with involves water. Below 32 degrees Fahrenheit, a water molecule is in a solid state known as ice. Between 32 and 212 degrees, water takes on its familiar liquid state, and above 212 degrees, it turns into a gas and evaporates. The behavior of water close to 32 and 212 degrees represents a phase transition. Bahcall is a physicist who was trained to look at these type of phase transitions in the hard sciences and the key insight of his work is that he has adapted this mental model to the topic of organizational behavior:

There’s no way to analyze the behavior of any individual and explain the group. Being good at nurturing loonshots is a phase of human organization, in the same way that being liquid is a phase of matter. Being good at developing franchises (like movie sequels) is a different phase of organization, in the same way that being solid is a different phase of matter.

When we understand those phases of organization, we will begin to understand not only why teams suddenly turn, but also how to control that transition, just as temperature controls the freezing of water.

Loonshots, p. 12

At first glance, the idea of adapting rules governing the state of matter to complex human organizations seems suspect. “Physics envy” is a common affliction in social sciences, such as economics, where academics attempt to bring more structure and order to the human condition than is warranted in reality. However, Bahcall makes a strong case for his theory based on a number of case studies demonstrating the success of organizations that carefully managed phase transitions, as well as examples of those that did not. He shows that small changes in the structure of an organization, as opposed to its culture, can transform a rigid company into one that simultaneously fosters loonshots while also protecting its existing franchises.

Polaroid’s Rise

Edwin Land fits the modern prototype of a technology visionary, from his eccentric personality to his technical genius. It is easy to picture Land transported to the current age operating comfortably within the modern-day technology ecosystem. It is not an exaggeration to characterize Land as the Steve Jobs of his era, as Bahcall points out in his account of Land’s introduction of the groundbreaking Polaroid SX-70 in 1972. The Polaroid SX-70 was the first instant camera that was easy to use and had broad-based appeal to consumers. Those of us who grew up in the 1970s and 1980s can easily recall the ubiquity of these cameras and the instant gratification produced by having a print in hand in as little as a few minutes.

Bahcall’s fascinating account of the rise and fall of Polaroid begins during Land’s childhood half a century before the Polaroid SX-70 changed photography. Land was the prototypical child prodigy who experimented with complex scientific projects at an early age. At age 13, he became obsessed with creating a polarizer in order to “unlock the mysteries of light”, a goal that no one had yet achieved. By age 19, he had accomplished his goal. His love of the scientific process drove those early accomplishments, and only later did he turn his focus toward practical applications, such as coating car headlights and windshields with polarizing filters to reduce glare.

Land’s first big hit had a major impact on America’s ability to wage war. Polarized sunglasses improved the ability of soldiers and sailors to deal with the glare of sunlight and adjustable shade goggles helped pilots to quickly adjust during the transition from low light to bright conditions. Although Land’s invention did not provide as great a contribution as the invention of radar, which is another case study presented by Bahcall, it clearly helped allied forces during World War II and provided Land and Polaroid with financial success.

After the war, Land turned his attention toward the application of his technology to photography. After his three year old daughter asked “why can’t I see them now” after Land took some photos on a vacation, he had a “lightbulb moment” that led him down the path that eventually resulted in the Polaroid SX-70 instant camera thirty years later. And financial success followed as sales grew from less than $1.5 million in 1948 to $1.4 billion in 1978.

Types of Innovation

This is a good point to take a step back and consider Bahcall’s distinction between two distinct types of innovation. The innovations created by Edwin Land were product breakthroughs which Bahcall refers to as “P-Type Loonshots”. P-type loonshots are technologies that, at one point, were widely dismissed or viewed as not having practical value before finding an application and achieving success. Even Land himself had no idea that his childhood fascination with polarizers would lead him, half a century later, to introduce a groundbreaking technology that would change consumer photography forever.

In contrast, there are loonshots that involve a breakthrough in strategy. New ways of doing business or new applications of an existing product, without the use of breakthrough new technology, are called “S-Type Loonshots”. Bahcall points to the example of Sam Walton as an S-type innovator. Walton did not invent any new technologies, but he found a way to deliver products to consumers at much lower cost. The same is true of Herb Kelleher’s S-type innovation that led to the success of Southwest Airlines. And, surprisingly, Bahcall characterizes both Facebook and Google1 as S-type innovators as well since they did not invent the concept of social networks and search, respectively.

Both P-type and S-type loonshots are often characterized as crazy ideas that have no chance of working. Until they do. And the disruption caused by S-type innovation can cause havoc for firms that are led by P-type innovators who fail to manage their organizations in a way that both fosters continuing innovation while protecting existing franchises. Such was the case for Edwin Land and Polaroid.

Polaroid’s Fall

For three decades, Land’s leadership produced one product innovation after another:

Polaroid followed the first sepia prints in 1947 with black and white (1950); automatic exposure (1960); instant color (1963); non-peel-apart firm (1971); the SX-70 all-in-one, foldable camera (1972); sonar auto-focus (1978); and countless other advances in between.

Loonshots, p 109

Edwin Land was at the top of his game as a visionary genius and, in addition to his role as the driving technological force at Polaroid, he was also the man responsible for running the entire enterprise. Land loved technology and loved making risky product bets. He acted primarily based on his love of loonshots rather than focusing on the strengths of overall corporate strategy. Polaroid was falling into what Bahcall refers to as the “Moses Trap”, which he defines as follows:

When ideas advance only at the pleasure of a holy leader — rather than the balanced exchange of ideas and feedback between soldiers in the field and creatives at the bench selecting loonshots on merit — that is exactly when teams and companies get trapped. The leader raises his staff and parts the seas to make way for the chosen loonshot. The dangerous virtuous cycle spins faster and faster: loonshot feeds franchise feeds bigger, faster, more. The all-powerful leader begins acting for the love of loonshots rather than strength of strategy. And then the wheel turns one too many times.

Loonshots, p. 93

Land turned the wheel one too many times.

How many of you fondly recall family vacations saved for posterity using the Polavision home movie system? Probably very few people remember the system because it was a commercial failure. However, the product received glowing reviews2 at the time. Edwin Land had done it again. Except he had pushed the envelope too far this time. No matter how marvelous this P-type innovation was, it could not overcome the cost. The Polavision player retailed for $465, the camera cost $210, and each Phototape, which provided just two and half minutes of recording cost $9.95. Translated into 2019 dollars3, the basic system cost nearly $2,600 and each tape cost $38. Especially compared to median incomes at the time, this marvelous recording device was out of reach for the vast majority of consumers, no matter how great it was. However, in anticipation of commercial success, Land insisted on building a new plant to produce over 200,000 Polavision machines, and a film assembly line produced ample supplies of consumable Phototape cassettes.

The end of this movie followed in predictable fashion when Polaroid’s management was forced to write down the value of unsold Polavision inventory just one year after Land’s splashy introduction. Land’s comment that the accounting write-down “was accounting jargon, a cruel misuse of language” mirrors what modern-day visionary leaders often say on Twitter when faced with bean counters who stand in the way of their grand visions. Land had allowed his zeal for elegant P-type innovation to cost his company over $200 million. Even worse, as would be borne out in the coming years, he had entirely missed the move to digital photography even though he was aware of the technology. His passion was in film, and so were Polaroid’s profits. He was forced to resign soon after Polavision’s commercial failure.

Having Your Cake and Eating It Too

The world needs men like Edwin Land, and in more important ways than having the latest and greatest consumer technologies. Bahcall presents other fascinating case studies in the book regarding loonshots that had vital roles in the allied victory in World War II as well as medical marvels that have saved millions of lives. We need P-type innovators, and we need them badly, for society to progress in the decades and centuries to come.

Society might benefit from the Moses-type leader who creates groundbreaking P-type innovations regardless of financial consequences, but those of us who either run companies or invest in them also care about harnessing these type of innovators while also ensuring the long term survival of companies. How can we create “loonshot nurseries” while simultaneously keeping a company’s core franchise alive and well?

Bahcall provides practical advice to leaders that he refers to as the “Bush-Vail Rules”, inspired by the management philosophy of Vannevar Bush and Theodore Vail, both of whom are discussed early in the book. The Bush-Vail system involves four key rules, the first three of which are outlined very briefly below:

  1. Separate the phases. This goes back to the concept of phase transitions. It is extremely difficult for one organization to both come up with loonshot innovations and to operate an existing business. Bahcall advocates creating separate groups for “artists” and “soldiers” rather than hoping that they can coexist within the same organization. This involves more than opening up a loonshot office in a San Francisco loft. One must tailor the organization structure to the purpose. Generally, loonshot groups should be managed with a flatter organizational structure and looser controls while franchise groups benefit from a more centralized structure with stricter controls. Bahcall also believes that organizations should not focus exclusively on P-type innovations because doing so can create blindness to S-type innovations that can upend a franchise built exclusively on P-type innovations.
  2. Create dynamic equilibrium. A creative genius like Edwin Land naturally favors the “artists” while thinking less of the “soldiers”, as his attitude toward accounting write downs demonstrated. While it is not impossible for a creative genius to eventually love his “artists” and “soldiers” equally, doing so requires concerted effort. Bahcall notes that Steve Jobs, early in his career, was very much an Edwin Land style leader but through hard experiences, had a second act at Apple where he treated artists like Jony Ive and soldiers like Tim Cook as equally important. Bahcall recommends that the leader of an organization should manage the transfer of technology between the loonshot and franchise groups without excessive intervention which he likens to acting as a gardener rather than as a Moses.
  3. Spread a system mindset. Bahcall advocates maintaining a system mindset in which one is constantly asking why certain outcomes occurred, analyzing both success and failure, rather than taking a simplistic view. It is more important to analyze the quality of decisions than just individual outcomes. It is very possible for a good process to result in occasional bad outcomes, just as it is possible for flawed systems to occasionally create good outcomes. This notion is very similar to the second-level thinking that investors such as Howard Marks advocate.

Getting Past 150

The fourth Bush-Vail rule is one that I consider the most important and deserving of more in-depth discussion. It has to do with a number that I have seen mentioned in many places as having special significance.

That number is 150.

Yuval Noah Harari’s book, Sapiens, which I reviewed last year, observed that for much of human history, the maximum size of a society was approximately 150 individuals. This seems to be the maximum size of a group that can operate effectively in a cohesive society when the group relies primarily on personal relationships. Harari pointed out that only when society developed larger concepts such as nationality and religion could groups of individuals larger than 150 take on elements of cohesion required for large societies to survive.

Just as nationality and religion binds together very large groups of people, far in excess of a couple of hundred, it is possible for companies to bind together larger groups as well. However, anyone who has been involved in companies of radically different sizes knows that small companies have dramatically different structures and cultures compared to large companies.

In a small company, the management span tends to be very wide – meaning that there are few layers of management between the CEO and individual contributors. The nature of small companies also creates an environment in which the incentives of individuals is to focus intently on the success of the overall organization and its mission. What difference does it make if one maneuvers politically in an organization in which there are few layers of management and survival depends on the success of the project?

In a larger company, management span tends to be narrower – meaning that there are many layers of management between the CEO and individual contributors and the number of direct reports for each manager is lower. The line of sight between the success of an individual’s project and the success of the company is much more diffused. There is a higher return for those who can maneuver politically because there are more layers of management and, typically, the pay gap between layers is larger than in a small start-up.

As an organization increases in size past the 150 mark, Bahcall believes that a phase transition typically results in which an organization shifts from one that is conducive to producing loonshots to one where the return on politics begins to exceed the return on actual achievement. However, he believes that there are a number of ways to raise this “magic number”. Still, beyond a certain size, a group will inevitably shift from a “loonshot mindset” to a “franchise mindset”, and this is why it is important to nurture your loonshot nursery as well as your franchise groups and to deftly manage the transition between the two.

“Here’s to the Crazy Ones”

Loonshots provides fascinating case studies that show beyond any doubt the returns to society that come from the types of people Steve Jobs would often call “the crazy ones“.

Jobs himself is a case study in how a “crazy one” can evolve from a Moses-like figure similar to Edwin Land into the executive who found a way to successfully manage loonshots while also sustaining his company’s core franchise. Today, Apple is run not by an “artist” but by a “soldier”. Tim Cook is an operational genius, not a product visionary, yet he has so far seemed adept when it comes to sustaining the “loonshot nursery” at Apple. With the recent departure of Jony Ive, Cook’s job has become more difficult. It will be fascinating to see how Apple evolves over the next decade.


Dan weighs his options. His bonus is based on something the company’s CEO mysteriously calls “community adjusted EBITDA” for the current quarter and he is one of three hundred engineers in a company of ten thousand employees. He has no clue what “community adjusted EBITDA” even means or how his project’s success will influence it. There is only one level of management between him and Janet – his direct supervisor – and rising up just one level in the hierarchy would mean a raise of around 30 percent. Dan saw his manager browsing LinkedIn before the meeting and has a feeling that his boss is looking for a new job. Dan decides to walk over to the coffee machine and strike up a conversation with Janet about the new principal at their kids school. After taking with Janet for 15 minutes, Dan leaves the office to catch an early train home, feeling good about his relationship with Janet and his prospects for promotion.


  1. I am not sure that I agree with Bahcall in the case of Google. While search existed before Google, one can argue that the utility of search before PageRank was limited and that Larry Page’s invention was a P-type innovation. []
  2. Polavision was hailed as a technological marvel, with the reviewer clearly in awe: “Once put into the player (like stuffing a slice of bread into a toaster), the Phototape is whisked to its starting position and, within 90 seconds, the fully developed color image appears on the screen via light shining through a prism in the cassette. The player produces an amazingly bright image, easily viewed by several people in either daylight or a darkened room.” []
  3. Source for conversion of 1978 dollars to 2019 dollars: BLS CPI Calculator []

The Case for Non-Consensus Active Investing

“Research is a quest for truth, not a confirmation of predetermined beliefs that we have concluded to be true. It must be conducted without an agenda. You should not care what truth will be revealed, as long as your process reveals the truth. Investors who go about their research to validate a preset conclusion are doomed to fall into the confirmation trap.”

— Rupal J. Bhansali, Non-Consensus Investing, p. 175

In Garrison Keillor’s fictional Lake Wobegon, “all the women are strong, all the men are good-looking, and all the children are above average.” We chuckle at the absurdity of the notion that an entire population can somehow be “above average” because, of course, this is not possible. Yet what is sometimes known as the Lake Wobegon Effect is alive and well in many facets of life.

Most drivers are convinced that they are well above average. A recent survey revealed that ninety percent of parents think that their child is above average. These types of misconceptions are known as illusory superiority, a cognitive bias that impacts many aspects of human life. We know that the vast majority of other people must, by definition, cluster near average, but we most certainly are not part of that run-of-the-mill group.

One of the reasons that people fall victim to illusory superiority is because human beings have an innate need to feel good about themselves. No one wants to believe that they are average or below average, especially in an area that they closely associate with their personal or professional identity. Maslow’s Hierarchy of Needs places self-esteem fairly high up on the pyramid and it is definitely a prerequisite for happiness. Almost everyone wants to be respected by others and, even more importantly, wants to achieve a certain degree of self-respect. No one has any desire to view themselves as inferior or incompetent.

The Hollywood stereotype of Wall Street would lead outsiders to believe that traders and investors are hyper-confident people certain of their ability to compete and win. Sometimes Hollywood stereotypes are not that far from the mark because it is rare to meet an investment professional who projects any hint that he or she is anywhere near average. After all, the role of active investment management is to compete, win, and significantly outperform the averages. An investor who is not able to prove above average skills will not be able to justify management fees and will eventually be out of a job.

While the need to outperform, and consequently to have high self-esteem, is ever present, we should bear in mind that human beings have even more fundamental needs related to safety and belonging. In the field of investing, it is very common for professional investors to cluster around commonly held beliefs and ideas because it is much more comfortable to be in agreement with others than to offer divergent views in opposition to the best loved beliefs of your peers. If you fail on Wall Street, it is much better to fail conventionally with everyone else than to take divergent non-consensus views and fail unconventionally. This leads the vast majority of investors to take on consensus views most of the time and results in dysfunctional behavior such as closet indexing that fails to add any long term value.

Rupal Bhansali advocates a far different path for active management in her new book, Non-Consensus Investing: Being Right When Everyone Else Is Wrong. While not against passive investing per se, Ms. Bhansali believes that there is a far better approach that makes it possible to do what academic theory argues is impossible: increasing returns while lowering risk. We all want to outperform passive indexes and any investor who has been around through multiple market cycles is aware of the need to contain risk. The ability to construct a portfolio of investments that outperform the market and carry a lower risk of permanent loss of capital could be viewed as the holy grail of investing. However, unlike a quest for an ancient relic, there are well understood principles that increase the probability of achieving the holy grail of investing. This book presents Ms. Bhansali’s approach to escaping the average and achieving meaningful outperformance.

Active vs. Passive

The fact is that any investor has the ability to match the market by using index funds. John Bogle, the inventor of the modern index mutual fund, was a relentless crusader for giving ordinary investors the ability to at least match market returns. Active management holds out the promise of either achieving market returns with demonstrably lower business risk or exceeding market returns without taking on much higher risk (or, better yet, taking less risk). At the time of Ms. Bhansali’s writing in November 2018, index funds had nearly reached fifty percent of U.S. stock fund assets. Passive index funds went on to exceed active funds based on assets under management in September 2019.

Ms. Bhansali believes that passive investing is becoming a “crowded trade” due to its amazing success in attracting assets in recent decades. She believes that this dominance has caused a number of risks to build up that are not commonly understood. Furthermore, she believes that the overall valuation level of stocks at the current time make it likely that passive strategies will provide only paltry returns in the future that will be insufficient for individuals and institutions that require greater returns.

Just because investors may “need” higher returns does not mean that the markets will give it to them, but Ms. Bhansali believes that it is important to invest actively in order to have a reasonable shot at decent returns in the years to come. One reason active strategies may become more viable in the future is that index funds could be causing various types of market inefficiency due to the mandate these funds have to own securities regardless of valuation. Active managers can monitor management behavior and hold their “feet to the fire”, and the actions of such managers increase market efficiency. In recent years, activist investors have done much to improve the operations of specific companies. The incentive to do this was to achieve outperformance. It is difficult to imagine even very large passive investors taking on activist roles and pressuring management because they have no incentives to do so – they are simply paid to match an index, not to improve returns.

The Ability to Stand Apart

Many investors confuse voluminous knowledge of facts and figures with differentiated insight. The problem is that merely knowing all the information about an industry or company does not provide a meaningful edge over other market participants, especially in the case of crowded trades.

“Markets do not reward research that discovers or proves what others have already discovered or proven. All the midnight oil burnt; frequent flyer miles logged; and arduous meetings with management, suppliers, customers, and competitors to conduct fundamental research amounts to zilch if you do not uncover anything new or different. Active investors who are unskilled in their research efforts are rightly facing an existential wake-up call: differentiate or die. It is not a market conspiracy but a market objective to weed out such undifferentiated active investors who add transaction costs in the form of high fees for their efforts but generate no value.”

Non-Consensus Investing, p. 45

Ms. Bhansali correctly observes that an investor must first be a business analyst and then a financial analyst. Many investors get this backwards. They seek to know every data point about a business but they do not go beneath the numbers to identify why a company has been successful or has run into trouble. Understanding financial data points is necessary to make good investment decisions but it is not sufficient.

BlackBerry and Apple

One of many brief case studies in the book involves the story of Research in Motion, the company behind the wildly popular BlackBerry device. Millennials may have only the vaguest memories of BlackBerry, but those of us in the business world during the first decade of the century recall what a cult following these devices had. They were must-have accessories because the reliability and security of BlackBerry was unmatched and there were no real substitutes.

Those who focused only on data points found the RIM story fantastic. The stock was roughly a 100-bagger over a span of less than six years through mid 2008. However, improvements in cellular networks, competing technology, and the emergence of smart phones made BlackBerry’s competitive advantages irrelevant. Investors who focused only on facts and figures did not act as business analysts. The question of why metrics such as profit margin and market share were high was not asked by many investors until it was too late.

Could investors have identified risks in the BlackBerry story early enough to escape the carnage in the stock that took place once the handwriting was on the wall? The book contains a number of questions that enterprising investors should be asking to get behind the numbers and understand the underlying drivers of the business. In particular, Ms. Bhansali provides a number of “myths and truths” about quality that can help investors differentiate between the real thing and value traps.

Will Apple’s cult-like following and seemingly impregnable moat be disrupted in a manner reminiscent of BlackBerry? This has been on the minds of many investors lately, especially as Apple shares have reached new record highs taking the market capitalization of the company to nearly $1.2 trillion in November 2019. Ms. Bhansali looked at the company in the 2017-2018 timeframe and came away unimpressed for a number of reasons. She views Apple as a mature consumer electronics company with single-product risk due to continued heavy reliance on the iPhone. Although the average selling price of new iPhones has been increasing in recent years, the frequency of replacement has declined and developed markets appear to be saturated while Apple has little to offer emerging market consumers at a price point they can afford.

Ms. Bhansali is not overly impressed with the pivot toward services revenue because the driver for such revenue continues to be correlated to the number of devices that are sold. If the installed base of iPhones shrinks, so would service revenue opportunities and she worries that this could cause Apple to become a melting ice cube. Importantly, she points out that there is no need for Apple to fail in order for investors to get hurt. All it would take to cause a significant fall in the stock price would be a moderate revenue decline coupled with declining margins. The resulting lower earnings would break the growth story and likely cause the earnings multiple to decline.

Of course, Ms. Bhansali may or may not be correct about Apple’s prospects. Obviously Warren Buffett would strongly disagree with this assessment! The important point, however, is that Ms. Bhansali is focusing on business drivers that are behind the reported numbers. She is asking the ever-important “why” questions regarding Apple’s current dominant position and attempting to formulate a non-consensus view.

Think Different

One of Apple’s most successful advertising campaigns was a celebration of people who “think different”. There might be safety in numbers and warmth in the middle of the herd, but those who seek to be an exception in any field of human endeavor must strive to be different in some way. Of course, the risk of being different but wrong is ever present. Being different is not a guarantee for success, but following the herd implies guaranteed mediocrity.

Ms. Bhansali urges active investors to “think different”, to dare to buck the comfortable consensus and come up with differentiated insights that have a chance of generating outperformance. Her book provides a number of valuable insights regarding how to go about the research process in a way that is likely to uncover non-consensus views and, even more importantly, how to control risk and avoid common traps. A healthy degree of self-confidence is essential for accomplishing any of this in the field of investing, but the same is really true in any field.

So … Active or Passive?

Should investors who lack either the interest or capability to implement a non-consensus strategy adopt a passive approach or look for a manager who has what it takes to outperform? Ms. Bhansali believes that the passive approach is unlikely to deliver the kind of returns that most investors need in the years to come. But is it possible to identify managers who can deliver better returns in advance? There is no doubt that such managers exist, but we do not know whether the successful managers of the past will be successful in the future. The risk is that one picks an active manager who goes on to underperform. If that happens, the paltry returns on offer from a passive strategy might seem desirable in comparison.

My own non-consensus view is that the vast majority of Americans would be best served by lowering their expectations and doing so with equanimity. The American household earning the median income lives a lifestyle that an American living a century ago would look upon with amazement and envy. Those of us with greater resources are even more fortunate, but still rarely satisfied. The problem is that the hedonic treadmill leads people to never be satisfied with what they have. To some degree, the quest for an ever-improving life is the American way, but this can be taken to excess and can lead to unhappiness. Most people would do well to lower their consumption, increase their savings rate, and dollar cost average into broad based index funds over a long lifetime. In fact, Warren Buffett, the greatest investor of the past seventy years, suggests that people should do exactly that.

Disclosure: The Rational Walk LLC received a review copy of this book from the publisher.

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