Mastering the Art of Pre-Suasion

“The elementary part of psychology—the psychology of misjudgment, as I call it—is a terribly important thing to learn. There are about 20 little principles. And they interact, so it gets slightly complicated. But the guts of it is unbelievably important.” 

— Charlie Munger in a speech to the USC Business School in 1994.

Charlie Munger has long been a strong advocate of viewing the world through a multi-disciplinary mindset.  Many readers are familiar with Poor Charlie’s Almanack which is the best way to get acquainted with Mr. Munger’s life and philosophy.  On a number of occasions, Mr. Munger has recommended that those who wish to become more familiar with psychology should read the work of Robert Cialdini.  Dr. Cialdini is best known for Influence:  The Psychology of Persuasion, a landmark book that has become standard reading for marketing professionals in recent decades.  Mr. Munger has been known to give copies of this book to friends and relatives and felt so strongly about the value the book has brought to the world that he gave Dr. Cialdini a gift of one Berkshire Class A share in appreciation.

The attraction of Influence for Charlie Munger was not primarily related to applying the techniques in a marketing setting.  Instead, Mr. Munger valued the book because it provided deep insights into the psychology of human misjudgment.  One of the very first articles to ever appear on The Rational Walk applied a few of Dr. Cialdini’s insights to the mystery of how Bernard Madoff was somehow able to use his weapons of influence to steal money from so many intelligent people for many decades.

Pre-SuasionIn Dr. Cialdini’s new book, Pre-Suasion:  A Revolutionary Way to Influence and Persuade, a key insight is provided that could change how marketing professionals approach persuasion.  Dr. Cialdini reveals that the major factor that separates extraordinary persuaders from average ones involves the key moment before a message is delivered.  By setting up a “privileged moment” prior to delivering a message, a persuader can materially increase the odds of a positive outcome.  What is a “privileged moment”?  Dr. Cialdini describes an approach called channeled attention that does not require the persuader to actually alter a person’s beliefs but only to alter what is prominent in a person’s mind at the time they are making a decision.  This is a major departure from the traditional view that it is necessary to change a person’s beliefs by persuading them regarding the merits of a proposal.  Instead, one must only pre-suade through channeled attention.

Human beings typically assume that whatever we are focusing on at a given moment deserves heightened attention.  Dr. Cialdini contends that the human mind can only really hold one thing in conscious awareness at any given point in time and that the cost of that heightened attention is a momentary loss of focused attention on everything else.  One striking example in the book involves a study of consumers who were in the market for a new sofa and were reviewing choices online.  Prior to viewing the sofas, individuals were either shown a background of fluffy white clouds or images of pennies.  Controlling for other factors, the individuals who were subliminally led to focus on clouds placed a higher priority on comfort while those who saw the pennies were more concerned with price.

The implications of this basic thesis are both fascinating and terrifying.  The individuals involved in the sofa study refused to believe that the background images of clouds or pennies had any influence whatsoever but their behavior said otherwise.  Essentially, persuaders – whether they are salespeople, politicians, or journalists – have the power to dramatically influence the actions of their targets merely by directing people’s attention toward what they want them to think about.  These techniques have also been used by police interrogators to persuade individuals to confess to crimes that they did not commit typically leading to convictions even when the individuals later renounce the false confession.

Assuming we buy into the primary thesis of “pre-suasion” via focused attention and channeling, the question naturally flows to the nuts and bolts of how one might command attention and direct it toward the desired objective.  Once the attention has been directed to the right place, it must be held there for long enough to produce the desired decision.  Dr. Cialdini provides a number of guidelines and potential roadmaps to follow.  As one reads through these concepts, it is tempting to think of these techniques as ones that would only work on “other people” – we cannot believe that we are subject to such persuasive techniques but, of course, almost all of us are!

What does this have to do with investing?  Well, perhaps it has a great deal to do with it when we look at our research process objectively.  Although Dr. Cialdini does not discuss the influence CEOs have on shareholders, surely the same principles of pre-suasion apply.  CEOs can focus our attention to certain facts and figures or even use subliminal suggestions in presentations to get us to focus on certain metrics while overlooking others.  For this reason, it seems prudent to immunize ourselves against this risk by avoiding any contact with management prior to an objective review of documents that are more fact based.

Although investors will vary in their research process, ideas typically flow from many initial sources – newspapers, magazines, blogs, newsletters, and more.  What is the first step one should take when investigating further?  Should we dive into the 10-K directly or perhaps review the latest quarterly conference call and slide deck?  Which would be less of a mental challenge?  Well, obviously it would be a lot easier to listen to the conference call while flipping through a slide deck.  However, by doing so, we are allowing management to pre-suade us!  The material that is presented, the order in which it is presented, and even the subtle hints in the presenter’s language can all have an influence on us whether we accept it or not.

How about skipping the presentations but diving right into an annual report?  That’s probably not a great idea if management provides a glossy annual report with a lot of marketing material in it.  It seems much more prudent to focus on the 10-K.  Obviously, even a 10-K can pre-suade us in various ways based on how the company is described and the areas that are emphasized, but we probably stand a better chance of remaining objective if we are in a text based format without visual imagery to exert any influence.  Then, by documenting what we, as investors, view to be the critical factors, it will be possible to resist potential attempts at redirecting our attention when we later review the conference calls, presentations, and glossy annual reports.

The applicability of Dr. Cialdini’s insights are endless and span multiple disciplines.  This is no doubt why Mr. Munger has given away so many copies of Influence over the years and felt strongly enough to give Dr. Cialdini one Berkshire Class A share to thank him.  There is some evidence that the influence has gone in both directions.  Dr. Cialdini thanks Mr. Munger for reviewing the manuscript prior to publication and there are several pages describing how Warren Buffett uses the concept of unity as a persuasive tool that has contributed to the unique loyalty Berkshire shareholders feel toward management.

Readers may wonder whether they should read Influence before Pre-Suasion.  It seems like doing so will increase comprehension of the topics discussed in the new book although each book can stand alone in terms of providing value.  It should be noted that both books come with extensive end notes.  In Pre-Suasion in particular, it is important to read the end notes along with the text.  In some cases, quite a bit would be lost without consulting the notes.

Click on these links to purchase a copy of Influence:  The Psychology of Persuasion and Pre-Suasion:  A Revolutionary Way to Influence and Persuade. Dr. Cialdini refers to Daniel Kahneman’s book, Thinking, Fast and Slow, which is an excellent resource for those who are interested in a more extensive tour of the mind.

Disclosure:  The Rational Walk LLC was not provided with a review copy of Pre-Suasion and purchased a copy of the book.

Implications of Cheap Natural Gas on Public Policy and Investing

There are few prices in America that are more visible than the cost of gasoline at the pump which has recently been on a rapid upward march reminiscent of mid-2008.  At that time, price spikes brought the cost of gasoline to well over $4 per gallon in most of the country.  The causes of oil price spikes vary over time but we can be sure that any hint of turmoil in the Middle East will have this effect.  Although there is vigorous debate among economists regarding the specific price point at which oil will threaten the nascent economic recovery, there is no doubt that consumer confidence and spending would be adversely impacted if prices continue to rise at the current pace.

Historical Context

Investors like to examine pricing anomalies, particularly related to commodities that could be viewed as substitutes but trade at radically different prices.  One barrel of crude oil has approximately six times the energy content of one thousand cubic feet (mcf) of natural gas.  One mcf of natural gas is approximately equivalent to one million BTUs (MBTU).

Despite the energy equivalence, for a variety of reasons, the pricing relationship between oil and natural gas is almost never exactly six to one. Typically, a ratio of 10 to 1 has been more common in recent years, although the ratio varies widely as we discussed in an October 2009 article describing the issue in more detail.  More recently, we revisited the oil/gas pricing situation in December 2010.

Pricing Anomalies at  Extreme Levels

With the recent spike in oil prices due to political turmoil in North Africa and the Middle East, the ratio has approached extreme levels of approximately 25 as the chart below plotting the ratio of one barrel of WTI oil to 1 MBU of natural gas illustrates:

The following chart visually represents how extreme the current pricing situation is.  We are using WTI crude prices in the exhibit as a good proxy for domestic crude prices but the ratio would be even more extreme if Brent crude were used:

From a pure energy equivalence perspective, it costs in excess of four times as much to purchase crude oil compared to natural gas.  While oil has steadily increased in price over the past two years, the price of natural gas has continued to struggle to rally due to higher supply produced by shale plays in the United States. The oversupply of natural gas has caused some companies to switch their focus to shale oil plays, but this may not have more than a marginal impact in the short run.

Investing Implications

Natural gas appears to be cheap compared to oil and has been cheap for some time.  Speculating in commodities is a risky endeavor since pricing anomalies can persist for very long periods of time.  In addition, important fundamental factors related to supply help to explain at least part of the cheapness of natural gas relative to oil.  Here is what Warren Buffett had to say about natural gas in a recent CNBC interview:

JOE KERNAN: You haven’t really bought natural gas or oil in the ground or–typically, right?

BUFFETT : Not very often, no. And, you know, it–I don’t know–the oil picture five years from now will be to, you know, may be much more dependent on politics than whether I can pick the best geologist in the United States. And, you know, I know we’ll be using more natural gas, I know it’s got all kinds of advantages and it’s cheap on a BTU equivalent to oil and it’s cleaner and all kinds of things. But in the end the price depends on supply and demand. And even though demand will go up some, I don’t know whether supply’s going to go up even faster than that. And so far it’s been–the last few years I should say that, you know, natural gas has been pretty disappointing. It hasn’t been disappointing in terms of finding it, hasn’t been disappointing in terms of its performance, it’s just been–there’s been too much of it around. And I don’t know–I’m not good at figuring out, you know, whether that will change a year from now, or five years from now, and I’m not in that game.

We have written about Contango Oil & Gas company in the past and believe it has a low cost advantage over other producers and could benefit from increasing natural gas prices over time.  However, as Mr. Buffett says, the supply and demand dynamics could keep a lid on natural gas prices for many years even if demand increases but supply increases more quickly.  In this type of environment, the low cost producer should benefit, particularly if Contango CEO Ken Peak is correct regarding the need for $6 natural gas for shale plays to earn a 5 to 10 percent return.

Public Policy Implications

At a time when the price of oil is dictated largely by developments outside the United States, it appears almost self evident that sources of domestic energy should be considered for economic and national security reasons.  The argument for domestic energy is even stronger when one considers how much cheaper natural gas is compared to oil on an energy equivalent basis.  An added bonus is the fact that natural gas is a cleaner burning fuel compared to both coal and crude oil.

T. Boone Pickens, among others, have advocated wider use of natural gas.  Mr. Pickens believes that the 18-wheeler truck fleet could be converted to use natural gas rather than diesel:

About 70% of the oil we import is used as fuel for America’s 250 million cars and light trucks and 6.5 million heavy trucks. Nearly half of the oil used for transportation is used as diesel fuel to power 18-wheelers. Natural gas is the only alternative. It is not only more abundant; it costs half as much and emits almost 30% less carbon dioxide.

If, in the normal course of replacements, we exchanged those 6.5 million heavy trucks running on largely imported diesel for new ones running on domestic natural gas, we could reduce our imports by 2.5 million barrels per day. We would be able to reduce our dependence on oil from the Middle East by half in only seven years.

Public policy currently places a heavy emphasis on alternative energy sources including wind power and solar.  In addition, the United States has counterproductive policies that heavily subsidize the use of ethanol as a motor fuel, a practice that Berkshire Hathaway Vice Chairman Charlie Munger has called “monstrously stupid” due to the impact on food prices.  However, ethanol has a formidable lobby in Washington and enjoys bipartisan support.

Ultimately, if given the choice between spending $100 on a barrel of oil versus $23 on the equivalent energy provided by natural gas, a rational individual would favor natural gas purely based on the economics of the situation.  When one adds in the fact that natural gas is a cleaner burning fuel and is available in abundance from domestic sources, it is surprising that broader political support does not exist for wider use.

Data Sources:

EIA:  Cushing OK WTI Spot Prices
EIA:  Natural Gas NYMEX Spot and Futures Prices

Disclosure:  Long Contango Oil & Gas.

Retailers ‘Stuck in the Middle’ May Soon Face Extinction

Much of what we do as investors involves studying businesses and critically evaluating the returns that are likely based on management’s competitive strategy.  The elusive search for true “moats” is often frustrated by quick technological change which can make yesterday’s incumbent firm today’s dinosaur.  Investors who pay a rich valuation for a business with a moat must be confident that the advantages leading to high returns today are not destroyed by new types of competition in the near term.

Competition has always been a threat to retailers and numerous strategies have been employed to achieve acceptable returns on investment.  Most investors are familiar with Michael Porter’s work on competitive strategy and the three “generic strategies” firms can successfully employ.  In his well known book, Competitive Strategy, Mr. Porter describes the three generic strategies:  Overall Cost Leadership, Differentiation, and Focus.  This can be translated into a retail context by observing the strategies used to appeal to mass markets, elite shoppers, and niche markets.  A business that fails to develop competitive advantages supporting one of the generic strategies is said to be “stuck in the middle”:

The firm stuck in the middle is almost guaranteed low profitability.  It either loses the high-volume customers who demand low prices or must bid away its profits to get this business away from low-cost firms.  Yet it also loses high-margin businesses — the cream — to the firms who are focused on high-margin targets or have achieved differentiation overall.  The firm stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organizational arrangements and motivation system.  Competitive Strategy, p. 41-42

It is not particularly difficult to think of companies that are neither cost leaders nor differentiators.  Usually such companies produce sub-par returns on invested capital but many have historically muddled along for years with incoherent strategies.

The days of muddling along without a clear strategy may be numbered for retailers in the age of the smart phone.  As The Wall Street Journal observed today in a front page article, shoppers are increasingly equipped with mobile phones that not only provide internet access but also often allow instant price comparisons by scanning bar codes on merchandise.  This is surely the nightmare of middling retailers that have long relied on confusion or ignorance to move uncompetitive merchandise.

Earlier this year, Nielsen projected that the smart phone market would exceed fifty percent of mobile phones in the United States by the end of 2011 as the chart below illustrates:

If it is possible to browse through the selection at Best Buy and immediately check prices at or Wal-Mart, pricing pressure is eventually going to drive most business to the lowest cost provider.  Even worse for “brick and mortar” retailers, most online retailers benefit from not being required to collect sales tax in jurisdictions where they lack a physical presence.  Customers who are reluctant to buy products “sight unseen” can then use the infrastructure provided by physical retailers to get comfortable with their purchase and then immediately scan the product’s bar code and order from the lowest cost online provider.

Best Buy recently reported disappointing results and the CEO made comments during the conference call related to competitive pressures.  Shares plummeted in the wake of the results as investors reconsidered the company’s strategic position and competitive strengths.  Retailers such as Best Buy have long competed for business by keeping a wide variety of merchandise in stock and promoting select products in order to bring customers into the stores and allow for cross selling higher margin merchandise.  This strategy may no longer be viable as smart phones begin to dominate consumer behavior in ways that would have been unthinkable just a few years ago.

Physical retailers will not become extinct but they will increasingly be forced to choose a coherent strategy based on a broad offering of very low prices or true differentiation.  While the threat of internet commerce has been a consideration for investors for much of the past fifteen years, the threat has become much larger with new smart phone technology.

Disclosures:  None.