The Ideas Report For Serious Investors

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Thanks to Aaron Edelheit for pointing us to this video.

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Exclusive Interview with Michael Mauboussin

Think Twice: Harnessing the Power of Counterintuition

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With the nearly unlimited supply of books on business and finance, it seems impossible to keep up with the list of important titles that appear on a regular basis.  This is particularly true for books covering the financial crisis.  While we have covered many of these titles in the book review series, it is sometimes beneficial to pick up a title on topics completely unrelated to business and investing.

The following list of ten suggested titles span topics ranging from history and politics to fiction and many are suitable for beach reading.  If reading about the financial crisis or Bernie Madoff’s scam seems unappealing for your summer vacation, consider one of these titles for a change of pace.  Enjoy!

History and Politics

Many of these titles are not exactly “light reading” but represent interesting diversions for those who prefer more substantial titles but are looking for something other than business and finance topics.

Stephen W. Sears presents the definitive account of the largest and most costly battle of the Civil War in Gettysburg.  The battle marks the furthest point of northern advance for the Confederate army and the turning point of the war.  Mr. Sears provides a detailed account of the preparations for battle as well as the aftermath.  Much of the battlefield remains intact today and the book is best read after visiting the park to obtain a feel for the terrain.  Weighing in at over 500 pages, this is hardly light reading but it is worthwhile for those interested in Civil War history.

Joseph J. Ellis presents a lively account of the interrelated lives of John Adams, Aaron Burr, Benjamin Franklin, Alexander Hamilton, Thomas Jefferson, James Madison, and George Washington in Founding Brothers. Rather than presenting a dry history of facts and figures, Mr. Ellis focuses on six key incidents in U.S. history starting with the famous duel between Burr and Hamilton and concluding with Adams and Jefferson’s friendship late in their lives.  An interesting 4th of July fact:  Both John Adams and Thomas Jefferson died exactly 184 years ago on July 4, 1826.

One effective antidote for those who consider history to be boring is to read Stephen E. Ambrose’s riveting account of the epic journey of Meriwether Lewis and William Clark in Undaunted Courage. Over two hundred years ago, at a time when nothing moved much faster than a man on horseback and no facilities for long distance communication existed, Lewis and Clark set out to explore the West and eventually reached the Pacific.  Thomas Jefferson’s decision to sponsor this expedition changed the course of American history.  This book is classified as history but it reads like an epic novel.

Interest in Thomas Jefferson usually peaks around Independence Day and with good reason.  As the principal author of the Declaration of Independence, Jefferson is not only revered in the United States but around the world as well for the democratic ideals his masterpiece expresses.  Jefferson The Virginian is the first of Dumas Malone’s six volume biography of Thomas Jefferson and remains a very readable book more than sixty years after publication.  This volume covers Jefferson’s early life as well as the Revolutionary War period.

George Orwell’s 1984 is a fictional account of political repression in a totalitarian society.  One interesting aspect of the book in light of today’s information age is how much easier it might be for “big brother” to be watching the actions of citizens compared to Orwell’s relatively low tech world of hidden microphones and radios.  Only the most paranoid believe that the United States is at imminent risk of an Orwellian future, but the book is a good reminder that vigilance is always required to safeguard the freedom and privacy of citizens.

Fiction and Travel

For some lighter fare, the following titles are worthy of consideration.

Road trips today are characterized by traffic congestion, eternal connectedness with smart phones and DVD players, and the endless repetitions of the same fast food chains and retail outlets no matter where you are in the United States.  Transport yourself back to 1960 when John Steinbeck took a road trip with his dog and wrote about it in Travels with Charley. At a time when the interstates were not yet complete, the early 1960s actually offered an opportunity to see America.  The same opportunity exists today for those who shun the interstate, but it is a path rarely taken.

Admirers of the late William F. Buckley, Jr. usually focus their attention on his political philosophy.  However, Mr. Buckley was also a prolific author of fiction and wrote a series of spy novels featuring Blackford Oakes, a James Bond-like character.  Stained Glass is set in Germany during the Cold War where Blackford Oakes goes undercover to monitor the activities of a Count seeking to unify Germany.  The entire Blackford Oakes series is an interesting window into the creative mind of a man who helped define the American conservative movement in the post-war period.

Michael Connelly’s Concrete Blonde is a riveting tale of a serial killer terrorizing Los Angeles and leaving grizzly calling cards with his victims.  Police Detective Harry Bosch has the task of hunting down the serial killer and a copycat who emerges years later using the same modus operandi. The book is part of a series featuring Bosch, a flawed but well intentioned detective, and Connelly makes efforts to realistically portray police investigations and forensic details.  This is a great book to read on the beach or during a plane ride, much like other books in Connelly’s series.

Stuart Woods spins a compelling tale set in the Caribbean in Shoot Him If He Runs with the protagonists, Stone Barrington and Holly Barker, hunting a shadowy rogue CIA agent known as Teddy Fay.  Dispatched the President himself, Barrington gets embroiled in a web of intrigue on an island run by a corrupt local government.  The storyline and characters have a “Bond-like” feel, although Barrington prefers Knob Creek on the rocks to shaken vodka martinis.  Another light selection for the beach or plane ride with a compelling, yet sometimes far-fetched storyline.

Alaska is the last frontier and it seems fitting to experience the journey by road.  The downside is that a round trip from nearly anywhere in the continental United States would take well over a month.  Ron Dalby provides a great travel guide in The Alaska Highway: An Insider’s Guide. It provides practical tips but is also great for those who have no immediate plans to make a trip, but might someday.  While I have yet to make the journey, the book provided many hours of entertainment putting together plans for an eventual trip.

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Most companies on a calendar fiscal year have released proxy statements over the past month.  In addition to annual reports, intelligent investors must pay close attention to proxy statements to determine the company’s philosophy on executive compensation.  Nearly every compensation committee includes what seems like boilerplate statements regarding aligning the incentives of management and shareholders.  However, as we have seen on many occasions, such as the example provided by Kraft’s absurd compensation policies, shareholders must be vigilant when it comes to matching rhetoric with reality.

Stephen F. O’Byrne and S. David Young have published a very interesting article entitled What Investors Need to Know about Executive Pay in the Spring 2010 issue of The Journal of Investing.  An abstract is available by clicking on the article link and the full article is available for purchase.  Mr. O’Byrne is the president of Shareholder Value Advisors and Mr. Young is a professor of accounting and control at INSTEAD.

Value Wealth Leverage and Revenue Wealth Leverage

The alignment of management with shareholder interests should be the ultimate goal of compensation committees.  The authors have developed two measures that help shareholders think about how management compensation reacts to changes in shareholder wealth as well as changes in revenues.

Value wealth leverage is defined as the ratio of executive wealth return to shareholder wealth return for a given measurement period.  In the case of an executive who also owns all of a company’s stock, the ratio is equal to 1.0 since changes in shareholder wealth create exactly proportional changes to the executive’s wealth.  On the other hand, a ratio of 0 indicates no relationship between executive wealth and shareholder wealth.

The authors have also defined a measure called revenue wealth leverage which calculates the ratio of executive wealth return to the percentage change in sales for the  measurement period.

Incentives for Value Destroying Growth

Simply having a high revenue wealth leverage is not, by itself, an indication that a manager will pursue value destroying growth because the components of pay that react to changes in shareholder wealth may partly or entirely offset the components of pay that benefit from the revenue growth.  The authors test whether there are incentives for management to pursue value destroying growth by assuming a situation where an acquisition would result in a 25 percent increase in revenue and a 15 percent reduction in shareholder wealth.

The question is whether the executive’s action will result in sufficient incremental executive wealth as a result of the revenue gain to offset the loss of executive wealth due to the erosion in shareholder value.  The authors use the example of Rex Tillerson of Exxon-Mobil to show that he would have a financial incentive to pursue an acquisition that increases revenue by 25 percent but reduces shareholder value by 15 percent.  This observation is particularly interesting in light of Exxon’s planned acquisition of XTO Energy. (Note:  This is simply an “interesting observation” on my part rather than a statement regarding whether Exxon’s acquisition of XTO makes sense.)

For more information regarding this research, visit The Journal of Investing website to read the abstract or to purchase the full paper.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

Disclosure:  The author of this article received a review copy of The Journal of Investing paper from Mr. O’Byrne.

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Those of us who completed our education prior to the mid 1990s often feel like students today have it easy in comparison.  Many of us still remember going to the library, finding books using a card catalog, and carrying stacks of books home.  High technology involved looking through old newspapers and magazines using microfiche.  Wikipedia, every student’s favorite reference source, did not exist.  It is easy to imagine how much time could have been saved and how much more could have been accomplished with access to today’s internet!

In the brief video clip shown below, Google CEO Eric Schmidt talks about how technology impacts the lives of younger people and whether the overall quality of education will be improved or hurt by instant access to information.  Mr. Schmidt points out that many aspects of modern technology have raised the bar and improved the quality of the young people hired at Google.  However, he is also concerned that long form reading may be on the decline since media is often consumed in much smaller portions.  This raises the important question of whether the internet may be creating a generation with knowledge that is a mile wide but only an inch deep.

The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

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We recently had the pleasure of interviewing Mary Buffett, author of Buffettology, The New Buffettology and the newly published Warren Buffett Management Secrets: Proven Tools for Personal and Business Success. We will be bringing you various portions of the wide-ranging exclusive interview in the next few days.

We start this series of posts with Mary Buffett's description of Warren Buffett's approach to "winning an argument," which is also discussed in Chapter 17 of Warren Buffett Management Secrets: Proven Tools for Personal and Business Success.

Click here to listen to or download the MP3 audio.

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Bill and Melinda Gates today announced a $10 billion initiative to develop vaccines that could save eight million lives in the developing world. This calculates to an investment of roughly $1,250 per life saved. What a remarkably low number. The U.S. government spent some $100 billion bailing out AIG -- the monetary equivalent of 80 million lives saved (assuming that Gates's calculations are correct and extrapolating to a bigger population).

Another stunning and counterintuitive finding is that extending the life expectancy of people in the developing world does not lead to a population explosion. On the contrary, a longer life expectancy has led to smaller family sizes in most developing countries that have experienced increases in life expectancy. The net result has been a significant decrease in the rate of population growth.

So, not only does Gates's investment -- relatively modest on a global scale -- promise to save the lives of children but also address the problem of population growth. Why does it take a private foundation to get this done when governments have far greater resources?

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Here is a fascinating talk by marketing guru Seth Godin on the emergence of new, Internet-enabled global tribes. He challenges us to lead a "tribe," as this is the modern way to effect change.

Thanks to The Big Picture for the link.

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Mohnish Pabrai of Pabrai Investment Funds and Guy Spier of Aquamarine Capital Management have both made a case for the use of checklists in investing. Here is an exchange with Spier from an interview with Portfolio Manager's Review earlier this year:

Q: When it comes to stock selection, you have talked about the importance of checklists. Why are they so crucial, and what are some of the key items on your checklist?

A: Those readers who have seen my two or three presentations know that I have talked about checklists. All of these ideas have emerged from conversations with Mohnish Pabrai, who noticed an article by Atul Gawande in The New Yorker with profound implications for investors. I'll share the basic insight that I have had as a result of these conversations: I think that we just have to acknowledge that there are some individuals out there — I think Warren Buffett in the investment world is one, Ajit Jain in the insurance world is another — who have a very particular ability to rationally analyze a situation in spite of crazy things going on in the world.

Most of us do not have that specific wiring. In spite of that, we can still improve our decision-making an awful lot by using checklists. The main way that I see it is that the investment world, either by design or by nature — and I think it is a combination of the two — throws up plenty of information that is designed to trigger one of two areas in the brain.

One is the threat detection fear mechanism, which throws up a very primeval response that has evolved within us for a very long time. It is one of the oldest parts of our brain — the fight-or-flight response. When we see something that makes us fearful, and we don’t have time to act, analyze and make weighted judgments, we have to decide either to run or to stay. We all know days in the market where that part of an investor’s brain is dominating and in which share prices can move around rather dramatically when compared to what appears to be very small amounts of news. So that is one sort of mode that the markets can be in, which is really the psychological mode of the majority of the participants in the market.

Then there is another side, which is irrational exuberance, as Alan Greenspan has described it, where the part of the brain that is being triggered is, as I’ve seen it described in various articles, the pleasure center of the brain. It turns out that the part of the brain we stimulate by the expectation of future profits is not that far away or dissimilar to the part of the brain that is stimulated, or lights up in CAT scans, when cocaine addicts either contemplate or are taking cocaine. These are very powerful centers.

Whether it is the fight-or-flight or the expectation of pleasure centers, the effect of both is to short-circuit rationally considered thoughts. They undermine the path of the brain that can make weighted, careful judgments about probabilities and about expectations. My perception is that it is the rational neocortex from which flow the very best investment decisions. Unfortunately, the world in which we operate is a minefield of opportunities to get caught up either by the fight-or-flight or by the pleasure center. So to the extent that somebody will talk about an investment being good when one is trembling with greed – I would not subscribe to that because trembling with greed implies that your greed and pleasure mechanisms in the brain are dominating the rational side.

I think that somebody like Warren Buffett is naturally wired not to be in either of those two extremes and spends his time in the happy middle. I think that what the rest of us human beings can do to train ourselves to be in that happy middle is use checklists. A checklist pulls us away from the kinds of actions that we would take if we were in either fight-or-flight or greed modes. So that is the basis for checklists.

The example I have given in talks is an airplane that is crashing. There is no question that checklists have been extremely helpful in reducing airplane accident rates. What it does is it brings the brain back to the place where one can make rational decisions.

Q: What advice would you give other investors on building an effective checklist? Is it primarily a product of past investment experience, i.e., mistakes — and if so, how does one differentiate between mistakes that should go on the checklist versus others that are simply unavoidable?

A: Obviously, in terms of building checklists, there is no question that the place to go is past mistakes. Not only one’s own past mistakes, but also to look at other investors’ past mistakes and see what those mistakes were. It seems to me, and it is a process that I am still going through, that the more specific the checklist item is the better.

I can give an example of an investment that I made where the CEO of the corporation was going through a divorce — a long, protracted and bitter divorce. In retrospect, when I look at what went wrong in that investment, I can see very clearly that the fact that he was going through this divorce meant that the CEO was much less able to focus both on the needs of the business and on capital allocation decisions. His whole investment, in fact, would have gone to his former wife if she had won the lawsuit. The whole company would not have belonged to him. So his emotional ties to the company were predicated on the outcome of the court case. His desire to make money for the company’s shareholders would have been hugely diminished if his wife had ended up controlling the company. So one of the items in my checklist is whether the CEO is going through major divorce proceedings, in which case I would tend to weigh that very heavily.

To give an example of checklist items that don’t come from individual or personal mistakes is the example of Coca-Cola and its ownership by Berkshire Hathaway. There was a period earlier this decade when Coca-Cola was trading at a multiple which was as high as 40 to 45 times earnings. We all know that Warren Buffett did not sell. I think that there is at least one statement in the public domain where he said that if given the chance to revisit that decision, he would have sold Coca-Cola.

I ask myself to what extent he was unable to make that choice at the time and execute a sale because he had already made public statements in the annual reports and elsewhere that Coca-Cola was an inevitable and permanent holding of Berkshire Hathaway. Making such a public statement is a very powerful driver of commitment consistency bias, which may have affected his ability to make rational decisions.

So what would go on the list? You would ask yourself the question, “Have I made public statements about this?” Obviously, the note to self is, don’t make public statements about positions you own that will predispose you towards owning them or not owning them or being able to sell them or not.

There is another example from Berkshire Hathaway, which is the acquisition of Cort Furniture, which did not turn out to be the phenomenal acquisition that some commentators suggested it was. It seems that one of the reasons is that Cort was in the business of renting furniture to people who had a temporary need. Cort benefited dramatically from the Internet bubble in which many companies were setting up offices that needed to be furnished rather quickly and had large amounts of money to spend. In the aftermath of the Internet bubble, the demand from that portion of the market was extremely attenuated and Cort’s earnings power was diminished significantly.

The basic insight that seems to have not been applied in the Cort acquisition, which has gone onto my checklist, would be, “Am I investing in an industry or a company that is benefiting from another industry that has just experienced a dramatic boom?” Another way of saying the same thing would be, “Am I investing while looking in the rear view mirror rather than looking at the road ahead?” Whether they are yours or somebody else’s, I think that mistakes are the most fruitful place to look for checklist items.

It is important to note that checklists are not wish lists. Obviously, we are looking for certain kinds of businesses and certain types of investment. That is what we are navigating for. The checklists are very specific items that are designed to bring our brains away from the influence of greed and fear. I would argue that I am not sure a mistake that is unavoidable is a “mistake” in terms of your question. I think that there are so many ways where one can go wrong. In retrospect we can see what we should have known. It is hard to control for the unknowable, because it is by definition unknown. The more one can throw onto an investment checklist, the better.

It is worth pointing out that no investment is going to pass every single investment checklist item. What the investment checklist will do is to throw up the issues that one should be focused on. Then an investor can try to weigh them to decide if they negate the benefits of the investment or not. One of the things that the checklist has done for me is to bring up the basic question: “Are we stretching to make the investment?” In this way investing is very similar to golf. In golf, one never hits a good shot if one is stretching or pushing oneself. The best golf shots come when we are acting well within our capacity. To that extent, a term that I do not think should apply to investing is, “I spent time getting comfortable.” The investment should leap out to you. If you are trying to get comfortable with something or it takes too long for you to get comfortable with it, then it is probably not a good investment. You shouldn’t have to get comfortable. That implies to me that I would be stretching.

In the above discussion, Spier credits Pabrai and Gawande for the checklist idea. Here is an excerpt from a seminal article by Gawande in the December 2007 issue of The New Yorker, in which Gawande described how checklists had transformed intensive care for the better:

If a new drug were as effective at saving lives as Peter Pronovost’s checklist, there would be a nationwide marketing campaign urging doctors to use it.

The damage that the human body can survive these days is as awesome as it is horrible: crushing, burning, bombing, a burst blood vessel in the brain, a ruptured colon, a massive heart attack, rampaging infection. These conditions had once been uniformly fatal. Now survival is commonplace, and a large part of the credit goes to the irreplaceable component of medicine known as intensive care.

It’s an opaque term. Specialists in the field prefer to call what they do “critical care,” but that doesn’t exactly clarify matters. The non-medical term “life support” gets us closer. Intensive-care units take artificial control of failing bodies. Typically, this involves a panoply of technology—a mechanical ventilator and perhaps a tracheostomy tube if the lungs have failed, an aortic balloon pump if the heart has given out, a dialysis machine if the kidneys don’t work. When you are unconscious and can’t eat, silicone tubing can be surgically inserted into the stomach or intestines for formula feeding. If the intestines are too damaged, solutions of amino acids, fatty acids, and glucose can be infused directly into the bloodstream.

The difficulties of life support are considerable. Reviving a drowning victim, for example, is rarely as easy as it looks on television, where a few chest compressions and some mouth-to-mouth resuscitation always seem to bring someone with waterlogged lungs and a stilled heart coughing and sputtering back to life. Consider a case report in The Annals of Thoracic Surgery of a three-year-old girl who fell into an icy fishpond in a small Austrian town in the Alps. She was lost beneath the surface for thirty minutes before her parents found her on the pond bottom and pulled her up. Following instructions from an emergency physician on the phone, they began cardiopulmonary resuscitation. A rescue team arrived eight minutes later. The girl had a body temperature of sixty-six degrees, and no pulse. Her pupils were dilated and did not react to light, indicating that her brain was no longer working.

But the emergency technicians continued CPR anyway. A helicopter took her to a nearby hospital, where she was wheeled directly to an operating room. A surgical team put her on a heart-lung bypass machine. Between the transport time and the time it took to plug the inflow and outflow lines into the femoral vessels of her right leg, she had been lifeless for an hour and a half. By the two-hour mark, however, her body temperature had risen almost ten degrees, and her heart began to beat. It was her first organ to come back.

After six hours, her core temperature reached 98.6 degrees. The team tried to put her on a breathing machine, but the pond water had damaged her lungs too severely for oxygen to reach her blood. So they switched her to an artificial-lung system known as ECMO—extracorporeal membrane oxygenation. The surgeons opened her chest down the middle with a power saw and sewed lines to and from the ECMO unit into her aorta and her beating heart. The team moved the girl into intensive care, with her chest still open and covered with plastic foil. A day later, her lungs had recovered sufficiently for the team to switch her from ECMO to a mechanical ventilator and close her chest. Over the next two days, all her organs recovered except her brain. A CT scan showed global brain swelling, which is a sign of diffuse damage, but no actual dead zones. So the team drilled a hole into the girl’s skull, threaded in a probe to monitor her cerebral pressure, and kept that pressure tightly controlled by constantly adjusting her fluids and medications. For more than a week, she lay comatose. Then, slowly, she came back to life.

First, her pupils started to react to light. Next, she began to breathe on her own. And, one day, she simply awoke. Two weeks after her accident, she went home. Her right leg and left arm were partially paralyzed. Her speech was thick and slurry. But by age five, after extensive outpatient therapy, she had recovered her faculties completely. She was like any little girl again.

What makes her recovery astounding isn’t just the idea that someone could come back from two hours in a state that would once have been considered death. It’s also the idea that a group of people in an ordinary hospital could do something so enormously complex. To save this one child, scores of people had to carry out thousands of steps correctly: placing the heart-pump tubing into her without letting in air bubbles; maintaining the sterility of her lines, her open chest, the burr hole in her skull; keeping a temperamental battery of machines up and running. The degree of difficulty in any one of these steps is substantial. Then you must add the difficulties of orchestrating them in the right sequence, with nothing dropped, leaving some room for improvisation, but not too much.

Read the full December 2007 article by Atul Gawande.

Read a new article by Gawande on the U.S. healthcare overhaul.

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Historians writing about events that have faded into a distant memory are challenged by the need to accurately portray these events and to provide analysis and commentary that sheds light on what happened and why.  In contrast, writers covering current events where the end of a story is not yet known face a much more difficult task.  Their interpretation of events may prove to be inaccurate or embarrassing in the not-so-distant future particularly when dealing with a subject related to technology.

Ken Auletta is apparently a brave author given his willingness to write about a story where the ending is still very much unfinished in Googled:  The End of the World as We Know It. Mr. Auletta provides a great deal of insight regarding Larry Page and Sergey Brin, Google’s founders, along with a good description of Google’s meteoric rise over the past decade.  However, the more interesting aspect of the narrative involves the forward looking insights provided by Mr. Auletta and many technology leaders who are quoted extensively throughout the book.

While the book is of particular interest to those seeking more color regarding the entrepreneurial story behind Google and its rapid rise, I found myself drawn to the clear implications for the newspaper industry as well as lessons that investors should learn based on Google’s story. For a review covering other details of the book, The Wall Street Journal published an interesting article earlier this month.

The Decline of Newspapers

Of all the issues facing society today, few come close to the importance of the decline of newspapers and journalism.  This may seem like an outrageous claim given the state of the economy, high rates of unemployment, and the range of other problems facing the country.  However, without top notch journalism, how will citizens be informed about these issues or hold government accountable?

One statistic from the book jumped off the page:

A regular reader of the New York Times spends thirty-five minutes each day with the print version, according to Nielsen, while those who read the Times online spend only thirty-seven minutes a month reading it.  These figures can be misleading, because they average in the occasional visitors who may spend a minute or less online with those who are online devotees.  Nevertheless, there is a wide disparity between online and print newspaper readers.  Pages 165-166

Thirty-five minutes per day versus thirty-seven minutes per month!  What could account for this disparity?  The online reader may be treating journalism as a “buffet” and browsing multiple sites for information rather than spending time exclusively with one paper.  However, the typical online reader may simply be missing a great deal of information compared to the print reader.  The online reader’s knowledge may end up being a mile wide and an inch deep as a result.

One factor that is seldom discussed is the fact that a physical newspaper, by virtue of its format and physical qualities, encourages readers to take in a broader variety of content than the typical online reader who searches for a topic (usually via Google) and is taken directly to the relevant article.  Often when reading a physical paper, one notices nearby articles that seem compelling enough to read but are not subjects that the reader would directly search for.  Some online sites are better than others in terms of suggesting related content, but none that I have seen come close to the physical properties of the printed newspaper.

From an economic standpoint, the book goes into quite a bit of detail regarding the loss of advertising that many papers have suffered and the fact that few papers have been able to charge for content.  While Google has played a role in this trend, it is by no means a situation that was caused by Google.  Readers have simply been conditioned to expect free information online and will hesitate to pay for access.  The drama associated with this dilemma escalated today when Rupert Murdoch’s News Corp. was reported to be in talks with Microsoft regarding a partnership that could result in News Corp’s newspaper content being removed from Google sites.

Creative Destruction and The Intelligent Investor

In the 1980s, who would have thought that the typical city newspaper was anything other than a wonderful monopoly-like business with a powerful economic moat?  As a teenager delivering and selling papers in the 1980s in the Silicon Valley, the question I faced was not whether a household subscribed, but whether they took the morning or evening edition, or if they favored the San Francisco Chronicle or the San Jose Mercury News.  Nearly every house had some type of newsprint on their driveway each day.

The newspaper industry is just one of many that have been impacted by the Internet in general and Google in particular.  Ad agencies, traditional broadcasters, and many other media companies have seen their economic models damaged severely.  Furthermore, few of these businesses twenty years ago could have forecast the economic earthquake to come. Many if not most of these businesses would have appeared to have strong economic moats in place.

Ignoring Google’s rise over the past decade would have been a recipe for creating blind spots when it comes to evaluating the strength of existing moats.  Investors need to constantly monitor their holdings and always consider whether it is possible for their business interests to be “Googled”.  Anyone who believes that it is possible to simply say “I don’t deal with technology” may avoid losing money in technology investments but get blindsided by the impact of technology in unexpected ways.

Avoid being “Googled” by learning the lessons of this book and applying the insights when evaluating the moats of businesses in your own portfolio.

The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk. 

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Do you receive Portfolio Manager's Review in the mail each month? Then you are eligible for a FREE copy of Jeff Benedict's book on R. C. Willey. Email us to request it.

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By Ravi Nagarajan

San Jose, California, September 24, 1998. Just another routine day at the office in a suburban office park in the Silicon Valley was interrupted by loud sounds of a celebration coming from the common hallway serving several companies in the building.  Was this a birthday party getting out of control, or some other disturbance?  Actually, it was the day of eBay’s initial public offering.  At the time, I was working as a software engineer for another company operating in the same office park and witnessed some of the festivities.  Based on the initial spike in the stock price, it was easy to see why some of the early employees were celebrating.

Due to the close proximity of eBay’s office, online auctions were often discussed around my office.  I was very familiar with the concept, the internet, and the company.  I would like to say that I failed to participate in the IPO due to application of rigorous value investment standards, but this would be revisionist history.  Instead, I was convinced that the idea of online auctions was crazy and could not understand why anyone would want to rummage around for garage sale items on the internet. I simply dismissed the business as a fad. My co-workers and I made fun of the crazy auction guys down the hall.  I never even read eBay’s financial statements, which I now regret even though it would not have changed my decision not to participate in the IPO.

Speculation, Investing, and Circles of Competence

I have been asked on many occasions why value investors tend to steer clear of technology companies even in cases where the investor has a significant understanding of technology.  In my case, several years of experience in software at the time surely provided the circle of competence required to evaluate eBay’s business model and to understand the technology involved.  The trouble was that my circle of competence did not extend to being capable of anticipating the emergence of entirely new industries that had no proven economic track record.  Even if I had spent the time to read eBay’s proxy filings, it is unlikely that I would have been able to confidently predict cash flows or to quantify downside risks.

Would it have been possible to develop a circle of competence that included the ability to forecast eBay’s cash flows?  It would be arrogant to assume that no one could perform such an analysis and perhaps there were some observers who even managed to predict eBay’s future growth with some precision.  However, it is safe to say that most buyers of eBay stock at the time were engaged in speculation rather than investing as defined by Benjamin Graham in Security Analysis:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.  Operations not meeting these requirements are speculative.

Thorough analysis and an understanding of the business would not be enough without also being able to confidently demonstrate the safety of the investment and prospects for returns going forward.  Significant wealth has been lost by individuals who mistake a technical circle of competence with an investing circle of competence.  It is possible to understand a business extremely well and not be in a position to intelligently value a company.

Example:  The Software Industry

Economic Characteristics

Let’s take a closer look at one industry that is very exposed to changing technology.  The software industry has economic characteristics that often provide successful companies with outstanding margins and returns on equity.  Successful companies typically have strong moats that provide protection against entrants, at least in the short run.  This is because switching costs in software tend to be very high.  Particularly in the case of commercial software targeting business users, companies do not wish to change vendors frequently due to the cost of implementing a new system and training staff members.  Buyers of commercial software are also very risk averse.  Usually, decision makers seek to minimize “career risk” by selecting vendors with proven track records that are recommended by consultants.

Sources of Revenue

Most software companies have three primary sources of revenue:  Software licensing fees, maintenance fees, and service fees.  License fees are normally very high margin due to the low marginal costs of providing an additional copy of software to a new customer.  Once the research and development costs have been incurred to produce a software product, the marginal cost of production for additional copies is extremely low.  Maintenance fees are normally charged for technical support and upgrades and typically have solid margins, albeit not as high as licensing revenues.  Many software companies also provide services associated with their products.  Service revenues have much lower margins due to staffing costs, but such revenues can still be worthwhile.  The revenue mix of a software company is important when it comes to valuation.

Forecasting Cash Flows

The economic characteristics of an established software firm allow for building models to forecast future cash flows with some precision given that revenue mix and margins tend to change slowly over time, except during periods of disruptive change.  It is all too easy to build spreadsheets with revenue and earnings projections far into the future.  Such forecasts can incorporate various assumptions regarding overall revenue growth, revenue mix, and margins and can be aggressive or conservative when it comes to growth projections.  The cash flow can then be discounted at the analyst’s chosen discount rate to arrive at a present value.  If the stock can be purchased at less than the indicated present value, would this qualify as an investment operation as defined by Benjamin Graham?

Technological Change:  The Wildcard

The fatal flaw behind this type of valuation model is that disruptive changes can occur in technology and software can be heavily impacted by such changes.  The nature of the change is not always incremental.  Change can sometimes appear suddenly and can invalidate business models that worked well for many years.  While the barriers to new entrants in software can be high within a “steady state” environment where technology is relatively static, the same is not true when technology changes rapidly.  In such a scenario, new entrants can leapfrog established players in a very short timeframe.

We have seen several examples of such change in recent decades, but perhaps no change was as profound as widespread adoption of the internet during the mid to late 1990s.  Incumbent firms that failed to adapt did not lose their revenue sources overnight, but they experienced steady erosion in short order.  In the case of business buyers, “career risk” drives decision making for most managers  and will lead to business for incumbent players, but there are always trend setters who will give new entrants with superior technology an opportunity.  Such new entrants can quickly displace incumbents and become the new “standard”.  This cycle happens again and again in the process Joseph Schumpeter called “creative destruction”.

Many new entrants that appeared in the 1990s are now the established incumbents.  Some incumbent firms in the 1990s successfully remained incumbents by adapting and embracing the internet and other advances.  Which incumbent firms today with substantial brands and economic moats will adapt successfully over the next decade?  Will “cloud computing” displace traditional applications or is it a passing fad?

These are all questions that can radically alter the economics of the industry in the coming years and the fortunes of existing players, even those with powerful moats in today’s environment.

Adapting to Change

When examining incumbent firms with current economic moats, it is particularly important to determine whether they have a track record of investing in R&D and successfully navigating major shifts in technology in the past.  Has the company cut R&D spending in the economic downturn to limit damage to earnings or have investments been maintained?  Does the company have a culture where change is embraced rather than feared?  Do employees “live and breathe” technology?  Some of these questions are unquantifiable but are still critically important.

What About Start Ups?

If it is so important to evaluate track records, then how can anyone invest in a start up?  This is a very important question, but one that may be outside the scope of investing as defined by Graham.  There is certainly an important role for venture capital firms and others who invest in early stage companies that have technologies which could be game changers and end up disrupting incumbent firms.  The economy would suffer significantly without venture funding.  Perhaps a widely diversified group of such companies can be selected with the idea that most will fail but the few that succeed will make the overall endeavor worthwhile?  While this may be true, I would still argue that such operations are not within the category of “investing” as defined by Graham because they fail the test of providing adequate safety of principal and satisfactory returns through quantitative analysis.

It is certain that closely adhering to the principles of value investing will result in missing most if not all early stage opportunities.  Value investors who choose to invest in technology firms are best served by focusing on established incumbent firms with attractive valuations and a history of adapting to change rather than speculating on unproven ventures.  If the investor does choose to participate in unproven ventures, it should be done with full awareness that the operation does not meet Graham’s standard as an “investment”.  This does not mean that the endeavor is unwise or doomed to failure, only that the tools of value investing are not suitable for providing guidance on the decision.

The author of this post, Ravi Nagarajan, is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.

Posted by manualofideas at 12:03 AM | Permalink | Comments (0)

India-based Professor Sanjay Bakshi recently presented to India's Ministry of Finance on the subject of persuasion.

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Miguel Barbosa, editor of the excellent blog Simoleon Sense, has published an exclusive interview with Michael Mauboussin, equity strategist at Legg Mason Capital Management. Writes Barbosa by way of introduction,

"Benoit Mandelbrot once said that “failure to explain is caused by failure to describe”. The world has experienced one of the most severe financial crises. How should we make sense of what happened? Without a doubt, we should describe the financial crisis in a multidisciplinary fashion. Only through multiple perspectives can we begin to uncover the origins of the “great recession”. Today, I’m pleased and honored to have one of the foremost experts in multidisciplinary thinking, Michael Mauboussin. In this interview we attempt to make sense of the recent crisis by discussing Mr. Mauboussin’s latest book, 'Think Twice: Harnessing the power of Counterintuition.' We also reference his past bestseller 'More Than You Know: Finding Financial Wisdom in Unconventional Places.'"

Read the full interview with Michael Mauboussin.

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We recently wrote about a New Yorker article that Mohnish Pabrai recommended at the recent annual meeting of Pabrai Funds in Chicago. Guy Spier of Aquamarine Capital Management also commented on investment checklists in an exlcusive interview with Portfolio Manager's Review. Spier also recommended a couple of books by Atul Gawande, the author whose writings apparently inspired Pabrai to give checklists higher priority in the investment process. You may be interested in viewing a case for investment checklists, presented by Mohnish Pabrai at Columbia University last April.

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Steven Pinker's essay "A History of Violence" is a couple of years old but very interesting nonetheless.

The key question on our minds: Is the world getting nicer or deadlier faster? Weapons and delivery systems have evolved in such ways that "a little nicer" may not be "nice enough" to prevent catastrophe. On the other hand, perhaps the threat of annihilation will finally catalyze major changes in how civilization resolves its conflicts.

(H/T to Adam Weinrich for bringing Pinker's essay to our attention.)

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Robert Cialdini's classic Influence has been recommended by Charlie Munger for its insight into human's response to subliminal messages and the actions of others. Cialdini is co-author of a newer volume entitled, Yes! 50 Scientifically Proven Ways to Be Persuasive. Putting on our value investors' hats and crafting an analogy, Yes! may be to Influence what Intelligent Investor was to Security Analysis.

Here is an excerpt of the list, sourced from the Farnam Street blog:

1. Inconvenience the audience by creating an impression of product scarcity. It's the famous change from "Call now, the operators are standing by" to "If the line is busy, call again", that greatly improved the call volume by creating the impression that everybody else is trying to buy the same product.
2. Introduce herd effect in highly personalized form. The hotel sign in the bathroom informed the guests that many prior guests chose to be environmentally friendly by recycling their towels. However, when the message mentioned that majority of the guests who stayed in this specific room chose to be more environmentally conscious and reused their towels, towel recycling jumped 33%, even though the message was largely the same.
3. Ads quoting negative behavior en masse reinforces negative behavior. Petrified Forest National Park A/B tested two versions of a sign imploring people not to steal pieces of petrified forest from the park. One mentioned large amounts of petrified forest taken away on an annual basis, the other one simply asked the visitors not to remove petrified wood. The first one actually tripled the theft ratio as it showed stealing petrified wood as something commonplace. Same effect was observed after airing an ad that implored women to vote, but mentioned that 22 million single women did not vote last year. That kind of information actually portrays not voting as more socially acceptable.
4. Avoiding magnetic middle. A California survey measured energy usage of a neighborhood on a week-by-week basis. When the average electricity consumption for the neighborhood was calculated, researchers sent thank-you cards to those using the energy conservatively, and a nice reminder to perhaps conserve to those who used electricity liberally. Net effect? While the liberals tried to cut down on unnecessary energy usage, the conservatives, finding out they're way below average, suddenly became way more liberal with their energy usage, which actually increased the amount of energy used by the neighborhood. Proposed solution that worked? Sending a smiley face card to conservatives with a request to keep doing what they were doing, instead of pointing out they were at the right end of the bell curve.
5. Too many options necessitate selection, and hence frustration, when brain decides it's unnecessary work. The example here is given by a company that manages retirement funds for other companies, and hence has access to retirement information of 800,000 employees. When employees were offered a choice of 2 funds, roughly 75% signed up for a retirement program. When the number of funds was increased to 59%, even though qualitatively this was a better deal for employees, only 60% decided to sign up. When Head & Shoulders brand killed off 11 flavors of the shampoo, leaving only 15 on the market, the sales rose 10%.
6. Giving away the product makes it less desirable. Researchers gave one group of people a picture of a pearl bracelet and asked to evaluate its desirability. Another group of people was given the same task, but prior to that was shown an ad, where the same bracelet was given away for free, if you bought a bottle of expensive liqueur. The second group considered the bracelet much less desirable, since mentally a lot of potential buyers (35% of them to be exact) shuffled the bracelet onto "trinkets they give away for free" shelf in their brain.
7. A more expensive product makes the old version look like a value buy. An example here is a Williams-Sonoma bread maker. After an introduction of a newer, better, and pricier version, the sales of the old unit actually increased, as couples viewed the new item as "top of the line", but old product was all of a sudden reasonably-priced, even though a bunch of features were missing.
8. If a call to action is motivated by fear, people will block it, unless call to action has specific steps. A group of people received a pamphlet describing the dangers of tetanus infection. It didn't describe much else. The second group of people got a description of tetanus infection, plus a set of instructions on how to get vaccinated. The second group exhibited much higher sign-up rate for tetanus vaccination than the first one, where many participants tried to block out the high-fear message urging that something as rare as tetanus would never happen to them.
9. A small gift makes people want to reciprocate. People who received a small no-strings-attached gift from a stranger were twice as likely to buy raffle tickets from him than those who were just pitched on raffle tickets.
10. Hand-written Post-It note improves response rate on inter-office letters. Researchers distributed three sets of questionnaires around the office. The first set included a hand-written Post-It note requesting completion of the survey. The second set got the same survey, with the request to return it hand-written on Page 1. Third group got the same survey with their name mentioned (in type) on page 1 of the survey. Response rates? 75%, 48%, 36%. People appreciated personalized approach, and somehow a Post-It note even highlighted the extra work that someone did before sending out the survey.

Read items 11-50 on Farnam Street.

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The author of this post is hedge fund manager Nick Gogerty.

Sam Savage's latest offering Flaw of Averages is a useful book and set of thought tools he calls mindles. If you have a PhD in statistics or mathematics, your job or role rarely begins and ends with you. Often your models will need to be explained to people. More importantly, the places where the models could or would go wrong need to get explained.

The Flaw of Averages provides a great read and introduction to basic concepts in probability and real life situations where things behave in unintended ways, such as the hidden stories in the "average".

The book's core strength is the author's fun and helpful voice. He is the stats teacher you wish you or your kids had.

Sam Savage has spent a long time in industry explaining and teaching how statistics and models work across sectors. His chief skill is as a creator of simple stories and mental models that let managers and regular people understand the value of statistics applied. Dr. Savage sells powerful "light bulb goes on in the head moments" for a living and sells the tools that let people have those light bulb moments in their own respective domains.

If you want a way to understand something from a new angle or some interesting new thought tools, take a look at the Flaw of Averages. Quite a few useful examples and free simulations are available at his website.

Topics covered include:

• Flaw of averages in finance and real estate
• Flaw of averages in supply chain management
• Examples of more successful product launches
• Petroleum (peak oil is hinted at)
• Many other real world applications and examples that would allow managers to share powerful concepts. If you can't afford a $2k/day stats manager to assess some of your business issues, try a few hours of reading this book.

Disclosure: 10 years ago, I bought one of Sam's modeling tools for excel and over the course of 4 years proceeded to lose it somewhere between living in Dubai, Denmark and Brussels. I called Sam up, explained the situation and he let me pick up an upgrade for minimal cost. He is not only a great teacher/practitioner but a nice fellow as well.

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Vitaliy Katsenelson, director of research at Investment Management Associates and author of the book Active Value Investing, recently published a thought-provoking presentation on making money in range-bound markets. We found the following takeaways particularly noteworthy:

• Investors typically describe markets as either bull or bear markets, ignoring the fact that markets are often "cowardly lion" or range-bound markets. In fact, the "bear markets" observed over the past century were actually range-bound markets that included both upward and downward moves in equity prices, ultimately leaving prices roughly flat over multi-year periods.
• The past decade has been characterized by a range-bound market, in which volatility has been high but market indices have ultimately remained rather flat over nearly ten years.
• Katsenelson argues that cycles in range-bound markets are not caused by the usual suspects, i.e., the economy, earnings growth, interest rates or inflation, but rather by one key factor: valuation.
• Katsenelson also observes a "tight" relationship between interest rates and P/E multiples by analyzing historical data from 1960-2006. Not surprisingly, periods of low interest rates justified higher P/E multiples, while higher interest rates led to P/E multiple compression. Somewhat surprisingly, however, Katsenelson also shows that the relationship between interest rates and P/E multiples was "extremely weak" from 1900-1960.
  
• A common feature of range-bound markets is modest earnings growth accompanied by P/E multiple compression, leading to low or no growth in stock prices. P/E multiple compression is at least in part caused by market psychology. The latter trumps both interest rates and inflation in terms of driving stock prices in the short term. Interest rates and inflation play a role in determining the length and extremes of market cycles.
• We may be in a range-bound market, as valuations and still high and earnings growth is likely to slow. If earnings decline materially, we may enter a secular bear market.
• Stocks outperform bonds over long periods of time, but they do not outperform materially in range-bound markets. The latter necessitate a "buy and sell" approach rather than a "buy and hold" approach to investing. Investors can earn excess returns by timing individual stocks based on their valuation rather than by timing the market.
  

For more information on Vitaliy Katsenelson's writings, visit ActiveValueInvesting.com.

Click here to buy Active Value Investing on Amazon.com.

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David Lau shares an interesting recent article from The Boston Globe:

It’s the single most famous story of scientific discovery: in 1666, Isaac Newton was walking in his garden outside Cambridge, England - he was avoiding the city because of the plague - when he saw an apple fall from a tree. The fruit fell straight to the earth, as if tugged by an invisible force. (Subsequent versions of the story had the apple hitting Newton on the head.) This mundane observation led Newton to devise the concept of universal gravitation, which explained everything from the falling apple to the orbit of the moon.

There is something appealing about such narratives. They reduce the scientific process to a sudden epiphany: There is no sweat or toil, just a new idea, produced by a genius. Everybody knows that things fall - it took Newton to explain why.

Unfortunately, the story of the apple is almost certainly false; Voltaire probably made it up. Even if Newton started thinking about gravity in 1666, it took him years of painstaking work before he understood it. He filled entire vellum notebooks with his scribbles and spent weeks recording the exact movements of a pendulum. (It made, on average, 1,512 ticks per hour.) The discovery of gravity, in other words, wasn’t a flash of insight - it required decades of effort, which is one of the reasons Newton didn’t publish his theory until 1687, in the “Principia.”

Although biographers have long celebrated Newton’s intellect - he also pioneered calculus - it’s clear that his achievements aren’t solely a byproduct of his piercing intelligence. Newton also had an astonishing ability to persist in the face of obstacles, to stick with the same stubborn mystery - why did the apple fall, but the moon remain in the sky? - until he found the answer.

In recent years, psychologists have come up with a term to describe this mental trait: grit. Although the idea itself isn’t new - “Genius is 1 percent inspiration and 99 percent perspiration,” Thomas Edison famously remarked - the researchers are quick to point out that grit isn’t simply about the willingness to work hard. Instead, it’s about setting a specific long-term goal and doing whatever it takes until the goal has been reached. It’s always much easier to give up, but people with grit can keep going.

While stories of grit have long been associated with self-help manuals and life coaches - Samuel Smiles, the author of the influential Victorian text “Self-Help” preached the virtue of perseverance - these new scientific studies rely on new techniques for reliably measuring grit in individuals. As a result, they’re able to compare the relative importance of grit, intelligence, and innate talent when it comes to determining lifetime achievement. Although this field of study is only a few years old, it’s already made important progress toward identifying the mental traits that allow some people to accomplish their goals, while others struggle and quit. Grit, it turns out, is an essential (and often overlooked) component of success.

“I’d bet that there isn’t a single highly successful person who hasn’t depended on grit,” says Angela Duckworth, a psychologist at the University of Pennsylvania who helped pioneer the study of grit. “Nobody is talented enough to not have to work hard, and that’s what grit allows you to do.”

The hope among scientists is that a better understanding of grit will allow educators to teach the skill in schools and lead to a generation of grittier children. Parents, of course, have a big role to play as well, since there’s evidence that even offhand comments - such as how a child is praised - can significantly influence the manner in which kids respond to challenges. And it’s not just educators and parents who are interested in grit: the United States Army has supported much of the research, as it searches for new methods of identifying who is best suited for the stress of the battlefield.

The new focus on grit is part of a larger scientific attempt to study the personality traits that best predict achievement in the real world. While researchers have long focused on measurements of intelligence, such as the IQ test, as the crucial marker of future success, these scientists point out that most of the variation in individual achievement - what makes one person successful, while another might struggle - has nothing to do with being smart. Instead, it largely depends on personality traits such as grit and conscientiousness. It’s not that intelligence isn’t really important - Newton was clearly a genius - but that having a high IQ is not nearly enough.

Consider, for instance, a recent study led by Duckworth that measured the grittiness of cadets at West Point, the elite military academy. Although West Point is highly selective, approximately 5 percent of cadets drop out after the first summer of training, which is known as “Beast Barracks.” The Army has long searched for the variables that best predict whether or not cadets will graduate, using everything from SAT scores to physical fitness. But none of those variables were particularly useful. In fact, it wasn’t until Duckworth tested the cadets of the 2008 West Point class using a questionnaire - the test consists of statements such as “Setbacks don’t discourage me” - that the Army found a measurement that actually worked. Duckworth has since repeated the survey with subsequent West Point classes, and the result is always the same : the cadets that remain are those with grit.

In 1869, Francis Galton published “Hereditary Genius,” his landmark investigation into the factors underlying achievement. Galton’s method was straightforward: he gathered as much information as possible on dozens of men with “very high reputations,” including poets, politicians, and scientists. That’s when Galton noticed something rather surprising: success wasn’t simply a matter of intelligence or talent. Instead, Galton concluded that eminent achievement was only possible when “ability combined with zeal and the capacity for hard labour.”

Lewis Terman, the inventor of the Stanford-Binet IQ test, came to a similar conclusion. He spent decades following a large sample of “gifted” students, searching for evidence that his measurement of intelligence was linked to real world success. While the most accomplished men did have slightly higher scores, Terman also found that other traits, such as “perseverance,” were much more pertinent. Terman concluded that one of the most fundamental tasks of modern psychology was to figure out why intelligence is not a more important part of achievement: “Why this is so, and what circumstances affect the fruition of human talent, are questions of such transcendent importance that they should be investigated by every method that promises the slightest reduction of our present ignorance.”

Unfortunately, in the decades following Terman’s declaration, little progress was made on the subject. Because intelligence was so easy to measure - the IQ test could be given to schoolchildren, and often took less than an hour - it continued to dominate research on individual achievement.

The end result, says James J. Heckman, a Nobel Prize-winning economist at the University of Chicago, is that “there was a generation of social scientists who focused almost exclusively on trying to raise IQ and academic test scores. The assumption was that intelligence is what mattered and what could be measured, and so everything else, all these non-cognitive traits like grit and self-control, shouldn’t be bothered with.”

One of the main obstacles for scientists trying to document the influence of personality traits on achievement was that the standard definition of traits - attributes such as conscientiousness and extroversion - was rather vague. Duckworth began wondering if more narrowly defined traits might prove to be more predictive. She began by focusing on aspects of conscientiousness that have to do with “long-term stamina,” such as maintaining a consistent set of interests, and downplayed aspects of the trait related to short-term self-control, such as staying on a diet. In other words, a gritty person might occasionally eat too much chocolate cake, but they won’t change careers every year. “Grit is very much about the big picture,” Duckworth says. “It’s about picking a specific goal off in the distant future and not swerving from it.”

After developing a survey to measure this narrowly defined trait - you can take the survey at www.gritstudy.com - Duckworth set out to test the relevance of grit. The initial evidence suggests that measurements of grit can often be just as predictive of success, if not more, than measurements of intelligence. For instance, in a 2007 study of 175 finalists in the Scripps National Spelling Bee, Duckworth found that her simple grit survey was better at predicting whether or not a child would make the final round than an IQ score.

But grit isn’t just about stubborn perseverance - it’s also about finding a goal that can sustain our interest for years at a time. Consider two children learning to play the piano, each with the same level of raw talent and each expending the same effort toward musical training. However, while one child focuses on the piano, the other child experiments with the saxophone and cello. “The kid who sticks with one instrument is demonstrating grit,” Duckworth says. “Maybe it’s more fun to try something new, but high levels of achievement require a certain single-mindedness.”

Duckworth has recently begun analyzing student resumes submitted during the college application process, as she attempts to measure grit based on the diversity of listed interests. While parents and teachers have long emphasized the importance of being well-rounded - this is why most colleges require students to take courses in all the major disciplines, from history to math - success in the real world may depend more on the development of narrow passions.

“I first got interested in grit after watching how my friends fared after college,” Duckworth says. She noticed that the most successful people in her Harvard class chose a goal and stuck with it, while others just flitted from pursuit to pursuit. “Those who were less successful were often just as smart and talented,” Duckworth notes, “but they were constantly changing plans and trying something new. They never stuck with anything long enough to get really good at it.”

In recent decades, the American educational system has had a single-minded focus on raising student test scores on everything from the IQ to the MCAS. The problem with this approach, researchers say, is that these academic scores are often of limited real world relevance. However, the newfound importance of personality traits such as grit raises an obvious question: Can grit be learned?

While Duckworth and others are quick to point out that there is no secret recipe for increasing grit - “We’ve only started to study this, so it’s too soon to begin planning interventions,” she cautions - there’s a growing consensus on what successful interventions might look like.

One of the most important elements is teaching kids that talent takes time to develop, and requires continuous effort. Carol S. Dweck, a psychologist at Stanford University, refers to this as a “growth mindset.” She compares this view with the “fixed mindset,” the belief that achievement results from abilities we are born with. “A child with the fixed mindset is much more likely to give up when they encounter a challenging obstacle, like algebra, since they assume that they’re just not up to the task,” says Dweck.

In a recent paper, Dweck and colleagues demonstrated that teaching at-risk seventh-graders about the growth mindset - this included lessons about the importance of effort - led to significantly improved grades for the rest of middle school.

Interestingly, it also appears that praising children for their intelligence can make them less likely to persist in the face of challenges, a crucial element of grit. For much of the last decade, Dweck and her colleagues have tracked hundreds of fifth-graders in 12 different New York City schools. The children were randomly assigned to two groups, both of which took an age-appropriate version of the IQ test. After taking the test, one group was praised for their intelligence - “You must be smart at this,” the researcher said - while the other group was praised for their effort and told they “must have worked really hard.”

Dweck then gave the same fifth-graders another test. This test was designed to be extremely difficult - it was an intelligence test for eighth-graders - but Dweck wanted to see how they would respond to the challenge. The students who were initially praised for their effort worked hard at figuring out the puzzles. Kids praised for their smarts, on the other hand, quickly became discouraged.

The final round of intelligence tests was the same difficulty level as the initial test. The students who had been praised for their effort raised their score, on average, by 30 percent. This result was even more impressive when compared to the students who had been praised for their intelligence: their scores on the final test dropped by nearly 20 percent. A big part of success, Dweck says, stems from our beliefs about what leads to success.

Woody Allen once remarked that “Eighty percent of success is showing up.” Duckworth points out that it’s not enough to just show up; one must show up again and again and again. Sometimes it isn’t easy or fun to keep showing up. Success, however, requires nothing less. That’s why it takes grit.

Posted by manualofideas at 07:37 AM | Permalink | Comments (0)

The following slides are from a presentation by venture capitalist Vinod Khosla. Enjoy!
Great Quotes on Innovation and Entrepreneurship

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(click to enlarge)

Source: WallStats.com.

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Any applications for investors in this speech? (After all, much of investing is about the passage of time...)

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David Brooks recently wrote an interesting op-ed in the New York Times entitled, Genius - The Modern View. (Thanks to David Lau for bringing it to our attention.)

Writes Brooks,

Some people live in romantic ages. They tend to believe that genius is the product of a divine spark. They believe that there have been, throughout the ages, certain paragons of greatness — Dante, Mozart, Einstein — whose talents far exceeded normal comprehension, who had an other-worldly access to transcendent truth, and who are best approached with reverential awe.

We, of course, live in a scientific age, and modern research pierces hocus-pocus. In the view that is now dominant, even Mozart’s early abilities were not the product of some innate spiritual gift. His early compositions were nothing special. They were pastiches of other people’s work. Mozart was a good musician at an early age, but he would not stand out among today’s top child-performers.

What Mozart had, we now believe, was the same thing Tiger Woods had — the ability to focus for long periods of time and a father intent on improving his skills. Mozart played a lot of piano at a very young age, so he got his 10,000 hours of practice in early and then he built from there.

The latest research suggests a more prosaic, democratic, even puritanical view of the world. The key factor separating geniuses from the merely accomplished is not a divine spark. It’s not I.Q., a generally bad predictor of success, even in realms like chess. Instead, it’s deliberate practice. Top performers spend more hours (many more hours) rigorously practicing their craft.

Read the full article.

Posted by manualofideas at 09:11 AM | Permalink | Comments (0)

Has multitasking run its course? We're being bombarded with information (the irony of this post is not lost on us), and we're forced to multitask. Perhaps we would do better by cutting down on some activities.

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In the slide presentation below, Roger Ehrenberg, Managing Partner of IA Capital Partners, provides some advice on how to turn today's failures into the successes of tomorrow.

Thanks to Yaser Anwar for the link.

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...much of the chess master's advantage over the novice derives from the first few seconds of thought. This rapid, knowledge-guided perception, sometimes called apperception, can be seen in experts in other fields as well. Just as a master can recall all the moves in a game he has played, so can an accomplished musician often reconstruct the score to a sonata heard just once. And just as the chess master often finds the best move in a flash, an expert physician can sometimes make an accurate diagnosis within moments of laying eyes on a patient.

But how do the experts in these various subjects acquire their extraordinary skills? How much can be credited to innate talent and how much to intensive training? Psychologists have sought answers in studies of chess masters. The collected results of a century of such research have led to new theories explaining how the mind organizes and retrieves information.

...what matters is not experience per se but "effortful study," which entails continually tackling challenges that lie just beyond one's competence. That is why it is possible for enthusiasts to spend tens of thousands of hours playing chess or golf or a musical instrument without ever advancing beyond the amateur level and why a properly trained student can overtake them in a relatively short time. It is interesting to note that time spent playing chess, even in tournaments, appears to contribute less than such study to a player's progress; the main training value of such games is to point up weaknesses for future study.

Even the novice engages in effortful study at first, which is why beginners so often improve rapidly in playing golf, say, or in driving a car. But having reached an acceptable performance--for instance, keeping up with one's golf buddies or passing a driver's exam--most people relax. Their performance then becomes automatic and therefore impervious to further improvement. In contrast, experts-in-training keep the lid of their mind's box open all the time, so that they can inspect, criticize and augment its contents and thereby approach the standard set by leaders in their fields.

...motivation appears to be a more important factor than innate ability in the development of expertise. It is no accident that in music, chess and sports--all domains in which expertise is defined by competitive performance rather than academic credentialing--professionalism has been emerging at ever younger ages...

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Harvard Business School professor Niall Ferguson discusses his recent book "The Ascent of Money." The interview is a bit slow for our taste but Ferguson makes some interesting points.

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Popular astrophysicist -- and, apparently, part-time comedian -- Neil DeGrasse Tyson gives an interesting and funny talk on "ways to die" in our universe and elsewhere.

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Watch Ken Shubin Stein of Spencer Capital talk about cognitive biases and their implications for investors. He also discusses his favorite investment idea, American Express (NYSE: AXP) (starting 13 minutes into the talk). From Darden Value Investing Conference, November 6, 2008:

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In the spirit of Charlie Munger's latticework of mental models, we recommend a wonderful interview with Richard Feynman, the late physicist and Nobel Laureate.

It is impossible to do this interview justice in a brief summary. Suffice it to say that it exposes Feynman as one of those rare creatures who are truly in love with their chosen subject -- and with life itself. Buffett is another such individual.

Part 1 of 6:

Part 2 of 6:

Part 3 of 6:

Part 4 of 6:

Part 5 of 6:

Part 6 of 6:

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The following is Michael Milken's talk in 2001:

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