What Would You Buy If Price Didn't Matter? (Take Two)

Somehow, inexplicably to me, this blog has generated a modest (and believe me, my humility in using the term "modest" is well-deserved humility) readership. And here I thought it was an echo chambers for my ears only. Go figure.

A theme you might notice in the blog is that I want to challenge the limited way of thinking inherent to the acolytes of value investing. Before the torches and pitchforks come out, let me say defensively...I'm one of you!  Well, mostly. Probably 90 percent. But the absolute fixation on price to the neglect of those other traits of a good business and a good investment...well, that just keeps me spinning in my own circles, flirting with the (gasp!) growth-story stocks.

I'm using price more as my last box to check off in my investment checklist. I'm interested first in the qualities of the business itself. Does it have a profitable economic model? (i.e., returns on invested capital, cash producing...even if we have to look into the future to see it) Does it possess real competitive advantages? (i.e., scale-price advantage, brand, network effect or other means of making captive demand, or legal protections) And does it have a big market to grow into to compound its earnings?

And then, within the context of those questions, is Mr. Market offering it at a price that's either reasonable or discounted?

Margin of safety is not strictly a function of price. It's provided by the interconnectedness of competitive advantages, economic profitability, and ability to grow.

Perhaps I get burned and the strict-value minds feel vindicated. If that's the case, I will probably never admit it publicly because I'll be too busy panhandling the streets of my small town. 

So, for anyone new or interested, I wanted to re-issue my thought challenge. 

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I'm offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It's all legit in this little magical mystery market of mine.

So, let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise, and decide...what five companies would you pick?


The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely...


1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)



What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I'll keep a running update on the blog.

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

***

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

- Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

Re: Google vs. Your Boys (but really about amazon)

We had a very pleasant lunch, as we always do. He is an old and good friend. He was amused by my unhealthy fixation with Amazon. And so he sends me this gentle barb a few days later:  Google is coming! [Links to WSJ article.] 

Uh-oh, a threat to Amazon's AWS cloud computing service. I get these challenges with some frequency from people that have learned of my obsession. I love them. Not so much because it offers a chance for debate and I consider myself the superior debater. I'm not. It's more because the challenges keeps me honest. 

It reminds me of the verse from Rudyard Kipling's "If": 

...If you can trust yourself when all men doubt you,

But make allowance for their doubting, too...

It's the only way to keep a kernel of intellectual integrity in his game of investing...look for challenges to your theses. Not to fight back and counterpoint the opposing argument, but for the strength and the wisdom the challenge could bring, giving you the opportunity to improve your models, test your reasoning. It's possible to find something nearing sublime in approaching the debate with philosophical detachment, shunning dogma as best as our bloated egos allow.

Unfortunately, our tendency is to seek out those of like-minded opinions, forming echo chambers for our views and doubling down on the risk of our wrongness being compounded in a confirmation marketplace.

Below is my reply to my good lunch friend:

Thanks for passing this on, T. I'm fascinated by this impending convergence of the major tech giants. They're all sitting on these enormous and valuable assets, mainly large customer bases and some combination of tech gear, tech infrastructure, and customer captivity. As a sort of manifest destiny, they are all compelled to extend and expand the use of their infrastructure...those assets. It's inevitable, as if the combination of management ego and economic drive for higher profits, creates a siren's song for the businesses to expand. I've started calling it the growth imperative, a set of behaviors I've noted in other industries, too.

So it becomes interesting with Amazon, Apple, Facebook, and Google. [See The Great Tech War of 2012 by Farhad Manjoo in Fast Company back in October 2012.] Their markets, as they expand, are overlapping more and more. They must compete, not only to grow, but also to make sure one of the competitors doesn't gain some advantage that allows them to attack their core markets....sort of like offense is the best defense.

A theory I've considering works something like this: cloud computing is a huge market that Amazon entered early and has pretty much controlled. Amazon is taking great pains to commoditize the industry - making the services non-branded - so it will be defined by who can offer computing at the cheapest price to customers. Amazon has demonstrated its willingness to make AWS (its cloud computing) cheaper and cheaper, having lowered prices 20 times since launching. Jeff Bezos has thrown down a gauntlet and dared others - IBM, Microsoft, a slew of tiny players, and now Google - to follow. Amazon has said it will make it all about price.

That creates a fascinating dynamic, and this is where the theory part kicks in. What company can afford to offer cloud computing the cheapest? Both Amazon and Google have deep cash reserves, so they can duke it out on low price there while subsidizing any losses with their own cash. That could be a painful war, and we must ask who would win.

My bet would be with Amazon, and for a simple reason...Amazon has demonstrated both an indifference to how the stock market perceives it as it pursues long-term dominance of an industry, and it has demonstrated a capacity to suffer while its stock price is getting killed because it is losing money in pursuit of dominance. Jeff Bezos frequently says he's comfortable being misunderstood for long periods of time.

So let's consider this like a game theory scenario...you have two giants pressing on the gas, hurling their dragsters at each other in a business that one of them (amazon) is willing to define by price. They will both take losses. The more they fight, the deeper those losses will be, and the more likely their stocks will tank as long as the war persists.

Jeff Bezos is fond of saying something to the effect of ..we want to sell the same thing as everyone else, but because we run more efficiently than they do, we can sell it cheaper. So if they want to have a price war, they'll go broke 5 percent before we do.

He's signaled to the world his intentions and his willingness to be a fanatic in pursuit of them. Now, how crazy is google willing to be as it enters the cloud computing market? How deep is its capacity to suffer? And remember, there's a lot of catching up to do since Amazon has been in the market since 2006.

In this game theory game of chicken, my vote is with crazy Jeff Bezos. That dude's a fanatic!

Solon's Warning...More Thoughts On Success and Failure

I'm re-reading Nassim Taleb's Fooled By Randomness. There are a handful of books I think worth revisiting every year or two to see how your refined understanding of the world - those things you've learned since reading it the last time - influence how you interpret it. It can become a measure of how you've matured in your learning quest. Taleb's book(s) belongs in that rarefied air.

I'm not sure what it means about my own intelligence or reading comprehension level, but it just seems fresh with each new pass. Like I'm reading it for the first time though this is my third time flipping through its well-worn pages.

This will not be a book report. I wanted to highlight a quote that appears before the first chapter and relate it back to a previous post here.

Solon's Warning

Taleb retells an apocryphal story from ancient Greece in which King Croesus (the richest man) is making a futile attempt to get Solon (the wisest man) to agree that the former's wealth and success mean he must be the happiest.

Solon responded:

The observation of the numerous misfortunes that attend all conditions forbids us to grow insolent upon our present enjoyments, or to admire a man's happiness that may yet, in the course of time, suffer change. For the uncertain future has yet to come, with all variety of future; and him only to whom the divinity has [guaranteed] continued happiness until the end we may call happy.

These are the thoughts it inspires (mostly self-plagiarized from a previous post):

Thoughts on Success and Failure

What is success? Is it really an outcome? Too often we think of it as a destination as if it were a platform we land on and upon which we reside forever more. I think we would find that most people we consider successful don't think of it as such a static thing. It's very dynamic. And it's not accurate to use the term in such a general way. I would argue it's just not a precise use of the term.

Perhaps you accomplished a specific thing successfully. You employed strong thinking in an investment decision process that produced an outcome with high returns. That was an example of being successful, but does it define you as a "success." Or say you produced a string of these good outcomes with high returns. Again, those are multiple instances of success, but are you now a "success?" 

You can have a thousand such "successes" followed by a single "failure." How are you then labeled? Or you have a thousand failures followed by a single success. 

Such labels are meaningless. I'm reminded of Malcolm Gladwell's New Yorker profile of Nassim Taleb  [ah, this is why these thoughts reconnect for me a few months later...neural synapses, funny things] several years ago. (Click here to read Blowing Up: How Nassim Taleb Turned the Inevitability of Disaster Into an Investment Strategy.) Taleb revered Victor Niederhoffer as one of the world's best traders and a brilliant thinker. Niederhoffer had a respected fund with investors desperate to include their capital in his investments. He had more wealth than most people could hope for. 

Niederhoffer had it all. Until he didn't. He "blew up", as traders put it, when the strategy he had used with such success for a decade suddenly didn't work. He lost everything. One day he was a "success" and the next he was a "failure." Well, that would be the description if you chose to think of it in such "destination" terms. 

It all brings to mind the story of the Taoist farmer. I had a vague recollection of the tale, and googling it produced this version (from this source):

This farmer had only one horse, and one day the horse ran away. The neighbors came to condole over his terrible loss. The farmer said, "What makes you think it is so terrible?"

A month later, the horse came home--this time bringing with her two beautiful wild horses. The neighbors became excited at the farmer's good fortune. Such lovely strong horses! The farmer said, "What makes you think this is good fortune?"

The farmer's son was thrown from one of the wild horses and broke his leg. All the neighbors were very distressed. Such bad luck! The farmer said, "What makes you think it is bad?"

A war came, and every able-bodied man was conscripted and sent into battle. Only the farmer's son, because he had a broken leg, remained. The neighbors congratulated the farmer. "What makes you think this is good?" said the farmer.

Luck is fleeting. It is a point-in-time result. What we perceive as luck today, we may view as the root of great misfortune tomorrow. The same reasons we might have used to consider a person lucky today we might use to pity him tomorrow.

So goes success, and so the path is circuitous and the arrow points forever further.

Henry Blodget

I'm hesitant to admit such a fascination with him, but after several posts quoting or featuring him, I must now confess a bit of an obsession with Henry Blodget. To refresh on his story, you may turn to Wikipedia here. 

It helps to know the back story to understand the context of why he posted this image on his business news aggregator Business Insider back in April:

The grit required to stage a comeback (it's in process) after being laid so low is a much better story - a Greek tragedy reversed - than a straight line success story. 

Scale Advantage and The Great Coke Scandal

Profits are good. And our profitability bias - that preference to own, to cover, to work for, to partner with companies that turn a profit - is a pretty good filter to apply when evaluating a business for whatever reason. But the best companies sometimes forego profit in the short-term, investing capital more heavily than perhaps is absolutely required or plowing back what might have been profit to increase their expenses in certain areas that provide advantages over the competition. 

It's not as if they don't recognize that everyone prefers they were profitable. It's that they understand that delaying the gratification of immediate profits, when those dollars are spent wisely on honing the defenses of the business, can lead to much greater profits down the road. And, more importantly, it can lead to profits that are protected against the encroachment of bigger-smarter-richer competitors that want nothing more than to steal away its customers.

Profits can be very nice, but they do not necessarily make for the best businesses.  The best businesses couple profitability with sustainable competitive advantages that protect future profits. And when a dilemma requires companies to sacrifice either profits or competitive advantages, the best ones watch out for their long-term interests. They sacrifice profits and keep investing in their defenses.

Of the major categories of competitive advantage - strong brand, legal protection, captive demand, and scale - the one with the longest lasting benefits is scale. This is where the size and efficiency of your operations allow you to produce an offering for less than your competitors, so much so that no rational actor would dare attack your position. 

When combined with other forms of competitive advantage, scale makes for the deepest defenses of all.

The Curious Case of the Coca-Cola Secretary

In late-2006 a secretary at Coca-Cola headquarters conjured up a lurid plot. Working with two ex-convicts, she contacted arch-rival Pepsi and offered Coke's most sensitive trade secrets in exchange for large sums of cash. The cabal believed Pepsi would be eager to steal a glance of secret Coke recipes, that such information would somehow help the competitor in its never ending battle with Coca-Cola to win the cola wars. 

Pepsi wasn't so keen on the scam. In fact they called up the FBI immediately and were glad participants in an exciting sting to catch the crew in the act and send them away on federal charges. Besides questions of basic human decency, why would the Pepsi executives not be eager for the patented trade information offered up by the secretary?

At best, the secret Coke recipe is one part honest-to-god competitive advantage based on a particular mixture of ingredients to produce a specific taste. And it's nine parts marketing ploy, a wink at its audience to suggest Coke is so delicious that the company must keep the secret recipe behind locked doors (lest a competitor produce a beverage with the same flavors and thereby steal away all its customers, of course). The public loves the mystery that comes of a secret formula!

Coca-Cola's competitive advantages are far less grounded in the legal protection of patents and formulas defended as trade secrets than they are a potent combination of brand and economies of scale. The company has spent billions over the years on savvy marketing, creating a Pavlovian tie between the sound of fizz escaping from an opened bottle and a person salivating in anticipation of her refreshing drink. But more importantly, they have made the product omnipresent. You are probably never more than a few steps away from the opportunity to buy a cheap Coke the moment the urge hits you, whether that urge is induced from a commercial or your own thirst. 

This is an example of scale applied to distribution. Its products are everywhere, and making that happen is a far more impressive business feat than inventing a tasty carbonated beverage in the basement of an apothecary's shop. 

Coca-Cola has the benefit of scale in production costs, advertising, and distribution. They can produce a mind-bending amount of product for mere pennies per unit, with all the fixed costs being spread across  enormous production volumes. They can then buy national and international ads, reaching consumers all over the globe, inculcating them on the idea that Coke is it. And their distributors move tons upon tons of cases each day, spreading the cost of stocking shelves over all those bottles.

The benefit of investing to create all this scale means Coke can charge a pittance for each bottle of product, a dollar or two that most consumers will never miss, while still turning a very tidy profit. What would it take for a competitor to make a reasonable return at a comparable price point? Richard Branson tried in the mid-1990's with Virgin Cola, even pricing below both Coke and Pepsi in hopes of stealing only a sliver of their customers. The cola incumbents ramped up their advertising budgets in every market they thought Branson might have a reasonable chance of establishing a toe hold, and they leaned hard on their customers to keep shelf space off-limits to the upstart. Branson couldn't even get most grocery stores in his native UK to give his drinks a shot. When you can't gain entry through basic distribution channels, you must know your future is grim. Price doesn't even matter.    

Any other competitor would run into the same challenges trying to surmount the advantages provided by Coke's scale. As a last resort of scale, Coke could always fall back to its balance sheet - it has plenty of cash - and fight a price war to makes its products much cheaper than any alternative, gladly exchanging short-term profits to ensure it maintained long-term advantages. The profits will come back if the defenses remain strong.

And so we get a good chuckle out of the misguided secretary, hoping to make a buck selling Coca-Cola's most valuable secrets. In reality, Coke's competitive advantages are hidden in plain sight.  A big piece resides with its brand...but the bulk sits with its scale, the end-product of years of foregoing billions in additional profits in return for high volume production capabilities, wide reaching advertising, and a scaled distribution infrastructure.

Competitive Advantages - The Umbrella Categories

Sometimes it makes sense to deny the profitability bias, the investor's case of the Marshmallow Test, deferring the instant gratification of today to invest in defenses that promise even greater profits in the future.

Building those defenses is making investments in your competitive advantages, the bulwarks protecting your customers, your revenues, and your profits (current and future) against bigger-smarter-richer companies that want access to your market. 

For the sake of simplicity, let's say all competitive advantages fit under one of four umbrella categories: brand, legal protection, captive demand, and economies of scale. 

For brand, just think Coke or Apple. These are the icons of their industry that have somehow (through tremendous investment in quality, consumer experience, and marketing over long periods of time) endeared themselves to their end-users in ways that I can only describe with the term "gestalt." The whole is much greater than the sum of its parts. 

The connection with customers transcends emotional. It seems almost spiritual. Or cultish, take your pick. For true Apple believers, you would have to pry their cold, dead fingers off a Mac keyboard before getting them to type a document on a PC.  Steve Jobs' crew delayed profits for years and years as Apple invested heavily in engineering, design, elegant software, and lots of advertising. The totality of those investments contributes to the end-user's experience of buying and using Apple products in ways bigger than any of those  investments considered individually.

Bigger-smarter-richer companies could not replicate Apple's connection with customers. 

For legal protection, think about pharmaceutical companies having patent protection over the molecular formulation of their drugs. For example, patents gave Pfizer years of exclusive rights to sell Lipitor to help American baby boomers reduce the amount of cholesterol floating in their arteries. It brought Pfizer as much as $13 billion of annual revenue at its peak, and plenty of profits to boot. 

But let's remind ourselves, those profits were the result of investments that lowered Pfizer's overall profits for years before they peaked. The pharma giant invested hundreds of millions to develop the drug, patent it, win FDA approval to sell it, and then fight like crazy to defend and extend those patents. 

We see the full impact of legal protection as a competitive advantage by watching what happened to Lipitor when its patents finally expired in November 2011. In about a month's time, its market share was cut in half by generic competitors marching gladly past its now defunct bulwarks, selling their much cheaper alternatives to Lipitor patients eager for a lower pharmacy bill. 

For captive demand, "sticky" has become the popular descriptive term to explain a service whose customers have a hard time putting it down once they start using it. Cigarettes come to mind, what with they being addictive and all. But my preferred example is the way banks have used online bill pay as a sticky feature that makes it an enormous pain to ever ditch your existing account for a competitor's offer. Do you really want to trudge through the process of entering all your biller information, due dates, and payment schedules on another bank's website? And for what? A free toaster with your new checking account? No thanks. 

Finally, we have economies of scale, or just "scale" for short. The businesses best protected from bigger-smarter-richer companies have some combination of all four of the umbrella categories of competitive advantages. But the strongest have a healthy dose of scale, a trait that allows you to produce something for so much less than your competitors that the rational ones would see that it's foolhardy to even attempt to compete with you and the fanatical ones - those that make an irrational decision to compete anyway - would run out of money before you.  

We'll dig more later on the benefits of scale...

Profits As Marshmallows

Let's continue the thought from our last post regarding the profitability bias... 

Over the longer term a business must be profitable. Of course. But if it has the chance to be wildly profitable in the future with little chance of the bigger-smarter-richer company being able to steal its customers, perhaps those profits could be deferred for a time.

This is the business version of the marshmallow test, that Stanford University experiment from the 1960s popularized by Jonah Lehrer's 2009 article Don't from The New Yorker.  By way of brief recap, forty years ago Professor Walter Mischel brought four-year-old kids into a room for observation, offering each a simple choice: you could have one marshmallow now, a tasty-looking morsel set in tempting reach of your chubby fingers, or you could wait a few minutes and have two. 

This was the ultimate test of the ability to delay gratification, foregoing the instant benefit to get an even better benefit in the future. If you've spent much time around young children, you'll know that putting off pleasure does not come naturally to the vast, vast majority of them. This was Professor Mischel's experience, too. Most kids gobbled down the tempting treat within seconds of the proposition being made. For those who held out, not only did they double their marshmallow bounty, but Mischel discovered their ability to delay gratification correlated even more closely with high achievement later in life than other more obvious factors like, say, raw intelligence. 

Sometimes profits are marshmallows. We want that instant gratification of stuffing them in our mouths - getting that immediate surge of sugar energy - even though they could lead to even more profits in the future, profits that would be protected from bigger-smarter-richer companies trying to compete with us. If only we delayed our profitability bias for a time. If only we invested those profits into building and maintaining defenses for our business.

Next, let's talk about what those competitive advantages are...

The Profitability Bias

When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a profitability bias in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there's money left over, it's a profitable company. And the bigger the profits, the better the company.

And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you're using a framework to understand and assess businesses, it's fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.

Profits are good. They are best when they can be sustained, and they are misleading when they cannot be sustained. Unsustainable profits can trick you into believing a company is more valuable than it actually is when you assume those profits will continue coming in or that they will compound over time. 

But what happens if the profits go away? A bigger-smarter-richer competitor comes sniffing around, attracted by those tasty profits your business is showing, and decides it might like to get in the game. It decides to build the same product, but to build it better and sell it for less. And the bigger-smarter-richer competitor has the ability to do this.

Now those tasty profits are beginning to slip away as your company is forced to defend its market, spending more to earn each new customer, and pricing products lower to keep existing customers from deserting for the bigger-smarter-richer competitor.  Your business suddenly looks less valuable as the profits from yesterday don't translate into profits tomorrow. 

We need to check our profitability bias with another important concept that comes in handy when trying to gauge the quality of a business. 

Enter the competitive advantage. That post is next...

The Most Significant Battle in Amazon History (Why Bezos Celebrated the Bubble Popping)

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide much of what you need to understand the retail business of Amazon.com. We featured it originally in a post here. (And you can watch the full broadcast of the video here.) 

To remind you of the context, the interview corresponds with the steepest part of the dot-com collapse. Amazon's stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn't end until shortly after 9/11 when it hit a $6 bottom. Bezos own net worth dropped by half a billion dollars (reference here).  

And yet Jeff Bezos was doing all he could to hide his ebullience. 

Bezos welcomed the end of the internet-telecom bubble of 1998-99 for the simple reason that Amazon had reached scale and achieved a level of capital self-sufficiency that meant the company no longer depended on the goodwill of Wall Street for cash to grow operations. It was sitting on plenty of it and could generate more from operations.

The same was not true for other web retailers in the process of scaling up. They needed more funding to sustain themselves and grow. They had received a steady flow of it from venture capital firms willing and able to invest large sums in unproven businesses, confident they would recoup by bringing their seedling companies public in short time. But with the bubble popping, that all went away. It took down pets.com, wine.com, toys.com and countless other companies with which Amazon competed and (more interestingly) in which Amazon had made investments. 

Bezos had this to say about it with Charlie Rose:

So all these companies could get funded. And that's what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time...many of those companies might have been able to build the scale to be successful.

Losing its investments in online competitors hurt Amazon, but only in the most superficial and temporary sense. Amazon invested in these businesses as a hedge. Bezos was already working toward the lofty goal of being the ubiquitous force in online retail...the only place people would shop. That meant he would expand Amazon into every conceivable product category, offering universal selection. Of course he couldn't get there immediately. He had to prioritize where the company invested its money and time. So he adopted the land rush mentality, investing in a broad swath of developing web retailers in early stages of growth. 

If the competitors could reach any sort of scale - with their software, merchandising expertise, and distribution capabilities - they could begin expanding into adjacencies. It didn't matter what product niche they specialized in to launch themselves, they could use the infrastructure to expand. They could threaten Amazon's objective to be ubiquitous. So Bezos bought the competition or invested in them, holding his enemies closer than his friends. 

One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren't the ones we were going to do first...Pets.com, wine.com, etc....there were a bunch of things that we were invested in that didn't work out. We knew we weren't going to do those things anytime soon, but we wanted placeholders  in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by...a land rush mentality...It's hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we...behaved that way.

Then the crash came. The talking heads wanted to focus on Amazon's foolish investments in all these dot-com bombs, the value of which evaporated in a slew of bankruptcies. No doubt it hurt Bezos, but he had confidence in the bigger picture of what was happening. Why weep over these investments gone bad? They were hedges. The bigger bet was paying off. Your competition was gone, you didn't need Wall Street for more money, and you had scale.

Bezos was ebullient because he recognized, despite the stock price going down in flames, that he had just won the most significant battle in Amazon history. He was the last man standing. 

And so we can understand the confidence behind his statements in the closing minutes of the interview with Rose (emphasis is mine):

In the early days, that's when the company's destiny is really not in its own control. At this point in time, with the brand name that we have...we have so many assets now, now it really is under our control. We don't worry about externalities now. What we worry about now is that we don't do our job. And I'll tell you one of the things in this period that I kind of like is that it's a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn't lose.

And this conclusion:

Charlie Rose: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What's the odds of the first being true versus the second?

Jeff Bezos: Let's put it this way: we get to decide, nobody outside the company can decide that. 

Jeff Bezos was history's happiest man for losing $500 million in personal fortune in 2001. He had long ago separated the concepts of the value the stock market places on his business versus the value contained within the actual operating business...the intrinsic value. Bezos knew how temporary that loss would be and the great path it set for Amazon's future.

Avon Products: Andrea Jung v. Wendy Nicholson

I spent a little time in 2011 following the saga of Avon Products and its CEO, Andrea Jung. By way of quick synopsis, over the span of a few years Avon whirled from darling to dumbkauf multiple times. Stories told by the financial media and the analyst cabal tracked close to the volatile swings of its stock. Andrea Jung engineers a turnaround, the story went, with her brilliant management technique. The stock ticks up high. Andrea Jung fails to inspire Avon sales rep, the stories read shortly thereafter, strategy must be reconsidered as earnings sag.

Jung and her management team were willing participants, playing the expectations game over and over again with the analyst cabal. They contributed guidance, tried to influence where the roulette wheel of The Consensus Estimate would land each quarter, and spun the most positive message to the investment world whenever Avon released its financial results.

Jung said it well in a 2006 interview with BusinessWeek’s Stephen J. Adler. (here)  “How do you deal with criticism?” Adler asks.

“I think you’re never as good as they say and you’re never as bad. The truth is somewhere in between,” was Jung’s reply.

So it is with the story being told about the performance of the business, the qualities that lend it strength or create vulnerabilities, and the future that lies ahead. The story gets bright and optimistic; the story swings low and pessimistic. The truth lies somewhere in the muddy middle.

By late-2011, the story being told about Avon was unequivocally bad, and not without merit in this case. The company was reeling from a bribery scandal in China and an IT implementation gone so wrong in Brazil that the company could hardly service its salespeople or customers. These markets were important to Avon’s growth, and the effects of the snafus were showing up on financial statements. The company was missing The Consensus Estimates on revenue and operating profit.

On its own, each of these was certainly a problem, but also containable. Occurring together as they did, however, the events catalyzed each other and accelerated into a full-scale blaze. In an October earnings announcement and conference call with the analyst cabal, Jung had attempted to describe what her team was doing to fix the problems and orchestrate another turnaround. She was now taking questions, when Wendy Nicholson of Citigroup came up in the queue.

(The conference call is here.)

Conference Call Operator: Your next question comes from Wendy Nicholson.

Ms. Nicholson: With Citigroup. My first question is, are there any more ERP implementations that have to come around the world in big markets or is Brazil the last one? And then my second question goes to this: whatever update, outlook thing that you're going to have in the first quarter. And I guess my question is, I know you know you guys are probably eager to hold our hands and to give us a message and just set a strategy just so the people have some direction to march towards, if you will, maybe internally as well. But it strikes me that you guys need to do a tremendous amount of work, probably change a bunch of people in management, probably change your capital structure, maybe take another restructuring charge, maybe exit a market like what you did in Japan. But I think it took a decade to come to that decision. Maybe you'll come to that decision about some other markets. That strikes me as a humongous amount of work. And unless you're planning on handing this off to the new CFO December 1 and saying, "Hey, you got 6 weeks to figure this out," it strikes me that saying it's a first quarter solution could be really premature. So have you thought about the idea -- go back and hire McKinsey again. Go back and really go to the drawing board. Think about taking the company private.? I mean, it strikes me that you guys are so totally screwed up in so many ways. The change has to be radical, and I don't know if saying, "Hey, we're going to come out in February with financial targets" is enough. That's it.

Sure enough, the financial media lead their stories with the quote from Wendy Nicholson that is meant to represent the frustration of the entire analyst cabal, “it strikes me that you guys are so totally screwed up in so many way…”

Ms. Nicholson had supported Avon, and at one time endorsed it to the salesman and clients reading her research notes. Now Avon had failed her with these operational blunders and these misses against The Consensus Estimate. Andrea Jung had failed her. Ms. Nicholson’s fury was peaked, and she wasn’t going to let an opportunity slip by to scorn the object of her previous affection; to insert herself into the story.

Andrea Jung was replaced as CEO the following April, a personnel move with plenty to justify it. She had made big mistakes. And she engaged in the expectations game, playing hard in an attempt to keep the Avon stock price up. In the end, she could not satisfy the analyst cabal. She lost the game. And she lost her job. 

Good News Earnings Call v. Bad News Earnings Call

Earnings call archetypes:

First, the Good News Call. All is right with the world. Management is proud to report they have exceeded consensus expectations by two pennies. The CFO reads from a prepared statement, but his voice has a little life to it for a change. He strays a bit from the script. But just a bit. 

And hey, guess what, somehow the CEO found his way to the call. That almost never happens! The man is just so busy. He's eager to share his insights into why business is so good. Luck has very little to do with it. It's culture...skill...management technique.

Question and answer time. The queue fills up quickly. Each analyst prefaces his question with a hardy congratulations. The tone of his voice betrays a belief that he somehow contributed to the outcome; that he's a part of this winning team. Because he predicted this winner! Formality is tossed, as everyone addresses everyone else by christian name. 

"Hi Bob. It's Darryl from Highfalutin Capital Management. First, let me say terrific job! We all knew you had this kind of quarter in you."   

"Thanks Darryl. We really appreciate hearing that. Especially from you. Your support means a lot to those of us here in the executive suite."

If they were in a locker room, towels would be swirled into tight spirals and popped playfully onto one another's backsides. 

CEO and CFO are downright loquacious, glad to answer all questions. Noting at times that they ordinarily don't provide THAT sort of guidance; THAT level of detail, but what the hell...just this once.

The call ends, and everyone breathes a deep, cheerful sigh. Management takes off early for the day and heads for the links. The analysts churn out bullish reports about the wonderful prospects for this business, accept congratulatory calls from their firms' salesmen while instructing them to get clients buying more and more, and then dutifully watch the ticker blink green.

***

Second, we have the Bad News Call. Management released the press statement as late as possible last night. Despite all attempts to reclassify expenses and revenue in the past few days, the earnings are two pennies below Wall Street consensus estimates. Down slightly from the same quarter last year. 

The CFO reads from his prepared remarks. His voice is gravely. He just sounds worn down. He keeps tightly to his script. I'm sorry, he says at the end, but Bob, our CEO, wasn't able to make it to provide his management outlook. He's with a very important client today. But the CFO is happy to take questions.

The queue fills up quickly. "I'm not sure how you could have let this happen," says the first analyst. "This result puts you in the lower half of your guidance estimate. And I thought you UNDERSTOOD that we UNDERSTAND that if you provide a range for your estimate, we assume that means you'll be on the high side. Please explain to me, Mr. Senior-Vice-President, how I should explain to my clients that your stock won't fall in half in the next quarter?"

The CFO explains dutifully that - while we would never lay blame on the economy, we're a company that takes full responsibility for its results - the economy does sort of stink right now. 

And so the questioning continues until the CFO is mercifully saved by the operator chiming in, "That's all the time we have for questions this morning."

The call over, the CFO hangs up his phone. He looks over to the CEO Bob sitting across the table, a sheepish look on his face after begging his colleague to excuse his absence. "That was the best we could do. Circumstances were just out of our control this time."

Meanwhile, the analysts crank through their timid predictions for the company's future. True, they were bullish just two quarters ago. But that was before management demonstrated it was inept. Now, they tell their salespeople, we should instruct our clients to sell, sell, sell. It will be months before this business gets back on track.

CEO Philosophy On Stock Price: Home Depot

Marc Beniof's words (as noted in a post yesterday, here) sent me thumbing through a few more books in my library. What have other CEO's had to say about their stock prices? 

From the excellent book, Built From Scratch, by Home Depot co-founders Bernie Marcus and Arthur Blank, come the following quotes. (Which, by the way, in no way diffuses my enthusiasm for this book. When studying retail, it is as important to read this as Sam Walton's Made in America. No question!) 

The Home Depot has always been a high-multiple stock. Part of the explanation for it is that the financial community trusts us. (page 183)

Anticipating a hit to earnings from a bad acquisition in 1984, the early days, CEO Bernie Marcus went to the Wall Street throne to plead his case for not punishing the stock price:

We arranged a series of meetings in New York in which Bernie and Ron Brill, every hour on the hour for a full day, came clean with fund managers and analysts who covered our company. Standing before each group, Bernie stood up and bluntly announced, "I am the CEO of this company, and I am a schmuck," in precisely those words. "We screwed it up..."

After that, Bernie told them about the corrective measures that had been put in place to prevent a repeat in the future. He assured them that the growth and profitability would continue. And they believed Bernie.

...We disappointed the Street for the first time...Suddenly, analysts said we didn't know what we were talking about. It was the nadir of the business. (page 184)

Finally, the following quote calls into question whether the tail was wagging the dog. How much did attention from Wall Street influence their decision to expand in the Northeast? Don't get me wrong. I understand that stock price plays a big role in a company's ability to raise capital for growth needs. There is a reality to wanting the stock price to be high versus low. I get it. But the slippery slope of this mentality can be frightening. 

During the first three years of our Northeast invasion [store expansion beyond its Southeast base], 1988-91, our stock just went crazy. Getting a presence to that part of the country exposed us to Wall Street in living color. For the first time, analysts and brokers saw how busy the stores really were. Seeing is believing; our stock price once again was climbing upward. (p197)

There is a disconnect here. It's creating some serious cognitive dissonance for me. On the one hand, these CEO's are smart and savvy. They don't need a lesson in Stocks 101 from me...they understand that the stock price is not a direct reflection on the performance and/or promise of the business. I can't imagine many CEO's actually subscribe to the theory of efficient markets in which the stock price is somehow magically aligned with the true value of the business. No, they understand that the stock price is subject to whims, fancies, and misunderstandings of investors.

And yet, there's this other hand. They keep playing to it. That makes sense in the Home Depot case from 1984 as they desperately needed capital to grow the business, and they saw the best source of capital as issuing new stock or new debt, both of which would be affected by the current stock price. If it plunged, their access to capital would be cut off.

I get that. I understand that when you need their capital, you're hostage to the Wall Street game. You have to go to fund managers and analysts from time-to-time with hat in hand.

What I don't get is that they often seem to be struck by the bug themselves. They tend to get caught up in the price, as if it were somehow the only scorecard by which they can measure their success as people in business. And worst yet, they allow (and perhaps encourage) their employees to do the same thing...to get excited by a rising stock price and to believe they are somehow doing something wrong when the price goes the other way.

That may be true some of the time. Sometimes (oftentimes even) the stock price does react to legitimate bad decisions by people in the company. But sometimes it just moves up and down, completely disconnected from the reality of the business.

I have no immediate way of understanding why many CEO's do what they do. I'll punt this discourse on the complexity of human psychology and just revisit the quote from Jeff Bezos that got it started (here). It seems wiser the more I think of it:

We have three all-hands meetings a year, and I'll tell people that if the stock is up 30% this month, please don't feel you are 30% smarter. Because when the stock is down 30% a month from now, it's not going to feel that good to feel 30% dumber. 

***

For some more posts related to this topic, refer to these...

CEO Philosophy on Stock Price: Amazon.com and salesforce.com

To Be Misunderstood...The Witch's Dilemma

Whom Does Management Serve

My Contribution To the Facebook Noise  

CEO Philosophy On Stock Price: Amazon and salesforce.com

The Jeff Bezos Approach to Stock Price

In April 2008, Peter Burrows of Businessweek sat down for an extensive interview with Amazon CEO Jeff Bezos. The article, Bezos On Innovation, featured this piece of quotable wisdom on how to teach your employees to think about the value of the stock they own in your business:

We have three all-hands meetings a year, and I'll tell people that if the stock is up 30% this month, please don't feel you are 30% smarter. Because when the stock is down 30% a month from now, it's not going to feel that good to feel 30% dumber.

The salesforce.com Contrast

I thought of the quote early this morning while drinking coffee and reading Behind the Cloud by Marc Benioff. The salesforce.com CEO has this to say about the morning the company listed on the NYSE:

The elation I felt on the morning we went public lasted long beyond the opening bell. It was incredibly gratifying to watch the stock climb; you can't help but take it very personally. We ended our first day of public trading at $17.20, a 56 percent gain - making salesforce.com the best-performing tech IPO 2004 had seen thus far.

I don't fault him for being excited. He just realized a long-held professional ambition for himself, doing so at the helm of a business that was ushering in a paradigm change (and that is not hyperbole, I can't overstate what salesforce.com has done to software) in the way an entire industry operated. Elation is a natural and justifiable emotional response. 

He does represent, however, the starkest EMOTIONAL contrast to Bezos' highly RATIONAL approach to what the stock price of your business actually means. It's tempting for CEO's to interpret it as a sort of validation of their ideas and performance; that a high multiple of price to earnings means you've done something intelligent and virtuous to earn the trust of Wall Street. 

They understand you, and you yearn to be understood. 

But what have you committed yourself to? What happens when you have to make a decision that you know is in the best long-term interest of your business but that hurts short-term profitability, up-ending your string of quarter-over-quarter earnings growth? 

Now you're misunderstood. Wall Street punishes you. That stock price, trading at such a high multiple to profits, suddenly seems way too high to the analysts and existing investors. It plummets. 

How do you feel now? More importantly, how do you explain that to your employees who shared your excitement but don't really understand that stock price and business performance are often disconnected?

Jeff Bezos earned his perspective the hard way. Later, in the same article as above, Bezos has this to say: 

When the Internet bubble burst, our stock went from over 100 a share to a low right after September 11 of 6. Throughout that entire period, the fundamentals of the business continuously improved. You can see the stock price going in the opposite direction of the fundamentals. So it wasn't that worrisome to us.

***

For some more posts related to this topic, refer to these...

To Be Misunderstood...The Witch's Dilemma

Whom Does Management Serve

My Contribution To the Facebook Noise 

Confirmation Marketplaces and Ideological Amplification

Here's a thought in the early stages of baking in my mind...

In his 2009 book, The Big Switch, Nicholas Carr describes a experiment in which researchers brought together one group of politically liberal-minded folks and an off-setting group of conservatives. They surveyed each participant beforehand to understand his pre-existing views on topics such as same-sex marriage, affirmative action, and global warming. This was the baseline. Then they put the liberals together in one room and the conservatives in another and basically said talk amongst yourselves.

When discussion time expired, the researchers surveyed the individuals again, asking the same questions as before. How did the discussion with like-minded participants influence the initial views as expressed in the baseline questionnaires?

In short, people's views became more extreme and more entrenched on all three issues. The liberals came out more liberal, and the conservatives came out more conservative. 

Deliberation thus increased extremism...every group showed increased consensus, and decreased diverstiy, in the attitudes of its members.

The researchers came to call the effect ideological amplification. It's one of those funny wiring glitches of the human brain, and its effects go far beyond matters of politics. 

Throughout the weekend I found myself thinking about this tendency and its potential to create trouble. If you're in a profession that requires complex and nuanced logical thought - think scientific discovery, philosophical truth-seeking, medical diagnosing, investing - it's imperative that you find ways to root out the bias that inevitably creeps into your process of thinking. You must design thinking mechanisms for identifying them and then formulate the discipline to root them out.

Yet this is hard to do. Very, very hard. It's so difficult to challenge your own ideas. Our natural tendency is to find ways to support what we're thinking, not to disconfirm it. And this becomes more true the more we develop the idea, especially if we begin promoting it to the world. 

And since we're social creatures, too, we often take our ideas to the world in search of support. It's a rare person that takes his ideas to groups of people that are likely to shoot them down. More often we take our ideas to Confirmation Marketplaces...supporting family members and like-minded colleagues. Or industry conferences, email listservs and online forums whose tendencies we already recognize to be aligned with the bent of our existing thoughts. 

What happens here, and I don't think we sufficiently account for this in our thinking process, is ideological amplification. These groups and forums become places for us to feel better about what we're thinking. To confirm our existing thoughts - and often to promote them - rather than challenge them. 

Such confirmation is probably fine if you're idea is already well-threshed out and true. But more often than not, the ideas require a healthy dose of intellectual pummeling to verify and/or deny the reasoning behind them. Disconfirming challenges to off-set our natural confirmation biases. If we seek out the echo chamber of confirmation marketplaces, we're not likely to get that. 

What Would You Buy If Price Didn't Matter?

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I'm offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It's all legit in this little magical mystery market of mine.

So, let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise, and decide...what five companies would you pick?


The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely...


1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)



What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I'll keep a running update on the blog.

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

***

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

- Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

Greenblatt vs. Burry: Even Value Investors Disagree

I didn't intend this to be a series, but it has quickly turned into one. The original idea, from this post, is that holding up company managers as "shareholder friendly" (in that they do a fine job representing shareholder interests) can be like a backhanded compliment. Which shareholders, exactly, are they representing? Because it's a certainty that few of the company owners share the exact same interests or desires for the business. 

The most stark contrast might be between investors with an interest in the business showing short-term gains to impress the market, increase the stock price, and provide an opportunity to exit with a profit. They will want managers to work over their accruals as best as possible to show higher earnings. Or to just stop making investments in the business and let the lowered expenses generate a bigger bottom line. 

Their objectives are not going to mesh with the investors hoping to stick around for the long haul. This group will not be excited by elaborate accounting to increase GAAP earnings. Nor will they want executives to neglect important expenses (like marketing, talent acquisition, research and development, etc.) in order to show a fatter profit next quarter. These expenses are investments in spurring growth and/or maintaining strong barriers to entry, both important in maintaining long-term profitability.

And even reasonable, level-headed investors can disagree with each other and therefore have diverging interests.

Case in point: Joel Greenblatt versus Michael Burry, a disagreement Michael Lewis brought to light in his book, The Big Short.

Joel Greenblatt, of value investing fame for his various books and tremendous track record with Gotham Capital, seeded Michael Burry's hedge fund and benefited from multi-year period of impressive returns. Then Burry made his big bet against sub-prime lending, a complex and hard to understand investment, but one with a high likelihood of success (in Burry's estimation at least). 

Burry's fund was down 18 percent in 2006. It was making his investors very edgy, and most of them - while being perfectly happy with his extraordinary returns in the years leading up to this - pushed him hard to ditch the strategy. As they threatened to pull their capital from him, he locked it up. 

From the book:

In January 2006 Gotham's creator, Joel Greenblatt, had gone on television to promote a book and, when asked to name is favorite "value investors," had extolled the virtues of a rare talent named Mike Burry. Ten months later he traveled three thousand miles with his partner, John Petry, to tell Mike Burry he was a liar and to pressure him into abandoning the bet Burry viewed as the single shrewdest of his career.

Listen...there is a certain fog of war to these things. This stuff is not black and white. What seemed such a low-risk, high-return investment to Burry appeared quite different to Greenblatt. Perhaps Burry did a poor job communicating his ideas to the Gotham Partners. Perhaps the partners did a poor job listening. Regardless of the reasons, here we have two very intelligent investors and reasonable people disagreeing over how the money should be invested. 

What is the shareholder friendly move in this dilemma? Should Burry try to liquidate his bets to give Greenblatt his money back? Not only would that go against a thesis Burry held with deep conviction, but it would ensure a loss as the strategy had not yet matured. 

Or was the the shareholder friendly move the very action that Burry took? In other words, protecting Greenblatt against himself by locking up the money (no redemptions) and handcuffing him to the trade. 

History tells us Burry was right. Greenblatt made off like a bandit by getting stuck with his former mentee. But this is just one example. I have no doubt there is no shortage of counterpoint examples in which hedge fund money is locked up, promptly lost (Philip Falcone anyone?), and investors are left holding the pittance that remains. 

If reasonable, intelligent people (even value investors) can have diverging opinions and interests in a hedge fund example like this, surely the conflict only broadens when you have a wide base of investors in a public company. 

So, what exactly does it mean to be shareholder friendly? Does it mean paying out a fat dividend to keep pension funds happy even when you have an expansion opportunity to plow that cash into growth? Does it mean cutting your marketing staff during a down turn because you know your margins will be pressured and you don't want to disappoint Wall Street with a down earnings period? Does it mean cutting off a research initiative after two years of losses when you have high conviction that it will pay off in a big way if you just suffer another two years of losses to get it going?

*****

I'm a big fan of Joel Greenblatt. His books have helped my thinking tremendously, and he is serving an important role as he spends time educating people about his investing methods. And while I use the story of Michael Burry to illustrate my point, I want to make sure Greenblatt has the chance to make his case.

He did so in an October 2011 presentation to the Value Investing Congress (courtesy of Market Folly here). 

In a Q&A Greenblatt was asked about Lewis' account of events. His response was witty (and I suspect true), but more importantly he provided some balance to the whole affair...

Michael Lewis has never let the facts get in a way of a good story. What they got wrong in the book is Burry wanted to side pocket both mortgage and corporate CDS... we did not want him to side pocket the liquid corporate CDSs … only reason we took money from him was we were getting redemptions.

Greenblatt was not the unreasonable ogre Lewis made him out to be. He had his own pressures. This doesn't contradict my point. In fact, I think it strengthens it. Sometimes a manager must be able to ignore the panic of his investors. He just might be protecting them in the long-run by sticking to his strategy despite their immediate needs. We know this happens in publicly traded companies, too. Large investors (hedge funds, pension funds, mutual funds) get calls for redemptions that force them to sell their holdings to generate cash to pay out departing investors. They must sell irrespective of the investment prospects.

The CEO of a publicly traded company can't, of course, stop investors from selling. But in understanding that investors will often have interests that diverge from those of the business itself, one can see that it does make sense - sometimes - to vest enough authority in managers to let them ignore their shareholders and keep plugging away for the long-term benefit of the franchise.