Upcoming Event: Aswath Damodaran Valuation Seminar and Retreat

October 28, 2024 in Diary

Editor’s note: Alex Gilchrist is supporting the organization of this wonderful event. MOI Global has no control over the contents of the seminar, nor does MOI Global receive any compensation for recommending this event.

This exclusive two-day seminar, presented by Arc and MOI Global and led by Professor Aswath Damodaran, on the picturesque island of Mouchão in the medieval town of Tomar in Portugal, will be an immersive event that will explore key valuation concepts such as estimating cash flows, growth rates, and discount rates, using real-world companies to address common challenges.

The program is crafted to provide value for both senior and junior participants alike, ensuring that all attendees—regardless of experience—can deepen their understanding of these foundational concepts.

Overview by Aswath Damodaran:

You may ask if this is for senior people or juniors. I just say that all valuation is basic and what people take out of it will vary depending on whether they are junior or senior. In short, this is designed for a very broad and diverse audience.

There are as many models for valuing stocks and businesses as there are analysts doing valuations. The differences across these models are often emphasized and the common elements are generally ignored. In this two-day seminar, I will start with the estimation issues and basics of intrinsic valuation, talking about the big picture perspective that must be brought to the estimation of cash flows, growth rates and discount rates. I will use real companies as lab experiments to bring home the estimation questions that have to be dealt with in valuation. Once I have the foundation laid, I will launch into an assessment of the loose ends in valuation and talk about valuing control, synergy and cross holdings in companies. Then, we will move on to what I term the dark side of valuation, valuing difficult-to-value companies across sectors (intangible assets, cyclical and financial service companies) and across the life cycle (small private, young growth, mature transition and declining/distressed companies). In the last part of the session, we will cover the use and misuse of multiples in relative valuation.

The objective of the training is to provide the fundamentals of each approach to valuation, together with limitations and caveats on the use of each, as well as extended examples of the application of each. At the end of the seminar, participants should be able to:

  • Value any kind of firm in any market, using discounted cash flow models (small and large, private and public)
  • Value a firm using multiples and comparable firms,
  • Analyze and critique the use of multiples in valuation,
  • Value “problem” firms, such as financially troubled firms and start up firms,
  • Estimate the effect on value of a restructuring a firm 

The first day of the seminar will establish the fundamentals of discounted cash flow valuation, with a special emphasis on the estimation issues that come up when estimating discount rates, cash flows and expected growth. It will look at the choices in terms of DCF models and how to pick the right model to value a specific firm. In addition, we will use the basic structure of the discounted cash flow model to take a comprehensive look at how to enhance firm value. In addition, we will focus on a myriad of estimation questions related to cash flows, discount rates and growth rates. We will end the day by looking at the terminal value in DCF valuation: how best to estimate it and common errors made in computation.

The second day’s discussion will begin with an analysis of what we call the loose ends in valuation – how to deal with cash, cross holdings and other assets, what the value of control, synergy and liquidity are and how best to deal with employee and management equity and option grants. It will also then extend into the discussion of difficult to value companies. The last part of the day will be dedicated to relative valuation. A range of multiples that are used currently in valuation, from earnings multiples (such as PE, Value/EBIT, Value/EBITDA) to sales multiples (Revenue/Sales, Price/Sales), will be discussed and compared. The relationship between multiples and discounted cash flow models will be explored, and the notion of a “comparable” firm will be examined. (What is a comparable firm? How do you adjust for differences in growth, risk and cash flow capabilities across firms, when estimating multiples?) Finally, the special difficulties associated with comparing multiples across time, and across markets, will be highlighted.

Download the brochure.

Click here to sign up.

(Click “Reserve – Invitation Only”. Use password “aswath”. Under Referral Code, enter “MOI Global”.)

Editor’s note: Alex Gilchrist is supporting the organization of this wonderful event. MOI Global has no control over the contents of the seminar, nor does MOI Global receive any compensation for recommending this event.

Leveraging Tech and Know-How — A Treatise on European Growth

October 22, 2024 in Diary, Equities, European Investing Summit

This article is authored by MOI Global instructor Roshan Padamadan, chairman at Luminance Capital, based in Singapore.

Roshan is an instructor at European Investing Summit 2024.

Many decades back, India had a moniker for its rate of growth called the Hindu rate of growth: Coined by an Indian economist, Raj Krishna, in 1978, it was meant to denote the 3-4% growth rate seen by India in the 1960s-1980s. It was not a compliment. Peers, other former colonies in Asia, were booming. E.g. Singapore moved from a port city-state with no natural resources, and a barely educated populace to a First World nation, within about 30 years. The moniker conveyed a level of fatalism and contentment, as if India chose, or was forcibly choosing a low level of growth to ensure its socialist policies were effective. India was under a heavily constrained regime where every business activity was subject to licenses and quotas, called the License Raj.

Country/Region 1960s 1970s 1980s
Hong Kong 9.0% 8.5% 7.5%
Singapore 9.5% 8.8% 7.7%
South Korea 8.6% 9.5% 9.0%
Taiwan 9.6% 10.0% 8.5%
India 3.5% 2.9% 5.6%

Source: IMF

Followers of India know that India broke out in 1991, with the dismantling of the License Raj. India joined the WTO in 1995.

Coming to the present moment, India is considered to be one of the beacons of global growth, growing when others are slowing. Perhaps it is the story of the hare and the tortoise. India has made itself a global leader in a couple of areas – software services and generic pharma products. In other areas, it wants to get better, but the result is not yet clear. India now makes 14% of Apple’s iPhones, a significant shift for a country not hitherto known for global manufacturing prowess. Can India become a major manufacturing hub? It might – especially if it imports tech and know-how in the early years.

India’s other export – Indian-origin CEOs – sadly do not count to India’s GDP. Several of the top Tech companies have Indian origin CEOs – Microsoft, Google, Adobe, IBM, etc.. Looking at the broader Fortune 500, the percentage is still significant, at ~30%.

Looking at expected growth rates for the next two decades:

Country 2024-2033 2034-2043
India 6.3% 5.5%
China 4.0% 3.5%
USA 1.4% 1.2%
EU 1.5% 1.3%
Eurozone 1.4% 1.2%

Source: IMF, World Bank

Looking at these World Bank and IMF forecasts, it appears that the Developed World is looking at a much lower rate than even half the Hindu rate of growth. What does this mean for investing? Should one only invest (only) in high growth economies?

Factors of Growth

Growth comes primarily from two factors: population growth, and growth in productivity.

India is at the top of this list of expected fertility rates for the next 2 decades. Europe is not far behind the USA.

Country 2024-2033 2034-2043
India 2.0 1.8
China 1.2 1.3
USA 1.7 1.6
EU 1.5 1.4
Eurozone 1.4 1.3

Source: UN Data

But there is one key difference: the USA has much higher net immigration rates. Most or all the Indian-origin CEOs made their mark in the USA, not in Europe.

Country/Region 2024-2034 2034-2043
India 0.8% 0.5%
China -0.2% -0.5%
USA 0.6% 0.5%
EU 0.1% 0.0%
Eurozone 0.1% 0.0%

Source: UN Data

China’s population is shrinking, the effects of the one-child policy coming home to roost. Europe has zero population growth in the decade of 2034-2044, per the UN.

On productivity: As the population becomes more efficient, GDP grows. E.g. An intern learns mail merge, and can send out an email to 50 people in five minutes, instead of 50 minutes, that’s an increase in productivity, which will flow through over time to higher revenues for his or her firm. Do this across the population, and you have GDP growth. Look at countries like Luxembourg which punch way above its weight. Denmark and Netherlands are good examples too. Ireland is skewed due to its tax haven status, and both Switzerland and Luxembourg are boosted by large wealth management practices.

Rank Country GDP per Capita (USD) Resource Rich
1 Luxembourg $131,380 No
2 Ireland $106,060 No
3 Switzerland $105,670 No
4 Norway $94,660 Yes
5 Iceland $84,590 Yes
6 Denmark $68,900 No
7 Netherlands $63,750 No
8 San Marino $59,410 No
9 Austria $59,230 No
10 Sweden $58,530 No

Source: IMF, 2024

Some analysts like to look at how productive a company is, looking for over, say, USD 200,000 per person per year as a thumb rule. I know a startup CEO who uses this metric to see if he is being efficient with his workforce. He lives in Dubai, his HQ is in California, and his main development team is in Bangalore. Where is Europe in his world view? He is looking at a pure tech company in Europe that owns patents, which he can leverage.

This is perhaps the key to Europe’s future growth: leveraging its advantages in tech and know-how. Know-how is a bit softer than pure tech –- it is the combined knowledge of a workforce, built up through experience.

Europe is rich in culture and heritage. So many of the current inventions came from the Renaissance. While it’s possible that they were invented before –- China claims to have invented/discovered almost the same things a few hundred years earlier — Europe still should get credit for (re)inventing and (re)discovering on a first-principles basis.

Region Invention Year Details
China 868 AD The earliest known printed text, the Diamond Sutra, was created using woodblock printing during the Tang Dynasty.
Europe 1450 AD Johannes Gutenberg invented the movable-type printing press, revolutionizing printing in Europe, bringing the Bible to the masses

Source: History.com

Follow the Growth

European companies can take their know-how around the world and grow – there. Follow the growth, could be a mantra for the coming years. This is possibly one of the few ways to prosper in a low-growth environment, where local EU rules rival the Indian License Raj, and total fertility rates are falling.

French entrepreneurship visas for example have circular rules – one already needs to be a long-term resident before they apply for a permission to have an entrepreneur visa. This rules out non-residents moving there to start a business. Take Ageas SA, as an example of an European company embracing global growth. It is an almost unknown Belgian insurance company, carved out from the former Fortis group. Its market cap is around EUR 8.8bn (a lucky number, by Chinese measures, where the number 8 sounds like the word for prosperity).

Ageas makes ~50% of its revenues from Asia. More than 2 decades back, it made a prescient investment in China. It has an almost 25% stake in China Taiping, China’s 5th largest insurer. This now provides about 30% of group revenues. And another 20% comes from South East Asia, in a tie up with Maybank, under the brand Etiqa. Ageas is in 14 countries, and it does not particularly care to roll out its name – it is agnostic to financial investments; or operating with a local partner’s name; or going to market with a new brand name/ JV brand (e.g. Etiqa). This is a good example of leveraging know-how, bringing product knowledge, and risk management expertise to the table.

This imported growth makes Ageas stand out, like a giant among dwarves, as low population growth and low productivity growth hamper Europe’s chances of increasing its standard of living substantially in the decades to come. Ageas pays a nice dividend (~7%+) and has enough cash flow to buy back stock at a decent clip (~1.7% of market cap)

Europe has not had a tech wonder at the level of Apple, Facebook, etc.. We need to reflect on why that is the case, because the average education level is very high. The French are known for amazing math skills, the Finns regularly top test scores, and the Germans abound in PhDs.

My observations are twofold: (1) Language barriers fragment the market, both in terms of labour markets and consumer markets. (2) The nation state is still very powerful, and nationalist sentiments prevent consolidation, and economies of scale.

Recently, while in Paris, I bought a Red Bull intended (originally) for the Swedish market. No one could figure out the flavour written on the can – skogsbärssmak – until I used Google Translate (an American invention). Even Andrea Orcel (CEO, Unicredit) may have struggled to solve that one- and he speaks 5 European languages. The distribution for Red Bull Limited Editions was inconsistent, I never knew what flavours I would get in what shop, and it was a bit of treasure hunt. Imagine the job of the Reb Bull supply chain manager – he/she has to decide how many cans to print in each language, for each flavour – English, French, German, Italian, Swedish, etc. And if they remain unsold, they have to be diverted to another country, where perhaps no one can read the labels.

UniCredit’s (from Italy) move to buy Commerzbank (in Germany) may well get shot down, as the German establishment does not want an Italian bank buy one of its own. For a non-European, it appears to be one European bank buying another. Arguably, a non-German buyer will probably result in lower job cuts, and lower overlap, than if the buyer was another German bank. A common market is a true single market only if consolidation is not blocked on national lines. With the rare exception of Airbus, we do not see many European champions, only national champions.

The Rise of Artificial Intelligence

Revolutions are great levelers. Can Europe use the AI revolution to increase productivity while enjoying a high quality of life? Software stacks can be rewritten much more easily and a lot of reinvention is going to happen. Young upstart companies can pop up anywhere. Given Europe’s high latent talent pool, perhaps a new Terravision can arise. Terravision was a young team from Berlin that came up with a product that was later contentiously replicated by Google Earth (Netflix has a show).

The revolution is that AI means that a 5-person team can probably make a product that would have required 20-200 people to make in the old paradigm. Usually software development involves many teams working together – product , software, UX/UI design, testing, etc. AI is increasingly being used in technical product design, and it can write code – that can work right from the first run.

Which software stacks would get rewritten first? Simple, niche vertical software? Or complex expensive and expansive software, with a whole new design paradigm. Or somewhere in between?

Klarna, the flexible payments company, headquartered in Stockholm, sent shivers down the software world when it announced in mid-September 2024 that it will exit the use of Salesforce (arguably the world’s most widely used CRM) and Workday, a leading limited-scope ERP system, focusing on HR and Financials.

Having been an ERP implementation specialist, I have seen how it works across many different modules, and the interconnection points are many for a highly sophisticated system such as SAP, or Oracle 11i/12, where it can integrate manufacturing, shipping, financials and HR, and so on. It took me 2-3 months of full days of training to get Oracle ERP certified.

Comparatively, the workflows of Salesforce is simple. I have used far cheaper versions than Salesforce and enjoyed high productivity. (Hat tip to Nimble CRM).

Workday primarily has a 2-module focus, Financials and Human Resources, with the latter being the traditional core base. Having worked extensively on Workday Financials, and being a classically trained ERP specialist with Oracle 11i and SAP Financials expertise, I can say that workday Financials makes the use accept several shortcomings and live with it. I am not surprised that someone is saying they are willing to reinvent it.

Now it is a different matter if Klarna will find it worthwhile to invest the time and effort to use it purely in house. But I do believe it is open season for a competitor of Salesforce or Workday to launch an attack, with a simpler stack, reinvent the software and offer a cheaper version, because it now costs way less to build new software.

Europe has a high level of technical and technological knowledge and if it is tapped well, Europe can continue to squeeze productivity gains. Don’t give up on the next tech wonder coming from Europe– just do not surprised if they launch their product in the USA, due to (relatively) simpler regulations.

For now, some of the largest market cap companies in Europe sell fashion to the Chinese – e.g. LVMH, Hermes. That’s not very sustainable over a period of the next few decades. The look-up-to-the-West is a very delicate balance and the 4000-year-old (Chinese) culture can easily turn away from the LVMH/Chanel/Dior/Hermes preference it currently shows. That fashion sense alone perhaps is not going to save Europe. That demand is fickle, especially if tensions flare up over issues such as Taiwan – e.g. the Chinese can easily boycott French product if France sides with the USA in any issue involving Taiwan, for example. Homegrown Chinese brands are growing, and it’s a matter of time before China creates its own super luxury brands. Did you know that the luxury all-inclusive vacation you spent at Club Med, you were enjoying the services of a Chinese conglomerate? I met Fosun Group in Shanghai. They have 10 listed entities within the group, and make about half their money from outside China.

China’s rise as a great power was visible at the Paris Olympics, tying the US with 40 gold medals. At the Tokyo Olympics, China was just one medal short of the US (38 vs. 39 gold). To see the ascendancy of a nation, compare this to the dominance USA had in Rio (2016) : USA 46 gold medals, vs. Great Britain 27 and China 26.

Rounding up my treatise on European growth, I believe Europe’s companies should study AI closely to see what can be done, and what could be done to them. AI is levelling the playing field and Europe’s companies need to innovate or partner up or risk falling by the wayside.

European companies should embrace growth, and go to where growth is booming- figure out ways to get exposure to India and China and others economies in Asia. Asians work much harder than Europeans – words for death from overwork exist in Japanese (karoshi), Chinese (guolaosi) and Korean (gwarosa), while such terms are not common in European languages.

If you can’t beat them, join them. This could be a good motto for Europe in the coming decades. The technological lead over the last 500 years is now narrowing. Europe is now afraid of China’s cars. They are just better value-for-money and we saw the unthinkable news that Volkswagen is considering job cuts at its home base, Wolfsburg. Perhaps one way for Europe to participate in Asian growth is to ally with it. Bring its technology to Asia – and also be willing to import it when Asian companies are at a better level. I went to test drive a BYD, and was surprised to find a café inside the car showroom. They had a full menu, and I enjoyed an excellent craft beer – after my drive.

Stellantis is the new name for the merger of the former Fiat Chrysler and the Peugeot group. This entity now owns Fiat, Jeep, Maserati, Alfa Romeo, etc.. Stellantis is making a multi-platform bet, embracing a way to make ICE, EV and hybrid cards on the same production line. Such a technology-agnostic approach may serve it well, as it simplifies all its over 20 types of cars to a 5-platform model. Apart from this, the most interesting part of Stellantis is its 20 % ownership of Leapmotor, a Chinese EV maker. And the rights to market Leapmotor outside China. The DNA to think innovatively and to enter into such a partnership is my definition for how Europe should diversify and grow. Whether the partnership succeeds or not is not the topic – I am pointing out that such cross-country partnerships may be the key, to not just survive, but prosper.

I would happily retire in Europe and enjoy the beauty and the culture. But if I seek growth, I look for ties to Asia and the U.S., and an eye on AI.

I may or may not have positions in any of the stocks mentioned, and may be recommending buy or sell actions to certain clients, where I have considered their overall risk profile. Nothing here should be considered a buy or sell recommendation. Please work with your advisor for a balanced portfolio.

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From the Archives: Michael Melby on Small- and Micro-Cap Value Investing

October 20, 2024 in Deep Value, Equities, Full Video, GARP, Idea Appraisal, Idea Generation, Interviews, Jockey Stocks, Micro Cap, North America, Portfolio Management, Small Cap, Special Situations, YouTube

We are pleased to share a timeless interview with Michael Melby of Gate City Capital Management.

The following video is sourced from the MOI Global archives.

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The Great Rotation: Rethinking US and International Equity Allocations

October 14, 2024 in Diary, Equities, European Investing Summit, Letters

This article is authored by MOI Global instructor Brian Chingono, partner and director of quantitative research at Verdad Advisers, based in New York.

Brian is an instructor at European Investing Summit 2024.

After a stellar 15-year run of robust earnings growth, US stocks have appreciated so much that they now represent 70% of developed market allocations, according to popular indices like the MSCI All Country World Index (ACWI).

As American earnings growth has outpaced international peers over the past 15 years, US stocks have returned 13.4% annualized, more than doubling the 5.9% annualized return of developed international stocks.

But with more than a quarter of total US market capitalization being attributable to just six technology stocks today, it’s worth questioning whether hyper-concentration in yesterday’s winners will be a winning strategy in the years ahead.

To start, it’s worth noting that the US stock market’s magnificent run over the past 15 years has resulted in a cyclically adjusted PE ratio (CAPE) of 36x today, a valuation level that is firmly within expensive territory by historical standards. In the figure below, we grouped historical values of the United States’ CAPE ratio into three categories with an equal number of monthly observations. Each category is highlighted as a backdrop to the time series of US market valuations since 1926.

Figure 1: United States CAPE Ratio (1926–2024)

Source: Robert Shiller’s website.

While the US market trades at an expensive valuation of 36x CAPE today, international markets are more moderately priced, with the European market trading at 21x CAPE and the Japanese market valued at 25x CAPE as of June 30, 2024. As a forward-looking measure, the CAPE ratio has a negative relationship with expected returns, as shown in the figure below, with higher CAPE valuations being associated with lower returns over the next decade.

Figure 2: Global 10-Year Returns vs CAPE Ratio (US: 1926–2024), (Int’l: 1975–2024)

Source: Robert Shiller’s website and Ken French’s website. The regression function applies to the US market.

In addition to lowering expected returns, the expensive valuations in the US may also increase idiosyncratic risk in a portfolio through hyper-concentration in the biggest winners of the past decade. Consider a seemingly diversified index like the ACWI benchmark, which contains more than 2,750 large- and mid-cap stocks from around the world. This global index mechanically allocates two-thirds of capital to the United States, and within its developed market allocation, the United States has a weighting of almost 70%.

Figure 3: MSCI ACWI Allocations (June 30, 2024)

Source: MSCI.

To understand why a 70% US allocation may not be the optimal choice for a typical investor in developed markets, it’s important to trace how the ACWI Index arrived at this allocation in the first place. At a fundamental level, equity ownership entitles investors to a portion of companies’ future net income. If we start at this elementary level and sort all developed-market stocks by the net income they generated over the past 12 months, we find that 55% of net income was generated by US firms and 45% was generated by firms in developed international markets. So if an investor were to allocate capital according to where income is being generated today, they would have 55% of their developed equity capital in the US and 45% allocated to international markets.

But financial markets are forward looking. So, in addition to considering trailing earnings, market participants also account for growth expectations when setting prices. Because growth expectations are higher in the US relative to international regions, aggregate market capitalization is significantly larger in the United States. Therefore, based on relative growth expectations, the US allocation within a developed market portfolio increases by 10 percentage points to 65% when companies are sorted by market capitalization.

An implicit assumption behind this market-weighted approach is that analysts are accurate in forecasting earnings growth. But empirical evidence suggests that, on average, analyst forecasts are no better than nominal GDP estimates when forecasting earnings growth over long-term horizons.

Figure 4: Developed Market Allocations by Weighting Methodology (July 2024)

Source: S&P Capital IQ.

Beyond the doubtful accuracy of long-term growth forecasts, commercial indices further orient investors toward questionable allocations by focusing on float-adjusted market capitalization. This means more weight is given to stocks that have a higher proportion of shares available to trade freely on the stock exchange, as opposed to the strategic ownership stakes held by founders and other company insiders. The reason commercial indices prioritize free float is because they are designed for deploying capital at massive scale, especially for the likes of Vanguard and BlackRock. And it also happens to be the case that US firms tend to have a higher proportion of free float relative to their international peers in Europe and Japan. Therefore, the free-float adjustment further exacerbates the bias toward high-expectation US stocks, raising the US allocation by 5 percentage points to a 70% weight when developed market stocks are sorted by float-adjusted market cap.

Fortunately, there are other benchmarks available to investors who are skeptical of lofty growth expectations and aren’t massive enough to be comparable to State Street. For example, investors could start by setting their regional weights according to net income generation (i.e., 55% weight in the US and 45% in developed international markets). Notably, this starting point offers more balanced allocations while still acknowledging the principal role of the United States as an economic engine.

By setting regional weights according to net income, rather than float-adjusted market cap, investors would also benefit from capturing more attractive valuations in international regions. As shown in the chart below, international markets trade at a substantial discount to the US, across multiple measures of value. And within the cheapest segment of each market, valuations are especially attractive internationally, with P/E ratios averaging around 10–13x and Price/Book ratios averaging around 1.1–1.4x across all levels of capitalization.

Figure 5: Global Valuations (July 2024)

Source: S&P Capital IQ.

We believe more balanced allocations across regions would enable investors to increase expected returns within their equity portfolios. Based on current levels of the CAPE ratio, the Nobel laureate economist Robert Shiller estimates that nominal expected returns over the next decade are around 5.2% in the US market, compared to 6.7% in the European market and 6.8% in the Japanese market.

While the US market has dominated over the past decade, an encore may not necessarily follow over the next decade. Growth narratives that previously seemed inevitable can quickly change when faced with reality. For example, consider how the “magnificent seven” has recently shrunk to the “magnificent six,” with Tesla down 14% year-to-date as expectations for electric vehicle growth have moderated. Only 12 months ago, auto industry forecasts by S&P Global were projecting 38% annual growth in EV production in 2024. But in July of 2024, that same forecast was slashed by more than half to 14% growth. Perhaps more concerning for those who bet on EV growth, there are indications that hybrids may play a larger role in the energy transition than previously anticipated, with many car manufacturers announcing new hybrid models and some moving toward flexible architectures that would continue their production of internal combustion vehicles indefinitely, alongside hybrids and EVs. Cars that are at least partially powered by fossil fuels may not become obsolete at all.

If this downward revision in growth expectations could occur among EVs, which are subsidized (and in some cases mandated), we believe a similar reality check could occur with current expectations for artificial intelligence. Relative to the US, international markets are less exposed to the AI expectation frenzy. So when considering a benchmark for their global developed equity portfolio, investors may be well served by balanced allocations that are based on net income generation, with around 55% weight in the US and 45% internationally.

Disclaimers: This does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. This information generated by the charts, tables, and graphs presented herein is for general informational and general comparative purposes only. This document may contain forward-looking statements that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and investors may not put undue reliance on any of these statements. References to indices or benchmarks herein are for informational and general comparative purposes only. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. The information in this presentation is not intended to provide, and should not be relied upon for, accounting, legal, or tax advice or investment recommendations. Each recipient should consult its own tax, legal, accounting, financial, or other advisors about the issues discussed herein.

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The Market for Obesity Drugs, and Some Thoughts on Wegovy

October 14, 2024 in Diary, Equities, European Investing Summit, Letters

This article is authored by MOI Global instructor Stuart Mitchell, investment manager at S. W. Mitchell Capital, based in London.

Stuart is an instructor at European Investing Summit 2024.

Over the last ten years markets have been characterised by unusually low interest rates and all sorts of resulting distortions in capital markets. In the equity world, the dash to speculative technology and growth-at-any-price has led to an extraordinary boom and bust of fund managers like Cathie Wood and Baillie Gifford.

The Scottish Mortgage Trust share price

Source: Refinitiv

But even now, seventeen months into a tightening cycle, investors continue to be lured into new bubbles dreaming that they have found another Nvidia.

One such bubble may well be Novo Nordisk. The share price has risen by almost three times over the past two years driven by expectations for their anti-obesity drug Wegovy.

Novo Nordisk share price

Source: Refinitiv

So what is Wegovy? Wegovy is the weight loss brand name for Semaglutide that was originally developed by Novo to treat type 2 diabetes in 2012.

Wegovy is a glucogen-like peptide-1 receptor agonist (GLP-1) that mimics the incretin glucagen-like peptide-1 to increase the production of insulin and lower blood sugar levels. The effect is to lower appetite and slow down the process of digestion in the stomach. The STEP1 trial published in 2022, ‘revealed an average 14.9% reduction in bodyweight from baseline during 68 weeks of treatment with semaglutide 2.4 mg plus a lifestyle intervention, compared with just a 2.4% reduction in the placebo plus lifestyle intervention group.’

With so many obese people in the world the opportunity for the drug appears to be very significant.

Source: Handelsbanken

The consensus for analysts is that GLP-1 sales will reach $100 billion by 2031 and that Novo will command a 45% market share.

But is this realistic? We are sceptical for a number of reasons.

Let’s us just try to use our common sense for a moment…

1/ Are we really going to prescribe $100 billion of drugs for conditions that can be largely remedied by eating less and doing more exercise.

2/ And is it likely that the GLP-1 market is going to be two-thirds the size of the $164 billion cancer industry. A disease that kills and can’t be cured by eating less and exercising more…

3/ Looking at it another way, the world’s largest selling drug in 2022 was HUMIRA with $21.6 billion sales. HUMIRA is a monoclonal antibody used to treat all sorts of miserable conditions such as rheumatoid arthritis, ankylosing spondylitis and Crohn’s disease. Can it really be correct that Novo’s GLP-1 sales will be almost twice large.

4/ Many say that it will reduce the incidence of heart disease and lead to significant cuts in heart related healthcare spending. The problem, however, is that once you stop taking Wegovy you rapidly put the weight back on. At $1,350 per month (US list price) are you really going to take Wegovy for life and suffer all the side-effects (more anon…). And at best maybe you delay by a few years the incidence of heart disease. But that cohort may well become susceptible to the more-expensive-to-treat cancer as they live longer?

But the enthusiasts among you will say that I am just a fat-denier?

Well let’s go into the detail…

5/ And this is important. Novo Nordisk say that patients are most likely to take the drug for four years. Independent research suggests something very different. A recently published Obesity Society study into ‘Early-and later-stage persistence with antiobesity medications’ link found that only 19% of patients remained on treatment after one year. Wegovy had the highest one-year persistence but still only 40% remained on the treatment after one year. Novo has said that they will present stay time data for Wegovy sometime in 2024…

6/ As we mentioned, most analysts expect Novo to have a 45% market share of the GLP-1 market (67% of expected 2028 Novo sales). But at the last count, there are currently 74 drugs in development…So many that Johnson and Johnson’s CEO, Joaquin Duato, said that ‘it’s too crowded for us’.

7/ But even if the market was to remain dominated by Novo and Lily, the Lily molecule seems to be more effective. A recent study into the ‘Comparative Effectiveness of Semaglutide and Tirzepatide for Weight Loss in Adults with Overweight and Obesity in the US’ link showed that the Lily drug was ‘significantly more likely to achieve 5%, 10% and 15% weight loss and experience larger reductions in weight at 3, 6, and 12 months’.

Source: Handelsbanken

8/ An this is where it gets interesting. Did you know that 75% of all anti-obesity drug users are women? So we may well be looking at a market that is somewhat smaller than thought. Have a look at the BBC documentary The Skinny Jab Uncovered link. You may be surprised to learn that Semaglutide is freely available at knock-down prices in beauty salons across the country. There are even Tiktokers who sell it?! Have a look at the Forbes article link.

9/ So that leads us to the question of pricing. Budget Semaglutide seems to be freely available at an 80% or so discount to prescribed Wegovy. This must somehow undermine the price of the drug? In addition, The Inflation Reduction Act gives the power to the US government to negotiate prices for the largest Medicare drugs from 2026. But before then a ‘maximum fair price’ will be set for Wegovy in February 2024 which some analysts believe could lead to a greater than 25% price reduction.

10/ And we haven’t got to the side-effects yet. Wegovy and other GLP-1’s are linked to nausea, vomiting and diarrhoea.

Source: Handelsbanken

There may also be a risk of thyroid cancer and suicidal thoughts. The FDA has received 265 reports of suicidal behaviour from patients taking GLP-1’s since 2010.

Source: Handelsbanken

11/ So how big will the GLP-1 drug market really be? The modelling is fiendishly complex but for all the reasons that we discussed the market is likely to be a lot smaller than consensus forecasts of $100 billion sales. A leading in life science consulting IQVIA, estimated that the market could be worth anything between $17 billion and $100 billion.

Source: Handelsbanken

Let’s say that stay rates are a year (not four), that Novo end up with say a 10% market share, that the cohort is predominantly female and that pricing is lower than expected…Then hey-presto Semaglutide could end up as $5-10 billion blockbuster. Still a big drug but not the $47 billion mega-drug that many expect.

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Disclaimers: This does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. This information generated by the charts, tables, and graphs presented herein is for general informational and general comparative purposes only. This document may contain forward-looking statements that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and investors may not put undue reliance on any of these statements. References to indices or benchmarks herein are for informational and general comparative purposes only. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. The information in this presentation is not intended to provide, and should not be relied upon for, accounting, legal, or tax advice or investment recommendations. Each recipient should consult its own tax, legal, accounting, financial, or other advisors about the issues discussed herein.

The Challenge of Choosing a Company for a Multi-Decade Investment

October 4, 2024 in Diary, Equities, European Investing Summit, Letters

This article is authored by MOI Global instructor Ole Soeberg, founder of Nordic Investment Partners, based in Copenhagen.

Ole is an instructor at European Investing Summit 2024.

Looking at companies that have been winners over the past 10, 20 or 80 years it’s easy to see what have driven their performance. Identifying outperforming businesses for coming generations is much more difficult than finding potential winners for the next 5 to 10 years.

Long-term investing is very challenging

In early September 2024, I was reading a September 1944 issue of the New York Times. In the Business section, I came across a news brief about PepsiCola Company announcing a 2-for-1 stock split. After the split, PepsiCola would have 7.5 million shares outstanding. On that September day in 1944, PepsiCola had a market cap of $112 million. Fast forward 80 years to 2024, and Pepsi has a market cap of $233 billion and 1.35 billion shares outstanding. The annualized CAGR, excluding dividends, has been 10% since 1944. In hindsight, it’s easy to see that PepsiCola was a good investment.

However, the 1944 NYSE list was full of companies that no longer exist or have merged into other companies listed today. So, how do you find a company that will not only be around 80 years from now but also grow in value by 10% or more per year?

Which company would you invest in today and keep for generations?

Which company would you buy shares in today (2024) to hold and pass on to future generations, who would then reap the financial benefits of your foresight 80 years from now?

It’s really hard to predict which businesses will thrive over such a long-time span, as the average company tends to last only a few decades. In my valuation work, I only project 20 years forward and do not use terminal value after 20 years, as I believe corporate destiny (long-tailed terminal value periods) is arbitrary.

You can approach this by being rational and focusing on core essentials like housing, food, and other necessities, as they will continue to be in demand 80 years from now. A good housing location in a politically stable country will likely remain in high demand, but will it achieve a 10% CAGR like Pepsi?

Most investors have a horizon of just a few years and monitor fundamental performance and valuation along the way. Holding on for 80 years is outside the comfort and competence zone for most.

Current use of earth resources is not sustainable

A future oriented energy company could be worth holding for 80 years. I believe humans usage of planet Earth need to become more aligned to the sustainable use of our planet. And burning 300-400 million years old plants and biomass that have been in the ground under pressure and heat to become oil & gas in the current period is not a solid road into the next centuries.

Hence, we need to change our energy sourcing from fossil fuels to new sources. Solar, wind, hydro and nuclear all serves that path well and my pitch for MOI Global 2024 is Vestas, the global leader in wind turbines.

Energy sourcing is someday likely to come from fusion – same process as the Sun – and subsequently make current renewable energy sources obsolete. It is however still many years out, so for the next 10-20 years current renewable energy sources should be good.

Back to the mindset of most investors and the 80-year challenge. I would not bet Vestas Wind Systems is around a few years after fusion power or some other more potent power source becomes a reality.

Vestas: Self-help margin recovery story with a tailwind

Vestas is the idea I will present at European Investing Summit 2014, hosted by MOI Global.

Vestas is the world leader in wind power turbines and focused on Europe and North American markets. Due to an order book that did not appropriately incorporate higher costs for steel, transports etc, Vestas profitability plummeted as they had to shoulder the cost increases. All new contracts/order are made with better profitability and hence Vestas earnings are very likely to increase significantly in the coming years.

Vestas can probably work fine for the next 10-20 years as power from low carbon sources replace traditional fossil fuels, but its not a 80 year investment pitch.

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Ted Seides Shares Insights from His Book, Private Equity Deals

October 2, 2024 in Audio, Full Video, Interviews, Podcast, Private Equity, Transcripts

We had the pleasure of speaking with Ted Seides, author of Private Equity Deals: Case Studies of Dealmaking from Capital Allocators.

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About the book:

Over the past 20 years, the private equity industry went from a cottage industry to a powerful juggernaut that touches every corner of the global economy. Totalling $5 trillion of investments, private equity constitutes an important investment allocation for public and corporate pension funds, university endowments, non-profit foundations, hospitals, insurance companies, families, and sovereign wealth funds worldwide. There’s no more important sector of institutional portfolios or the global economy to understand than private equity. Private equity owned businesses are everywhere around us and touch every aspect of our daily lives. In Private Equity Deals, Ted Seides gives you an insight to the conversations that typically happen behind the closed doors of institutional investors and private equity managers. Through a series of case studies across different types of private equity transactions, Private Equity Deals shares the dynamics of deal making, companies, and ownership that make private equity a force in the world.

About the author:

Ted Seides, CFA is the founder of Capital Allocators, an ecosystem that includes podcasts, gatherings, and advisory. Ted launched the Capital Allocators podcast in 2017. The show reached 20MM downloads as of August 2024 and has been recognized as the top institutional investing podcast. Alongside the podcast, Ted created Capital Allocators Summits with friend and industry veteran Rahul Moodgal to bring together industry leaders to connect and learn. He developed Capital Allocators University to teach senior professionals non-investment disciplines that are essential to investment success. He also advises managers on business strategy and allocators on investment strategy. In March 2021, Ted published his second book, Capital Allocators: How the world’s elite money managers lead and invest that distills key lessons from the first 150 episodes of the podcast. In October 2022, he was honored as Citizen of the Year at With Intelligence’s inaugural Allocator Prizes.

From 2002 to 2015, Ted was co-founder of Protégé Partners LLC and served as President and Co-Chief Investment Officer. Protégé was a leading multibillion-dollar alternative investment firm that invested in and seeded small hedge funds. In 2010, Larry Kochard and Cathleen Rittereiser profiled Ted in the book Top Hedge Fund Investors. In 2016, Ted authored his first book, So You Want to Start a Hedge Fund: Lessons for Managers and Allocators, to share lessons from his experience. Ted began his career from 1992-1997 under the tutelage of David Swensen at the Yale University Investments Office. During his five years at Yale, Ted focused on external public equity managers and internal fixed income portfolio management. Following business school, he spent two years investing directly in public and private equity at three of Yale’s managers, Brahman Capital, Stonebridge Partners, and J.H. Whitney & Company. With aspirations to demonstrate the benefits of hedge funds on institutional portfolios to a broad audience, Ted made a non-profitable wager with Warren Buffett that pitted the 10-year performance of the S&P 500 against a selection of five hedge fund of funds from 2008-2017. Ted writes a blog called What Ted’s Thinking and previously wrote columns for Institutional Investor, CFA Institute’s Enterprising Investor, the late Peter L. Bernstein’s Economics and Portfolio Strategy. He is a member of the Advisory Council for the Alliance for Decision Education and a participant in the Hero’s Journey Foundation. Ted previously served as Trustee and member of the investment committee at the Wenner-Gren Foundation, Trustee and head of the Programming Committee for the Greenwich Roundtable, and an Advisory Board member of Citizen Schools-New York.

Ted graduated Cum Laude from Yale University and received an MBA from Harvard Business School.

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Capital Allocation Lessons from Business Leader Henry Singleton

September 25, 2024 in Audio, Case Studies, Equities, Featured, Jockey Stocks, John's Blog, North America, The Manual of Ideas, Transcripts, YouTube

Several years ago, in a special audio program, John Mihaljevic reviewed the life and times of Henry Singleton, founder of Teledyne. Singleton is highly regarded for his long term-oriented, independent-minded approach to shareholder value creation.

printable transcript download audio listen as podcast

We are pleased to share the following transcript with you. The transcript has been edited for space and clarity. The narrative relies on George Roberts’ Distant Force and other sources. Quotation marks are used to denote direct quotations from third-party sources, though in some instances quotations may not be marked but should be apparent from the overall context.

Henry Singleton was one of the most brilliant engineers and businessmen of the twentieth century. We will look at a book on Mr. Singleton entitled Distant Force, authored by George Roberts, a long-time business associate and president of Teledyne Corp, which Singleton founded.

First, we’re going to survey a few articles on Henry Singleton and give you an overview of his life before going through some of the most interesting passages of the biography by George Roberts. In a New York Times obituary in 1999, the year of Mr. Singleton’s death, Leon Cooperman of Omega Advisors is quoted as saying that Singleton understood how to move between real assets and financial assets in a way you don’t see today. “He was the most brilliant industrialist that I’ve ever met and I’ve met many,” said Mr. Cooperman.

Singleton was said to have an ability to recite lengthy passages from Shakespeare and other poets, and he liked to play chess without looking at the board, keeping the positions of the pieces in his head.

Quoting Arthur Rock, a venture capitalist who provided the initial financing for Teledyne and served on its board for 33 years, Singleton didn’t care what other people thought. His style was to stay in his office and to think things up, and to get other people to carry them out.

Singleton was not only a businessman but also a scientist. He invented a method for degaussing submarines, which allowed American submarines to go by German submarines without being detected. He has many patents to his name and was respected in scientific circles.

Here’s a comment by Bill Nygren, fund manager of the Oakmark Fund. In a 2002 letter to investors Nygren says that in 1960, “Henry Singleton founded Teledyne, a company that grew rapidly for a decade via a combination of internal growth and acquisitions. When the opportunities for value added acquisitions disappeared, Singleton switched gears. From 1970 to 1984 he used his cash to repurchase 82% of Teledyne’s grossly undervalued common shares. As a result, the stock price increased from $2 to $250.” Singleton, says Nygren, was a pioneer of maximizing shareholder value by shrinking the business. Quite an interesting concept.

A key to Singleton’s success in creating shareholder value was his ability to reduce the share count and not worry as much about growing the size of Teledyne as about growing value on a per-share basis. In The Money Masters, John Train quotes Buffett as saying that, “the failure of business schools to study men like Singleton is a crime. Instead, business schools hold up as models executives cut from a McKinsey & Co. cookie cutter.”

Buffett wrote in a letter to shareholders in 1980, “if a fine business is selling in the marketplace for far less than its intrinsic value, what more profitable utilization of capital can there be than significant enlargement of the interest of all owners at that bargain price.” Berkshire had not pursued that avenue until fairly recently because Buffett felt most of the time that he could deploy capital in other businesses. Buffett has taken the view that Berkshire shareholders should be holders for the long term, and that he’d prefer not to enrich one group of shareholders, presumably the ones staying with the company, at the expense of another group, presumably those who would be selling at a low price if Berkshire bought back shares.

John Train also quotes Buffett as saying that Henry Singleton has the best operating and capital deployment record in American business. That’s quite a statement.

Many stories were not complimentary of Singleton. A story in Businessweek in 1982 blasted him for buybacks. That story, having been written just before the great bull market, could not have come at a worse time for Businessweek because the buybacks Singleton executed proved to be extremely prescient.

One of the things Singleton believed was engaging an uncertain world with a flexible mind. Singleton is quoted as saying, “I know a lot of people have very strong and definite plans they’ve worked out on all kinds of things, but we’re subject to a tremendous number of outside influences and the vast majority of them cannot be predicted, so my idea is to stay flexible. My only plan is to keep coming to work every day.”

This improvisational grand design Businessweek magazine saw as the milking of tried and true operating businesses and the diverting of funds to allow the Chairman to “play the stock market.” Obviously, this criticism is not warranted but it’s something pointed out in an article in the New York Observer in 2003. That article also goes on to say that Singleton’s reserve was icy. His disdain for the press was complete and thoroughgoing. The Businessweek article just rolled off his back. It puzzled him that his friend Leon Cooperman would bother to draft a nine-page rebuttal, complete with statistical exhibits. Why go through the trouble, Singleton might have said.

Another point that the Businessweek article failed to raise was under what circumstances the buybacks Teledyne was making occurred. There’s a stark contrast between companies doping repurchases when their executives are selling stock and companies repurchasing stock simply for the benefit of continuing shareholders.

Singleton never sold a single share of Teledyne, so the share repurchases made his percentage stake in the company grow over time. This contrasts with many companies that have come to be large repurchasers of stock in recent years, often at prices above intrinsic value.

An infamous example is Countrywide Financial, which spent nearly $2 billion on stock buybacks over two years. Subsequently, its stock lost more than 75% of its value. While the buybacks were occurring, Countrywide CEO Angelo Mozilo was selling shares. That would have been antithetical to a Henry Singleton.

Let’s look at an article on Singleton published in Forbes Magazine in 1979. The article describes him as the aloof son of a well-to-do Texas ranger. This is noteworthy in two respects – for the size and quality of the company he built from scratch, and for his almost arrogant scorn for conventional business practices. The article goes on to say that what distinguishes Teledyne beyond its position on various lists is that during a period when inflation eroded corporate profit margins, a period when corporations sold more and enjoyed less, Teledyne’s profitability was growing, not shrinking. The article was written after a period of rampant inflation in the U.S.

Singleton had spent three years at Annapolis, then switched to the Massachusetts Institute of Technology, where he earned his Bachelor’s, Master’s, and Doctorate of Science in electrical engineering. This reminds me a bit of John Malone of Liberty who went to Yale, a liberal arts school, and yet Malone studied science there and has gone on to greatness in business.

Singleton was educated as a scientist, not a businessman. He did not leap into entrepreneurship but trained for it over decades at the best schools of practical management in the U.S., first as a scientist at General Electric, then as a management man at Hughes Aircraft. Then in the early days at Litton Industries when founder Tex Thornton and Roy Ash were building one of the first truly “hot” companies of the post-World War II era. Not until 1960, when he was 43, did Singleton found Teledyne.

Several sources observe that Singleton was supremely indifferent to criticism. In the early 1970s, when investors and brokers alike lost their original enthusiasm and deserted the shares, Singleton had Teledyne buy up its own stock. As each tender offer was oversubscribed by investors of little faith, Singleton took every share.

When Wall Street, indeed even his own Directors, urged him to ease up, he kept right on buying. Between October 1972 and February 1976, he reduced Teledyne’s share count by 64%, from 32 million shares to 11.4 million.

The Forbes article has a remarkable statement by Singleton: “I don’t believe all this nonsense about market timing. Just buy very good value, and when the market is ready, that value will be recognized.” This is an interesting statement by Singleton on market timing because one can obviously look at his repurchases of stock at low prices and issuance of stock when it was highly-priced to make acquisitions as nothing other than market timing.

Singleton did not view it that way. He never operated with a compass that said, how can we time the stock price? Is the stock going to go up or down? He operated with a mindset that, if we’re buying the stock when it’s undervalued, it’ll go up at some point. And if we are making acquisitions using currency that may be overvalued because Wall Street is too optimistic, we might be getting a good deal. Sometimes when investors are able to acquire assets at below their intrinsic worth, in hindsight it will look like good market timing when in fact no market timing was attempted.

Let’s quote more from the Forbes article in 1979: Most impressive is that Teledyne’s capital shrinkage was not achieved at the expense of growth or by partially liquidating the company. All during these years, Teledyne kept growing where in its early years it had grown through acquisitions, 145 in all. In its capitalization-shrinking days, Teledyne grew from within and steadily.

In 1970, when acquisitions had ceased, revenues were $1.2 billion. In 1974, $1.7 billion. In 1976, $1.9 billion, and so on. In 1979, Teledyne was on track to generate $2.6 billion. Yet in the years sales more than doubled from $1.2 billion, Teledyne made only one minor acquisition and did not get deeply into debt.

In the early stages of his stock-buying program, Singleton did have Teledyne borrow rather heavily, but he paid down the debt out of cash flow. When investors, disillusioned with growth, became dividend-conscious, Teledyne refused to pay a dividend. “The second highest-priced stock on the Board after Superior Oil, Teledyne’s cash yield is zero,” according to the Forbes article. In the late 1970s, large companies were expected to pay a nice dividend. Equities, to some extent, were valued on yield. Perhaps one of the reasons Teledyne’s stock price may have swung so wildly is there was no dividend, and the shares didn’t have something tangible (a dividend yield) that would help investors peg the price of the stock. This turned out to be of great advantage to Teledyne’s long-term shareholders because it allowed Singleton to buy the shares when they got too cheap and to issue stock when it got ahead of itself.

Let’s put Singleton in perspective. During the time he all but ignored Wall Street, many of America’s top executives were trimming their sails to Wall Street’s changing winds. The Forbes article cites a few interesting examples: In 1974, Textron Chairman William Miller wanted to go after troubled Lockheed. His shareholders would have been delighted with this, but analysts questioned the proposed action and Miller backed away. Textron would have had an opportunity to get a big chunk of Lockheed stock at $3 per share. Only five years later, it was selling at $21 per share. By giving in to Wall Street analyst demands, Textron was worse off.

Another example is American Express attempting a tender offer for McGraw-Hill. It would have been a good deal, but AmEx Chairman James Robinson III ultimately backed off because of resistance on the Street.

In 1968, Xerox, which traded at a P/E of 53x, was about to merge with CIT Financial, a major company trading at a much lower multiple. This would have been an accretive deal for Xerox. They could have done it in stock. But investment analysts questioned the deal: why dilute a high-tech stock with a grubby money-lending business? Ultimately, Xerox Chairman Peter McColough retreated and instead blew $920 million for Scientific Data Systems, a fledgling computer company. Instead of making a great deal, Xerox ended up making a bad deal.

According to Forbes, “it would be hard to picture Henry Singleton trying an unfriendly takeover, but it would be harder to picture him backing away as American Express did once he had made an offer. It would be inconceivable for him to back away from the Lockheed deal or the CIT deal just because the brokerage fraternity disapproved. He kept buying up his own stock with both hands when the Street called him crazy.” The article continues, “we have not even mentioned what Teledyne makes or sells. That’s because what Teledyne makes or sells is less important than the style of the man who runs it. The fact is that Singleton unashamedly runs a conglomerate. What are the products and services upon which Singleton has put his stamp? Offshore drilling units, auto parts, specialty metals, machine tools, electronic components, engines, high-fidelity speakers, unmanned aircraft, and Waterpik home appliances.”

Evident to me is that for Singleton it all did come down to financial return. That’s what a lot of CEOs forget these days. They think their company is in a particular business and it’s destined to be in that business forever. Whatever free cash flow the business throws off is mindlessly reinvested in that business, when the purpose of a company is to maximize value for shareholders. A company does not have an obligation to stay in a business that’s failing, or whose margins are shrinking, or whose returns on capital are insufficient to justify continued reinvestment. Unfortunately, a lot of CEOs forget that.

The Forbes article goes on to mention Singleton’s partner George Roberts: “Singleton works closely with his president George Roberts who has his Doctorate from Carnegie Mellon in Metallurgy. Roberts is the Chief Operating Officer, and an extremely effective one. This is not the kind of conglomerate where headquarters staff only loosely supervises a number of good-sized semi-independent operations. Taking a leaf from Harold Geneen’s book, Teledyne has super-tight financial controls. Taking a leaf from 3M’s corporate books, it breaks up a huge business into a cornucopia of small profit centers, 129 in Teledyne’s case. So far in 1979,” writes Forbes, “all 129 of those are profitable.”

George Roberts, Singleton’s partner, goes on to say, “Forget products. Here’s the key: We create an attitude toward having high margins. In our system, a company can grow rapidly and its manager can be rewarded richly for that growth if he has high margins. If he has low margins, it’s hard to get capital from Henry and me. Our people look and understand, having high margins gets to be the thing to do. No one likes to have trouble getting new money.” It is interesting that Roberts focuses on margins and not return on capital. Obviously, the two are highly correlated, but it’s an interesting distinction that, for Roberts anyway, margins were the thing that made a business “good”.

Roberts also says, “The only way you can make money in some businesses is by not entering them.” That’s another statement CEOs should heed. The airline industry comes to mind. Buffett observed some years ago that the airline industry since inception had a cumulative loss. According to him, it would have been better for society if the airline industry had never come into being. [Ed. note: Perhaps ironically, perhaps reflecting the flexibility and growth of Buffett’s mind, Berkshire subsequently invested in airlines.]

The takeaway for individual companies is that sometimes the best thing to do is nothing — to preserve capital for when it can be deployed in a rewarding way.

Forbes also states that Singleton has an intellectual and old-fashioned respect for cash instead of bookkeeping profits. You can’t pay bills with bookkeeping profits. Fairholme fund manager Bruce Berkowitz comes to mind in this context because he has said repeatedly that cash is the only thing you can spend, and that’s why Berkowitz focuses on the free cash flow of his investee companies. [Ed. note: Berkowitz did invest in and hold onto shares of Sears Holdings even as Sears was bleeding cash.]

Let’s look at value creation from a string of acquisitions, how value was created when Singleton used stock to buy companies. Subsequent to that, when his own stock became cheap after the conglomerate crash of 1969, Singleton went in and bought enough of it to shrink the capitalization back to where it was when Teledyne had been a much smaller company. It was as though he had been able to renegotiate his earlier acquisitions at a fraction of the original prices.

If one can use stock as currency at inflated prices to acquire businesses that are fairly priced or even underpriced, and then one’s own shares decline, as they inevitably do simply due to market volatility, companies could actually “renegotiate” their earlier acquisition purchase prices by buying back their own stock, thereby eliminating the shares issued in previous deals.

Singleton was thrust into the role of “portfolio manager” at Teledyne by accident. It might never have happened, Singleton told Forbes, if Teledyne’s Argonaut Insurance subsidiary had not gone into trouble writing medical malpractice insurance in 1974. Singleton said, “The idea of indexing isn’t something I believe in or would follow.” He said this with scorn — quite amazing, considering that this statement was made in the 1970s, way before indexing had reached the extent to which it is used today.

Here’s how Singleton chose stocks for the portfolios of Teledyne’s insurance subsidiaries: He decided to buy companies he felt were well-run and undervalued. His biggest move was to put $130+ million, or 25% of the equity portfolio, into Litton, a company he had known for a long time. Said Singleton, “It’s good to buy a large company with fine businesses when the price is beaten down over worries about one problem. Litton’s problem was not a general one but an isolated problem, as ours was with Argonaut Insurance. To me, it was hard to believe the heads of a $3 or $4 billion business would not be able to handle one business problem.”

This is quite an interesting statement about investing and security selection. Buffett has talked about this as well when discussing his purchase of American Express back in the days of the Salad Oil scandal, when a single issue unrelated to AmEx’s business franchise, had depressed the stock so much that Buffett saw it as a phenomenal opportunity to acquire a quality business that was being rocked by one issue that ultimately would not impair the value of the entire franchise. As investors, we all may want to look for opportunities to pick up good businesses when there’s an issue that scares the market at large.

Singleton also bought many insurance company stocks for the portfolio, insurance being a business Singleton knew well. He also bought blocks of oil stocks and had good gains in those. Teledyne companies did geological exploration and made drilling rigs. Singleton was choosing a field he understood well in which to make investments in public securities.

Here’s Singleton’s reasoning on the subject of tenders: “In this climate where tender offers mean overpaying, I prefer to buy pieces of other companies, or our own stock, or expand from within. The price for buying an entire company is too much. Tendering at the premiums required today would hurt, not help, our return on equity, so we won’t do it.” Singleton also said, “Why pay ten times earnings in a tender for a company when I can buy pieces of companies for six times earnings and my own stock for five times earnings?” This again goes to his view on allocating capital to where that capital can go into the most undervalued assets. He was not an empire builder. He was interested in value creation on a per-share basis.

Singleton says he wouldn’t sell any of his blocks to would-be acquisitors. This is regarding some of the large positions in marketable securities that Teledyne held such as Litton. There was a lot of speculation at the time that Singleton was acquiring large blocks to either then make a bid for companies himself or obviously that he might sell out at a premium to would-be raiders.

Singleton, however, remained a friendly acquirer and ultimately that was to his benefit. That’s another parallel to Warren Buffett who also has gone to painstaking lengths to make sure that companies know he’s a friendly investor rather than a potential threat.

Here’s more on dividends that Teledyne didn’t pay. Forbes in 1979 says, “a few years ago when Teledyne’s stock was selling around ten, one of Singleton’s closest associates begged him to pay at least a token dividend. Singleton refused. He still refuses.

To begin with, he asks, what would the stockholder do with the money? Spend it? Teledyne is not an income stock. Reinvest it? Since Teledyne earns 33% on equity, he argues he can reinvest it better for them than they could for themselves. Besides the profits have already been taxed, paid out as dividends they get taxed the second time. Why subject the stockholder’s money to double taxation?”

What is Henry Singleton’s own sense of economic reality? “At a time when many top businessmen are gloomy about the future of the country, this is Forbes speaking in 1979, Singleton has this to say – I’m convinced the coming recession will not be too deep or long and we’ll have a good recovery following it.

It is so fashionable to complain about the restrictive regulatory environment in Washington that makes people forget how very much worse things could be. Long run, I’m happy about the prospects for America, for business and for Teledyne.” While this was a statement Singleton made in 1979, it’s something that could be echoed today in 2009 and it’s essentially what Warren Buffett has been saying ever since late 2008 when investors got concerned about the outlook. Some thought the world was coming to an end and yet as Singleton pointed out thirty years ago, that same sentiment would have been absolutely the wrong sentiment. And so this is another mark of great investors is that they have an ability to look beyond the now, and imagine what could be, and what will be in the future. And so when the broader market becomes too optimistic, those investors become cautious. And when the market becomes fearful, those investors become more optimistic because they see great values that they can acquire and ride for the long term.

Here’s another quote by Singleton, “I do not define my job in any rigid terms but in terms of having the freedom to do what seems to me to be the best in the best interest of the company at any time.”

This is obviously a very broad statement. And coming from managers without a track record of creating shareholder value, this statement could be frowned upon. But having a Henry Singleton say this is quite interesting because here’s a guy who created value because he was flexible and did not paint himself into a box, or an industry, or accede to the demands of investment analysts.

Let’s turn to the biography by George Roberts entitled Distance Force, by the way, a book that I would highly recommend. It’s available on Amazon.com as well as by the author himself if you do a Google search for George Roberts’ Distant Force.

Roberts actually has some data here on what Singleton really accomplished at Teledyne. An investor who put money into Teledyne’s stock in 1966 achieved an annual return of 18% over 25 years or a 53x return on invested capital versus 7x for the S&P 500, and 9x for General Electric. I believe this is from 1966 to 1993.

Roberts also states in the book, and were going to quote quite a few passages now, “that Singleton believed and often said that the key to his success was people – talented people who were creative, good managers and doers. From the start, he surrounded himself with that kind of person. Henry searched for talented people, went down even to the individual managers of his smallest companies.”

Today, stressing the importance of people is something that all companies do and often it’s just a statement that is meant for PR consumption. But Singleton was not a man prone to hyperbole or making statements simply for PR reasons. So it’s quite notable that he put so much emphasis on the talent of his employees and executives. George Roberts being one of those

And actually the way that Roberts ultimately teamed up with Singleton was in 1966 when Roberts was at Vanadium-Alloy Steel Company in Pennsylvania also known as VASCO. The two friends who had remained in contact over the years agreed that a merger of their companies would be profitable to both. With that merger, George became President of Teledyne with Henry as Teledyne’s Chief Executive Officer and Chairman.

In the book that we’re going to go through over the next half an hour, so Roberts searched his archive of corporate documents to construct a memoir that describes the first decade of aggressive acquisitions and diversification, Henry’s reasons for adding financial institutions to his highly technical mix, his controversial program of aggressive stock buybacks, the spinoff to shareholders of certain entities which greatly broadened their flexibility in handling their investments, and finally the difficult days of hostile takeover attempts that followed Singleton’s retirement from Teledyne.

“Singleton was born a farm boy in Texas. Born on November 27th 1916 on a small ranch in Hayeswood, Texas some twenty miles north of Fort Worth where his father raised cotton and cattle. This early rural background gave him a love of the land and cattle ranching that never left him, and led him in later years to become one of the largest private land owners in the United States.”

Roberts writes that he can attest to Singleton’s lifelong fascination with love of and belief in the importance and value of real estate of all types. “His family, Teledyne and property were clearly the three major loves of his life according to Roberts speaking about Singleton.”

One of Henry’s great talents was mathematics. “At the academy, this is the Naval Academy at Annapolis, an initial intense two-year program of mathematics covered what would normally be done in three or four years at the average college. At the end of those first two years, Henry ranked first in mathematics in our class of 820 students.”

Let’s see what Roberts writes about the beginnings of Teledyne. “Henry had three great ideas in creating and growing Teledyne. His first was to recognize the future importance of digital semiconductor electronics when this technology was in its infancy and by selective acquisitions to create a strong base in this growing field on which to diversify his company.

The second was to acquire and organize a selection of financial companies within his company to provide a strong financial base which also allowed the rest of the financial world to recognize Teledyne as an important entity and potential client.

The third was his innovative use of stock buybacks to further strengthen the corporation and enhance shareholder value.

Sales of Teledyne in 1961, the first full year of operation, were 4.5 million with a net income of 58,000 and a per share income of ¢13. By the end of the second fiscal year in October 1962, Teledyne’s sales had reach 10.4 million with a net income of 331,000.”

In making many of the acquisitions that Teledyne made, Robert says, “Henry depended on several very talented management people to survey the field for possible acquisitions and evaluate them as to their technology, management history and markets, and desirability as Teledyne properties.

Henry, however, made the final decisions based on his judgment as to their value, suitability and potential profitability, as well as their fit into the rapidly expanding family of Teledyne companies.

One of these men was Claude Shannon who was a good friend of Henry’s from his days at MIT and was a Director of the company for many years. He also played a valuable part in helping Henry evaluate many of Teledyne’s important acquisitions.” This is notable because Claude Shannon is a famous scientist of the twentieth century. In fact, there’s quite a bit written on him in William Poundstone’s excellent book Fortune’s Formula. Writes Poundstone, there are a few sure things least of all in the competitive world of academic recruitment, Claude Shannon was as close to a sure thing as existed that is why MIT was prepared to do what was necessary to lure Shannon away from AT&T’s Bell Labs and why the institute was delighted when Shannon became a visiting professor in 1956.

Shannon had done what practically no one else had done since the renaissance. He had single-handedly invented an important new science. Shannon’s information theory is an abstract science of communication that lies behind computers, the internet and all digital media.

It’s said that it is one of the few times in history where somebody founded the field, asked the right questions and proved most of them, and answered them all at once, was noted by Cornell’s Toby Berger.

So here’s somebody, Claude Shannon, who in terms of scientific accomplishment perhaps even exceeded Singleton himself. But this is the kind of man that Singleton attracted as a Director of Teledyne and someone to help him with acquisitions. Shannon was also an investor himself, and in Fortune’s Formula, Poundstone writes that in the late 1950s, Shannon began an intensive study of the stock market that was motivated both by intellectual curiosity and desire for gain.

He filled three library shelves with something like a hundred books on economics and investing. The titles included Adam Smith’s The Wealth of Nations, John von Neumann and Oskar Morgenstern’s Theory of Games and Economic Behavior, and Paul Samuelson’s Economics, as well as books with a more practical focus on investment. One book Shannon singled out as a favorite was Fred Schwed’s wry classic Where are the Customers’ Yachts?

At the time, Shannon was designing the roulette computer with Thorp. Shannon kept notes in an MIT notebook. A part of the notebook is devoted to the roulette device and part to a wildly disconnected set of stock market musings. Shannon wondered about the statistical structure of the market’s random walk and whether information theory could provide useful insights.

He mentions such diverse names as Bachelier, Graham and Dodd, Magee, A.W. Jones, Morgenstern and Mandelbrot. He considered margin trading and short selling, stop-loss orders, and the effects of market panics, capital gains, taxes and transaction costs.

Shannon graphs a short interest in Litton Industries – shorted shares versus price. The values jump all over with no evident pattern. He knows such success stories as Bernard Baruch, the lone wolf, who ran $10,000 into $1 million in about ten years. And Hetty Green, the Witch of Wall Street, who ran $1 million into $100 million in thirty years. As we’ll learn, Singleton’s record was quite remarkable as well.

As background to Teledyne’s acquisition period writes Roberts it is interesting to consider what was happening in that decade of the 1960s. During and after the end of World War II, there were all sorts of emerging new technologies, new ideas, new markets and new opportunities that hadn’t existed before the war.

There were many opportunities for small new companies to go into business during the war to provide the diverse products needed for the war effort, and many did so successfully. In addition to this, many veterans came out of military services at the war’s end and through the GI Bill had an opportunity to get tuition-free educations in some of the most prestigious universities and schools in the country.

They learned technologies they might never have had an opportunity to learn otherwise. They studied basic science skills such as physics, chemistry and mathematics, and also specialized technologies such as electronics, metallurgy, geophysics, oceanography and others. And some of these men and women used their new knowledge to start companies often on just a shoestring with their own family money.

By the 1960s, many of these companies had matured into established profitable companies and many of their owners were ready to relinquish, control, and do other things with their lives or they had reached the point where they needed more capital to continue to develop and were looking for ways to do that.

Then along came a company such as Teledyne with a high P/E ratio that was growing rapidly and was interested in acquiring them. It was a wonderful opportunity for these people, writes Roberts, and many of the companies that Teledyne acquired were this type of family-owned company.

On a September 1967 interview with Forbes magazine, Henry Singleton said “we have what is called a management inventory. We work our heads off to increase our own capability at collecting and promoting the right people. To the extent we succeed, the whole company will succeed. We increase our bets on the men who seem to be performers.

We try to get all our people instead of competing amongst each other within Teledyne to look outside and see that the real competitors are all the other large corporations in the U.S. Our objective is to increase our rate of earnings faster than they do. It is a lot of fun. As a result, we visualize it as a competitive game.”

It’s been observed many times that the best managers and the best investment managers for that matter view what they do as a game. They love the challenge that it presents, the competition, and they excel at that. That’s a common trait that one will encounter with many of the best managers.

In 1963, Teledyne entered the field of optics with the acquisition of Kiernan Optics. This was a company founded by Russ Kiernan in 1950. Russ has some interesting recollections of Singleton and Teledyne. He says,

“my first contact with Henry was in 1963 through a professor at USC where I was teaching in the Graduate School of Business which I was doing concurrently with running my own company, Kiernan Optics.”

“Henry’s interest in my company was because he wanted a precision optical capability while he was striving to obtain the IHAS – Integrated Helicopter Avionics System contract.”

“Our first meeting was brief but it was one in which each of us spoke with complete candor, and that became the basis for our lasting relationship. All our meetings were short but they were very effective. In our first meeting, we had agreed on a mutually satisfactory figure for the acquisition but during the short period in which the deal was being consummated the Teledyne share price declined slightly.”

“I requested a renegotiation but Henry quickly responded you wouldn’t be making that request if the price had gone up. End of discussion. Looking back on that, I thought this is the kind of man I respected and wanted to work for.”

“Either during the acquisition period or shortly thereafter, Henry made a very informal appearance at Kiernan Optics which created an immense impression on our employees. It had been my intention to return to USC to teach full time and write a book but Henry asked me to stay around for a while. That for a while lasted eighteen years as I saw Teledyne grow from a $20 million a year company into over $3 billion annually.”

“During the very early period, 1693 to 1964, Henry sought various methods for raising cash to support company operations. One technique he used was to borrow on the physical inventories of the individual companies.”

Another tidbit shared by Kiernan is that “Henry would sometimes call me and invite me to have lunch with him. We always went to a gardenia poker parlor because the lunches were inexpensive.

I would drive down and pick Henry up at his El Segundo office. These lunches gave us the opportunity to get away from the office environment for discussions about the company or just to chat.

When it was time to pay for our lunches, Henry would always have me pick up the check. I was surprised at first but I was delighted to have the privilege of having lunch with him. I think maybe he was continuing to teach me the value of frugality by not inviting me to an expensive restaurant.” The thread of frugality goes through everything that I’ve read about Singleton and Teledyne, and also about other successful business managers. While some expenses seem trivial that culture of frugality ends up permeating an organization and the results can be enormous.

Kiernan also writes that “as successful as the company became, Henry never felt that luxury automobiles were a necessity at any facility. In fact at one point, Henry suggested that Ford Pintos be used for company cars at all facilities.

This caused a bit of a problem when Jim Stitle and four of his staff, they were all big men in the 6’5”, 250-pound class who worked in the offshore oil industry tried to squeeze into a Pinto. It was an impossible task. The policy was later amended so that large station wagons could be used for field conditions.”

“I remember my final meeting with Henry on February 1st 1981, my day of retirement after eighteen years with Teledyne,” writes Kiernan, “I mentioned my desire to write an instructional book on business-related matters based on my experiences. Henry immediately sat down at his newly-acquired computer. It was the first such device at Teledyne in those days and proceeded to instruct me in the modern methods of writing using a computer.

He spent about half an hour explaining these modern techniques. I was truly amazed that this man who was running a $3 billion corporation will take the time to be interested in my retirement ambitions. I never completed that business policy book but my thoughts of that last meeting still remain with me to this day.”

This is quite interesting because what I’ve also experienced with many leaders is that when you’re in a meeting with them they never seem rushed. They always appear to have all the time in the world. And people who have met Buffett would attest to that as well, even though someone like Buffett obviously could be working frantically all day long.

But for some reason the most successful business managers manage to structure their time in such a way that any meeting that they do have, the person meeting with them feels like they are the most important thing in the world right at that moment and there is no distraction taking place during a meeting.

Roberts writes that “Teledyne made a major breakthrough in January 1965 because of Henry’s original interest in inertial control systems for aircraft. He and his staff had undertaken the development of an advanced airborne computer system that would allow helicopters to take off and land in remote areas without ground navigation aids to flight, in close formation and zero visibility, and to maneuver over difficult terrain without pilot assistance.

Fed data from an inertial platform and radar, it became known as the Integrated Helicopter Avionic System or IHAS competing against some of the largest most well-established companies in the field such as IBM and Texas Instruments, Teledyne was awarded the prime contract for the system by the Navy.

Suddenly, Teledyne had become a major factor to contend with in the aerospace and military systems industry and the company’s stocks soared from fifteen a share to 65 within a year. This gave the company resources to acquire much larger companies than it had been able to before. Sales had reached 86 million in that year with net income of 3.4 million. Company employees had risen from 450 in 1961 to 5,400 by year’s end in 1965. It was an incredible record for a company that was only in its fifth year of existence.

Then in 1966, Teledyne acquired Vasco which is a company that Roberts had been at. It had 43 million in sales and this made Teledyne a fully integrated specialty steel producer with electric arc melting, argon oxygen decarburization refining, vacuum induction melting and vacuum arc re-melting for the production of the highest quality steel products. With these capabilities, metals soon became one of the largest segments of Teledyne’s business.”

What’s striking here is that Teledyne evolved into an industrial conglomerate, many parts of which would be difficult to understand for an investor but Singleton apparently was able to clearly understand the business dynamics of each of these businesses and allocate capital to the ones that would earn him the best return.

Henry Singleton took George Roberts to Houston, Texas shortly after Roberts joined the company. In Houston was Fayez Sarofim, one of Teledyne’s directors who hosted a meeting with financial analysts and Houston businesspeople to meet Henry. Bowman Thomas of Sewart Seacraft, the ship construction company that had been acquired and Dick Bailey of the seismic exploration company were also there.

“Fayez Sarofim had been a classmate of our Director Arthur Rock who had been instrumental in the early financing of the company and had brought Henry and [another individual] together, creating Teledyne’s first major semiconductor operation. Rock was an executive at Hayden, Stone & Company at that time and had introduced Henry to Fayez who ran a very successful business investment service for clients.”

Arthur Rock of course is one of the original venture capitalists and we’ve done a little bit of looking into Fayez Sarofim who apparently has done extremely well in the investment business in a 13F filing with the SEC as of June 2009. Sarofim’s investment management firm had listed an equity portfolio with a value of more than $13 billion. So these are all men of great success that Henry Singleton managed to associate himself with in the early days of Teledyne.

Roberts goes on to say that “Henry spent hours studying the stock and bond markets, and was anxious to have both the funds and opportunity to pursue his life interest. I remember well just after returning from Houston, receiving a letter from Fayez extolling the benefits he could provide us with if I as President would allow him to select our investments.

Since I didn’t yet have any investment authority, I showed the letter to Henry. He quickly told me that he wanted to control the investing of his stockholders’ money. He did so and no one interfered. Not even the heads of the insurance companies who later joined us with their copious millions for investment.

It was not until twenty years later that Henry allowed Fayez to participate directly as a manager of investments from one of our then independent insurance companies. But Henry sought his advice many, many times over those years. Henry did teach me how to study the markets as he did, though only rarely did he ask for my initiative in making selections.

He knew of course that I was aware of the bank of information on corporate stocks and bonds he maintained on his computer system which he had used in evaluating his selections. He frequently discussed the reasons he had for making investment judgments with me so that I would be able to participate and back up his actions, and discuss those actions with our Directors and Executive Team.

He kept his Apple II and Apple III computers busy at his home, building his database, and used those tools incessantly in his management methods. He was a very early pioneer in using personal computers for business, financial, and technical purposes. As most engineers did, he loved the Apple concept and subsequently joined Arthur Rock on Apple’s board.”

So here’s further evidence of Singleton pioneering some methods both in business management as well as in managing Teledyne’s portfolio.

And here’s Henry talking about Russ Kiernan whom we mentioned earlier, when Roberts asked Henry what is so unique about Russ Kiernan, Singleton says that “what’s unique about him is that I’ll ask him a question about one of these companies that I’ve asked him to supervise and he always knows the exact numerical answer. If I ask him what they did in sales last month, he knows right away without calling someone to find out.”

So Henry said “that’s kind of fellow that you pick, who runs a company and does it well but is also able to quickly understand and supervise, and have the facts about other companies under his wind. That’s the kind of a group leader we need.”

Let’s talk about the second phase of acquisitions by Teledyne from 1966 to 1970. In the first six years of operation from 1961 to 1966 sales had gone from 4.5 million to 257 million, net income rose from 58,000 to 12 million and shareholder equity had risen from 2.5 million to 90 million. The company had started with 450 employees and five years later it had nearly fourteen thousand employees.

Roberts writes that he and Henry had always hoped that the owners of managers of the companies they acquired would stay on and continue to manage their operations, and most did.

“Many of these men had started their companies twenty or thirty years earlier with family money and had managed them into the successful and viable businesses that had attracted our attention and some were ready to retire.

In those cases, we often asked if there was a son or other relative who knew the business and would take over and manage it. Sometimes, one of the other top executives or technical people accepted the job. These men knew more about their specific businesses than we did and we wanted to keep their expertise. We had no intention of managing these businesses from the corporate level.

We did, however, establish our own unique financial and operations reporting system under the direction of George Forinsky, which enabled us to monitor their performance closely on a monthly basis and see any trouble spots before they became serious.”

Now, Buffett has said that he gets monthly reports from his subsidiary companies as well and perhaps one learned from the other. But it seems that both Buffett and Singleton wanted to have very timely data from the subsidiaries so they could evaluate their operations, and progress, and profitability, without necessarily speaking with those business managers every month, or even every quarter, or year.

Here are some standards that Teledyne had for deciding whether or not a company was a good acquisition candidate. Here are the questions that Teledyne asked – is the company profitable? Do they have a good balance sheet? Is their profit and loss statement accurate? Do they have a clean inventory? Is their backlog realistic and well-documented? Is their management on top of their operations? Would management be willing to stay if acquired? Have they made long range plans to maximize their profit in a sellout?

Does the business have growth potential? Is their opportunity for growth and profit? Can cash be taken from the company for use elsewhere? How is depreciation counted and is it a significant percentage of profits? What is the condition of their physical plant? And finally, and probably most important, would this company be a good fit within Teledyne organization and its goals?

This is a list of acquisition criteria that should be on every CEOs mind. Obviously, not all of those criteria had to be met 100% but those were the things that Singleton looked at and considered when doing deals. Perhaps one of the things that’s not on the list but was of immense importance to Singleton was the price that was being asked by the seller and also the currency that Singleton could use when making the acquisition.

Singleton also used creative M&A consideration at times, not just cash or stock, when they were acquiring Continental and needed to acquire more shares. Roberts says that “with Continental shares priced at $18 on the New York Stock Exchange in 1969, we offered $1.30 principal amount, 7% subordinated debenture due in 1999 for each share of Continental’s common stock. These debentures paid $2.10 annually yielding better than 12% to those tendering their stock – an attractive deal.”

So just to recap, here we have Continental shares trading at $18, Singleton apparently unwilling to offer a big premium with either cash or Teledyne shares but willing to give $30 in principal amount on a thirty-year fixed rate bond that had a 7% coupon, so in effect at 12% yield that was fixed for thirty years. And obviously, that seemed much better consideration to Singleton than either stock or cash.

Now, let’s look at an acquisition that George Roberts talks about in 1967. He writes “in April of 1967, Henry and I had become quite interested in a new company in Fort Collins, Colorado called Aqua-Tech. These people had developed a very successful product that you will probably recognize called the Waterpik.

It introduced the original idea of using a pulsed jet of water as an oral hygiene adjunct to the toothbrush. It was very efficient at removing food particles from between the teeth that a toothbrush often could not remove.

It was called to our attention and highly recommended by a broker in New York who knew Henry and there was quite a bit competition for the acquisition at that time. We prevailed however and acquired it for a 120,000 shares of Teledyne common stock and up to 35,000 additional shares dependent upon certain contingencies. The acquisition had a market value of over $23 million.”

I find this quite interesting. As another great capital allocator Warren Buffett has said that he’s not interested in buying companies at auction or companies that have a lot of competition for them. It seems that Singleton, while he obviously preferred to make acquisitions with no other buyers there, he didn’t shy away from competitive situations as long as he could use a currency that he thought gave him an advantage. And in this case, it was Teledyne stock.

By 1969, writes Roberts, “Henry and I decided that the prices for other companies we might be interested in were getting too high. This was partly due to increasing competition for these companies by conglomerates such as TRW and others who were growing the way we were. Also, after more than a decade of acquisitions by conglomerates including ourselves, many of the better companies had already been acquired from those available. And there were fewer companies that were really attractive to us.”

So this is when Teledyne essentially ended its first program of acquisitions in 1969. And once that program was ended then there was no longer a need for some of the finders as they called them whose main activity had been finding and negotiating the buyout of suitable new companies. And this is when several key execs left the company as they were no longer needed.

Now, let’s talk about Teledyne’s diversification into insurance and finance. And Roberts calls this Singleton’s second grade purpose. He writes, “Henry talked to me on several occasions about a book by the former Chairman of General Motors Corporation [GM]. He told me he had learned a very important concept form that book which he wished to use in the growth of Teledyne.

He explained that in about 1921 or 1922 after World War I and during a very difficult economic time of recession, General Motors had needed additional funds to finance their growth and had a plan to sell bonds to the general public. The bond sale was a complete failure and the Chairman had written in his book that it had taught him an important lesson.

It was that for a corporation to grow and to have a strong financial base, it needed to have as a part of itself an interest in substantial financially-oriented institutions. So General Motors had started the General Motors Acceptance Corporation and invested in other financial groups.

As a result of his interest in this idea, Henry had decided that at some point when Teledyne had reached a certain size, he would seek out financial organizations we could acquire. So near the very end of our acquisition period, we did go in that direction before we finally stopped.

We began acquiring a number of financial and insurance companies which was a significant change from our usual aerospace metals, industrial and consumer company acquisitions.

The first of these financial institutions was an insurance company in the life insurance business in Chicago. It was the United Insurance Corporation which worked under a holding company called the Unicoa Corporation.

In the years 1968 and 1969, we turned to the Northern California area and acquired a personal savings and loan company organized under the California thrift and loan statute called Fireside Thrift. And another insurance company in Menlo Park specializing in worker’s compensation insurance called Argonaut Insurance.

After the majority stock of the Chicago insurance company had been acquired through several tenders, we went to Texas and bought Trinity Universal Insurance Company of Dallas which was in the property and casualty insurance business. So then we had life insurance and casualty insurance operations of substantial size and a thrift and loan company.

Henry was once asked why the insurance business and he responded that if a company is going to keep on growing at the rate we want to grow, it has to do some new things along the way. What we’re doing now is providing the more stable base that will enable us to produce that growth four or five years from now.”

What’s interesting here is that neither Singleton nor Roberts mentioned float as a key reason for going into insurance even though the investment portfolio of those insurance subsidiaries eventually contributed major profits to Teledyne. Obviously, Buffett has talked extensively about float and how it’s helped Berkshire grow value over time.

The other interesting point here might be that this notion that for a company that wants to grow big and keep growing, it needs to have some sort of financial businesses within it. Today, especially sitting here in 2009, might be a very controversial notion as many otherwise find companies over the past few years got into troubles precisely because they had financial arms – just think of General Electric or even GM or Chrysler.

So this notion to some extent at least has been discredited. But probably because many of those finance companies that have been part of larger companies were really mismanaged in the real estate boom of say 2005 to 2007, and it’s hard to imagine that Singleton would have bought many of the financial instruments that brought some of these larger companies to their knees. And certainly the idea of using float has not been discredited in the least.

Roberts goes on to write that “by 1970, as we began our second decade, we had stopped our direct acquisition of companies. We decided there was no point in paying inflated prices for complete ownership of companies when we could buy a substantial interest in them through our insurance companies when the market prices were favorable.

Of course, we wanted profitable companies that were well-managed than businesses that we thought had a good future. Each of our insurance companies had the usual investment committees to manage how their portfolios were invested but in keeping with our system of running financial matters from the corporate office, Henry headed an investment panel that made all the final decisions on these matters.”

In the February 20th 1978 issue of Forbes magazine, Henry was quoted about his philosophy in regard to this. “There are tremendous values in the stock market but in buying stocks not entire companies. Buying companies tends to raise the purchase price too high. Don’t be misled by the few shares trading at a low multiple of six or seven.

If you try to acquire those companies the multiple is more like twelve or fourteen and their management will say if you don’t pay it, someone else will. And they’re right someone else does.

So it’s no acquisitions for us while they’re overpriced. I won’t pay fifteen times earnings that would mean I’d only be making a return of 6% or 7%. I can do that in T-bills. We don’t have to make any major acquisitions. We have other things we are busy doing.

As for the stocks we pick to invest, and the purpose is to make as good a return as we can, we don’t have any other intentions. We do not view them as future acquisitions. Buying and selling companies is not our bag. Those who don’t believe me are free to do so but they will be as wrong in the future as they have been about other things concerning Teledyne in the past.”

“By the end of 1969,” writes Roberts, “our tenth year in business, sales had passed the billion dollar mark for the first time at 1.3 billion and our net income had reached an all-time high of sixty million. Shareholders’ equity over those years had grown at a compound annual rate of 94%.”

And in a letter to shareholders for the year 1970, Singleton pointed out, “the strong financial condition of Teledyne is evident in our balance sheet. We have an excellent cash position, a ratio of current assets to current liabilities of nearly three to one, and a low funded indebtedness of about 25% of total capital.”

Here’s a point on continued internal growth of the company. “Some outside analysts wondered whether we could keep up the kind of growth and success we had been having without the income from continuing acquisitions. But they hadn’t seen anything yet. In spite of the adverse economic conditions of the 1970s as well as a malpractice insurance problem, and without the contribution of additional income from new acquisitions, Teledyne achieved continuous and rapid growth in sales and income throughout the difficult decade of the 1970s.

From 1971 to 1981, our compound annual growth rate in sales was 11.4% and in net income it was 22.1%. Some of this in the first year of that decade was due to the results of our new financial sector companies.” So that once again speaks to the importance of those financial companies once Teledyne had matured as a company and it wanted to continue its growth.

Here’s an interesting tidbit on the Teledyne identity and corporate image. Roberts writes that “when the discussion of how the acquired company should be identified had come up, Berkeley recommended that instead of keeping their original name or one we gave them, they should essentially keep their name and call themselves Teledyne in front of that name so Teledyne would become an integral part of each name and give each company a more direct identity as part of Teledyne. He suggested that we do this by calling them Teledyne so and so.

Henry thought that was a good idea so we eventually had names such as Teledyne Systems, and Teledyne Brown Engineering, and so forth. With the Teledyne name upfront, our company quickly became recognized throughout the business world. These company identification system standards were enforced quite rigorously.

And when an operating company deviated in their printed material or signage which a few did occasionally, we brought them to task on that. Henry was quite interested and involved in this process. He was very concerned about Teledyne’s image.”

This may sound a little bit contrary to what is said about Singleton elsewhere namely that he doesn’t care about what the press thinks of him or analysts thinks of him. But there’s an important distinction to draw here. He did obviously care very much about what his potential customers thought of Teledyne because that had a direct economic impact on the company whereas what Wall Street analysts thought or the press thought did not impact the fundamentals of Teledyne. In fact, the effect it did have was that sometimes the stock got so cheap that Henry could take it in at a bargain price.

Roberts writes about some of Teledyne’s financial controls to some considerable extent. And this is a chapter that by the way I would highly recommend reading in the book Distant Force. Roberts writes, “for a corporation of our size, we ran a rather lean corporate staff confined to the planning, and reporting, and auditing of the individual company results.

We had a Legal Department headed by the Corporate Secretary, a Financial Department headed by the Corporate Treasurer and a controller, a Public Relations Department to communicate with our publics and very few other activities. I think at maximum we had fewer than 150 persons on our corporate staff.

At the corporate level, our basic interest was in seeing that each company remained a financially healthy and profitable organization. Although we did establish a group executive system, we never let our corporate connection to our individual companies be filtered through too many minds and levels of management as many companies do. There was always essentially a one-on-one relationship between corporate and the managers of each operating unit.”

He also writes that “a lot of people have said that Henry and I managed Teledyne by cash flow and we didn’t do a lot of management by cash flow. We developed a measure that we called Teledyne return which was the average of your cash return and your profit. We’d say, you reported a profit of a million dollars but you only had half a million dollars of cash, so you only made $750,000, so tell us about the rest of the profit when you get it.”

I find this quite interesting because many value investors will say that they only look at the cash flows, they want to base their investment decisions on free cash flow primarily or exclusively, and there is a flaw in that in my mind because there was a reason why accrual accounting was developed.

And the idea was that on the income statement, you could show items that were not in that period’s cash flow but would be expected to contribute or detract from cash flow in future periods. And so the idea of accrual accounting is actually quite important.

Perhaps one of the reasons that many value investors prefer to look at the cash flow statement these days is because of the abuses that the income statement has suffered by virtue of management massaging earnings and making accruals that depended on what the Street expected of the company rather than on what made the most sense. But I find it quite interesting that Teledyne took an average of net income and cash flow, and that’s how they managed their companies.

Roberts also writes that “Henry spent most of his time planning the company’s strategy for future moves and directing our investment portfolios. He was interested in the big picture. I was the one who handled the day-to-day details of operating the company but he most certainly got involved when there were major decisions to be made or problems to be solved.

Almost every day I was in town, Henry and I usually discussed any of the problems or opportunities the company was facing. But quite often, Henry simply talked about his philosophy of running a corporation and the various financial strategies that he came up with as he sat in his corner office each day often working at his Apple computer.

He was a brilliant business strategist just as he was a brilliant chess strategist. He held a 2,100 rating, just 100 points short of a master according to Claude Shannon, and he came up with many creative ideas, ideas that were sometimes contrary to the currently accepted methods of managing a large corporation that prevailed in those days.

He always tries to work out the best moves, Shannon said, and maybe he doesn’t like to talk too much because when you are playing a game you don’t tell anyone else what your strategy is.”

On the Teledyne financial reporting system, Roberts writes that “it was a system in which the individual controllers of each company, each profit center reported to the president of his company and to the home office Controllers Department at the end of each calendar month.

Our fiscal month always ended on a Friday and by the following Tuesday morning, these reports from all 160 reporting entities were in our home office, controller’s office. They came in by electronic mail.”

This speaks to the very good reporting system that Teledyne had in place where even as early as the 1970s, here was a company using electronic mail to send financial reports from the company level to the holding company level by Tuesday morning following a Friday, giving obviously senior management a very good view into how the business was doing.

“With these systems in place,” writes Roberts, “we were able to maintain very close financial control of our operations and our capital management. Though we were criticized for this in some business publications, we were very conservative in our expenditures for capital equipment and facilities as well as for research and development. We concentrated on turning the businesses we owned into efficient cash generators.”

This to me brings to mind some of the criticism that Eddie Lampert has been subjected to as Chairman of Sears. And perhaps one can make the argument that with Sears and K-Mart it’s a little bit different but the criticism of Lampert has focused on the fact that he’s supposed to be a retailer, and as a retailer one is expected to make significant capital expenditures into the existing stores to remodel them and so forth, and also to have a plenty of inventory on hand to display in the stores. Lampert has disagreed with this, arguing that he can deploy the cash elsewhere and reap higher returns. Singleton apparently had the same outlook on capital allocation. [Ed. note: In hindsight, the Sears critics appear to have been right, but would higher store capex have made Sears materially more competitive against Amazon? Indisputable, however, is that Lampert’s share repurchases were ill-advised.]

Roberts writes that “there was a certain amount of resistance to some of the company’s controls in some quarters. Many of the acquired companies had been started by local entrepreneurs who had close ties in their communities and there was a certain amount of resentment at now being financially responsible to so-called absentee managers half a continent or more away. These feelings gradually dissipated as new and younger managers were brought up through their organizations.

Some of these companies had also reached a level of maturity before they were acquired in which their managers and staff had become quite comfortable with their current operations, and sales and profits, and lacked the drive to innovate or take risks in expanding their markets, or product mix, or sales. This attitude also dissipated in most cases with our help as time went by.”

Let’s turn to the all-important stock buyback period that was crucial to compounding value per share at a superior rate at Teledyne. Roberts writes that “in the early 1960s, Henry had used Teledyne stock to make a limited number of equity acquisitions in relatively small companies. He was limited in the size of the companies he would acquire by his company’s relatively low stock price at that time.

But by 1965, Teledyne stock had jumped from fifteen to 65 a share in one year largely because of the company’s success in winning the IHAS inertial helicopter guidance system contract against big competitors such as IBM and Texas Instruments. That gave us the ability to use Teledyne stock to acquire more and bigger companies such as I’ve described until there were 130 in all by the end of the decade.

These events were followed by the bear market of the early 1970s and Teledyne stock prices fell along with the rest from about forty a share to less than eight. Henry saw opportunity where most other company had saw none. Teledyne stock that had gone from a P/E ratio of about thirty to seventy in the 1960s suddenly went to a P/E ratio of about nine, or ten, or eleven to one which was about the same or less than that of companies we had been acquiring.”

Let me just correct something here, the P/E ratio fell to a P/E of nine, ten, or eleven. It never fell to one.

“One morning in May of 1972, Henry walked into my office at about 8:30 and said George we’re going to make a bid for our stock at twenty a share. I said are we really going to do that? I was totally amazed as he hadn’t even hinted about that to me before. It was also a surprise to everyone else at Teledyne when they heard about it including Art Rock who was certainly involved in most of our stock activities.

This was an excellent example of how Henry made all investment and stock decisions on his own. He did this every single time. They were all done when our stock was at a low P/E ratio. He believed that our stock was grossly undervalued and it was the first of a series of eight stock buyback offers.”

Roberts interestingly takes the book Good to Great by Jim Collins to task. He writes, “the author Jim Collins considered that Teledyne had never become a great company because its founder had not prepared a successor when he retired and thus the return to shareholders declined abruptly at that point.

He presented a graph titled The Ratio of Teledyne’s Cumulative Stock Returns to the General Market. It showed a steep price in that ratio over the years to a peak of about nine times at the point of Henry’s retirement and then a decline in the following years.

What this graph did not include after Henry’s retirement was the return that shareholders still received from the stock of the financial companies – Unitrin, Argonaut and other entities that had been spun off to them and that continued to provide them with returns that actually far exceed the returns from Teledyne itself. If cumulative return to shareholders is his criterion in that graph, he missed the mark by a wide margin in judging Henry’s company.”

And this is quite an interesting point here. Roberts deftly dismisses the criticism in the book Good to Great. But I imagine that for those only reading that particular book, the chart would very much support Collins’ view that once a towering founder and CEO such as Singleton retires without a good succession plan in place that value can decline rapidly and obviously the chart showed that, but the chart was completely incorrect in this case.

Let’s look quickly at Teledyne’s international marketing. And here is something that was said by Russ Kiernan whom we had mentioned earlier in this program. He said that “as the decade of the 1960s came to a close and in the early years of the 1970s, Henry recognized the advantages of developing international markets for the company’s products and services.

A few companies had already been engaged in foreign markets and had even established limited overseas manufacturing facilities. To meet these growing operations, Teledyne’s international marketing organization was established in the early 1970s with offices in Geneva, Switzerland and Singapore.”

So here was a corporation smaller than many other large U.S. companies that went global as early as the 1970s.

Roberts writes about the start of Teledyne’s third decade – “we had emerged from our second decade in business as one of America’s leading and most successful corporations, and we looked forward optimistically toward the third. In 1980, our consolidated companies achieved 2.9 billion in sales with a net income of 344 million.”

Then Roberts talks about Teledyne’s first spinoff and the interesting tidbit here is he writes that “in keeping with Henry’s philosophy that the shareholders should be given the opportunity to decide whether or not they wanted to be in this kind of a business, we decided to spin these operations off to them under the name American Ecology.

Thus, shareholders could opt to sell their interests in that business without selling their Teledyne shares if they wished. In the first quarter of this year, we distributed one share of American Ecology stock to our shareholders for each seven shares of Teledyne common stock.”

“1986,” writes Roberts, “was a year of significant management realignments in our company. At the annual meeting in April, Henry announced that he was giving up his title of Chief Executive Officer and that I would assume that title in addition to my position of President. He would remain Chairman of the Board.

He told the shareholders that the title change was in recognition of my leadership since I joined the company as President in 1966. He reiterated those comments in the only intra comm that he ever wrote. Henry was 69 at the time of the announcement. He stressed that the realignment would not mark any major change in Teledyne’s management style and told shareholders that he anticipated that we would continue to work together as a team as we had for the previous 20 years. Indeed, we did work closely together for the next ten years.”

Roberts also has a paragraph again on Fayez Sarofim who was the Founder, Chairman, President and Chief Executive Officer of his investment firm Fayez Sarofim & Company in Houston Texas.

“Sarofim was elected to the Teledyne board at that same meeting at which Singleton announced his retirement. Fayez was one of our early investors and a major shareholder, and in later years became an important advisor to Henry in investment matters.”

In 1987, Henry was seventy and Roberts was 68. And Roberts writes, “a number of our key directors and company managers were over 65. The question of successors and in fact the whole question of just what would happen to Teledyne in the coming years was widely surmised.

In an article in the June 16, 1987 issue of Financial World, the possibilities discussed range from spinning off large parts of the company or breaking it up to taking Teledyne private or selling out. Henry’s response was we’re not particularly persuaded by quick temporary gains. We’d rather get something permanent and it takes time. If there’s anybody who wants us to do something real fast that’s going to be astonishing in terms of increased earnings or something, I don’t know how to satisfy such desires.

When pressed about spinoffs being a good way to boost shareholder value when acquisitions are too pricey, he replied, you’re thinking in the short term. I’m in the long term so I wouldn’t do anything like that for a temporary rise in the price of the stock.

You know there are companies that will sell one division and buy another because today this division generally supports a low multiple and the one they’re buying has a high multiple, and they think that may rub off on the whole company. That absolutely turns me off. The whole concept is repulsive. We don’t do things like that. We look at the economic long term possibilities.” Obviously, a strong statement here by Singleton regarding some of the idiocy that he saw in business management at the time, and unfortunately that hasn’t gone away over the decades.

Here’s an interesting perhaps final paragraph from the book, Roberts writes that “a final assignment from Henry Singleton was unfortunately given to me in his home a few weeks before he finally left us. Knowing he had a brain tumor, he had a final concern about our 1986 spinoff of Argonaut Group.

The board of Argonaut in 1989 had agreed with Henry that a study should be made to sell the company to another group or company so that we could be excused for managing the entity. He was disappointed as an investor in the performance of the stock under $20 a share and hoped that we could sell it for at least $30 a share. An outside firm had been hired to help do this job. After a number of months, the effort was canceled by the Board as no buyers were found.

Henry always thought that the management of the company not wishing to be replaced had failed in the marketing effort. He told me on that sad day that if he left us it would be my duty to replace the management and solve his problem.” What this paragraph shows is the unique dedication – you could call it fanatical, perhaps that Singleton kept to Teledyne until the very last days of his life.

Subsequent to Singleton’s retirement and passing, Teledyne was targeted by several hostile acquirers, eventually ended up merging. And today, certain pieces of Teledyne exist as independent companies while others exist as parts of larger companies.

This brings our program about Henry Singleton to an end. This recording and transcript are property of BeyondProxy, the publisher of The Manual of Ideas. I do point out that many of the quotations in the recording are from George Roberts’ book Distant Force which we highly recommend. Thank you.

Christopher Tsai Reflects on Timeless Values in Investing and Life

September 13, 2024 in Diary, Equities, Interviews, Reading Recommendations

Ezra Crangle, Editor-in-Chief of MOI Global en Español, had the distinct pleasure of speaking with Christopher Tsai, President and Chief Investment Officer of Tsai Capital Corporation.

Christopher’s investment approach has been influenced by Warren Buffett, Phil Fisher, and Charlie Munger, among others, as well as his own family’s long and storied financial history. Christopher’s grandmother was the first woman to trade shares on the floor of the Shanghai Stock Exchange, while his father, Gerald Tsai Jr., was a prominent investor and the first Chinese-American to lead a Dow Jones Industrials company.

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Luca Dellanna on Why Long-Term Investors Must Understand Ergodicity

September 7, 2024 in Audio, Diary, Equities, Featured, Full Video, Interviews, Invest Intelligently Podcast, Member Podcasts, Podcast, Transcripts

We had the pleasure of speaking with Luca Dellanna, author of Ergodicity: How Irreversible Outcomes Affect Long-Term Performance.

We are grateful to Guy Spier for the introduction to Luca.

This conversation is available as an episode of Invest Intelligently, a member podcast of MOI Global. (Learn how to access member podcasts.)

Watch the conversation (recorded on June 20, 2024):

printable transcript
audio recording

The following transcript has been edited for space and clarity.

John Mihaljevic: It is a great pleasure to welcome to this conversation researcher, author, and management advisor Luca Dellanna. I’ve known of Luca for quite some time and have read a couple of his books, but I must give credit to my friend Guy Spier, who I believe is the first person to bring Luca to my attention. He also helped make this interview happen, so thanks for that, Guy.

Luca, I know you’re an automotive engineer by training and have led teams and consulted for large multinationals. Then you essentially quit your job to do what you do now. I think this is always admirable and exciting, especially when you bring so much value to all of us. As a start, I’d love it if you tell us a little about what you are up to now these days, how you spend your time, and what you focus on.

Luca Dellanna: Thank you, John. Nowadays I spend half of my time writing and researching, usually around the topics of risk, people management, and operations management. The other half of my time I spend consulting. I usually work with senior leaders to improve the management capabilities of their organization, so I do things like training the managers and training the leaders in developing the managers.

John Mihaljevic: Today I’d love to talk to you about one of your books, the one on ergodicity. In a future conversation, maybe we can also talk about your latest book, which is called Winning Long-Term Games and also looks extremely interesting. The subtitle in Ergodicity is “How irreversible outcomes affect long-term performance in work, investing, relationships, sport, and beyond.” It’s a fascinating concept. We in the MOI Global community are investors and lifelong learners, so this is extremely relevant. As a starting point, how do you define ergodicity? How should we think about this?

Luca Dellanna: I think the best way to introduce ergodicity is not to talk about its definition. I use an example in the book that really brings the idea across. It’s a story of my cousin, who was a great skier. He made it to the World Championship in his age bracket when he was very young, but with one leg injury after another, he sadly had to quit professional skiing very early. From him, I learned the lesson that it is not the fastest skier who wins the race but the fastest one amongst those who make it to the finish line.

In the book, I use a numerical example to explain the point that not only does survival matter (we all know this) but that survival matters more than performance, at least over long-time frames. Here’s the example I make. Imagine a ski championship consisting of ten races. My cousin is a great skier, so he has a 20% chance of winning each race. However, because he takes a lot of risks, he also has a 20% chance of breaking his leg in each race. The question is how many races he is expected to win in a championship of ten races.

The naive answer is two races because we think, “There are ten races and a 20% chance of winning each; ten times 20% makes two.” However, the real number is only 0.71, because if my cousin breaks his leg during the first race, not only does he lose that race, but he also loses the possibility of participating in future races. He only has an 80% chance of participating in the second race, a 64% chance of participating in the third race and so on.

We get this huge difference. In a world where irreversible losses do not have long-term consequences, my cousin wins two races. In the real world, where irreversible losses absorb future gains, my cousin only wins 0.71 races. This difference caused by irreversibility is what ergodicity is about. A situation is ergodic if irreversible losses do not have long-term consequences and you can rely on averages. The real world is non-ergodic, which means that 1) irreversible losses absorb future gains and 2) because of that, you cannot rely on averages.

John Mihaljevic: That’s a great example. To stay with the skiing analogy for a moment, there are some great skiers or have been in the past who end up winning many of the individual races they enter, and they also don’t get taken out of the race. What does that say about their skill level? Are they not skiing at 100% and are they just so much better than the rest that they take fewer risks and still win individual races?

Luca Dellanna: Part of the answer to this is survivorship bias. We are seeing the subset of skiers who are running at 100% and survived, but we are not seeing the subset of skiers who didn’t survive, such as my cousin. This is one part of the answer. The second part of the answer is that skiing is a race to the bottom, by which I mean that in professional skiing, you can only have one winner. This means two things. If you are very skilled but also don’t take many risks, someone almost as skilled as you but taking more risks will be the one winning. Of course, there will also be a lot of other skiers who are just as skilled, take a lot of risks, and get out of the race because they injure themselves. We do not see them because of survivorship bias.

The point is that since there can only be one winner in professional skiing, there is this race to the bottom where you do not win only because you’re the most skilled person but also because you take risks beyond the level which would be optimal if there could be more winners. Conversely, in areas such as investing, there can be more than one winner. Of course, only one gets to be the richest person in the world, but if you define winning as getting very wealthy, as multiplying your wealth, there can be more winners, which means you do not need to take a suboptimal level of risks to be the winner. There are pathways to being a winner where you take a sustainable amount of risk.

The good way to think about it is to get rid of survivorship bias. You want to look at winners and ask yourself, “If we take 100 people with the same strategy as theirs, how many of them ends up winning?” If the answer is not 100, then you have a strategy which is not reproducible, meaning that if you were to adopt the same strategy, you are not guaranteed those results. Non-reproducible strategies work when you have a lot of people adopting them so that some drop out of the race but there are still some winners. They do not work when you are thinking about whether they are a good strategy for you because you are only one person and if you blow up, you blow up. You want to optimize for reproducibility before you optimize for maximum potential.

John Mihaljevic: Would it be fair to say it takes luck to win in skiing? It almost sounds like it does take luck, but more to not have a bad injury, to not have the irreversible loss. Let’s say the top 10 skiers in the world are pretty much the same in terms of skill and, as you say, it’s a race to the bottom. They all push it almost to the max. It’s almost like the one who was the luckiest in not getting injured ends up the overall winner.

Luca Dellanna: It’s a big component you’re mentioning. There is often this belief that if we say luck is important, then it means that skill is not important. It’s not like that. Skill is extremely important, and so is hard work. Everyone who wins a race is not just lucky but also incredibly skilled, and they put in an incredible amount of hard work. It’s just that when you can only have a limited number of winners, skill and hard work are not sufficient anymore, and you also need to have a bit of luck.

John Mihaljevic: Would you say that the skier you mentioned at the outset was, in a way, rational in what he did because maybe that was his only way to have a chance at winning, and he took that risk of losing everything? That’s just how the game works. If you want to have a chance at winning, you also have to take that risk.

Luca Dellanna: You’re highlighting a very important point. The moment you decide to compete to win in a race to the bottom, if your objective is to become number one, then the rational thing to do is take a high level of risk. What’s irrational here is the decision to compete in a race to the bottom in the first place. It’s my opinion. That’s the big topic in the other book, Winning Long-Term Games – you should not compete in races to the bottom to win because those are races where to win, they make you do things with a high potential of being bad for you.

The rational thing is to not participate in a race to the bottom. If you’re competing, try to find competitions which can have a large number of winners. For example, you compete in investing, but you do not compete to become the wealthiest investor in the world. You just compete to grow your wealth a lot, which is a type of competition that doesn’t mislead you because the rational thing to do is not to take a suboptimal amount of risk anymore. My advice is to make sure you pick competitions in which you do not have to take an excessive amount of risk in order to have a chance of winning.

John Mihaljevic: Turning to investing, where anyone can be a winner based on that definition, I’d love to understand a little more the nuances of how you look at the concept of irreversible losses absorbing future gains. Mathematically speaking, is it the idea of a multiplicative series having one zero? It’s all a zero or a kind of, if you’re down 50%, you need to be up 100% to get back to even, and if you’re down more, you need to be up a lot more. How should we think about this mathematically?

Luca Dellanna: It’s both things you’re describing. If you go bankrupt, are forced to liquidate an investment at an awful price or have so many losses that your investors decide to cash out, this basically brings you to a zero, a failure point (the technical term is “absorption barrier”). The other phenomenon is multiplicative risk: if you go up 50% and then go down 40%, you have actually lost money. You are not up 10% but below where you were at the beginning. That is also part of it. One way to see it is that if you invest $1,000 and then lose 50% of your investment, you did not just lose $500 but also the future profits those $500 might have generated.

John Mihaljevic: Looking at some of the most successful investors, like Warren Buffett, it sounds like they do grasp this concept very well intuitively. Do you think the longevity of a track record has a certain quality to it itself, and not just the returns because people will often compare returns? It sounds like the longevity of those returns is maybe even more important.

Luca Dellanna: Exactly. Because of compounding, longevity is extremely important. We all know Warren Buffett made most of his wealth during the last years, and that’s not because he had a higher rate of return but because of the effect of compounding. You do need the longevity because if you look at absolute numbers, the big gains are made later in time. To get into longevity, you need to have the ability to survive.

The longer your returns are sustained, the more likely it is that your strategy will produce future returns. Nassim Taleb calls it the Lindy Effect in his book Antifragile. It is the idea that the longer something has been around, the longer it is expected to survive, but it does not apply to things that have a limit to how long they can survive, such as humans. If you survive 90 years, you are maybe expected to survive another five years, but there is a hard limit. For things that do not have this natural bound — such as ideas, investments, and technologies — what you observe is that the longer they have been around, the longer they are expected to be around in the future.

The underlying reason for the Lindy Effect is that if you survive for long, we can deduce that your hazard rate, the chances of dying every any single year or your chances of going to zero in any single year, are low. The longer you survive so far, the more certainty we have that your hazard rate is low, and therefore the more likely you are to survive in the future. For example, for Warren Buffett, who sustained the long returns for many decades, we can be rather confident that his hazard rate is low, whereas if you pick a random investor who has very high returns but has been in the game for only the last two years, we do not know their hazard rate. The hazard rate might be high, but the investor has not gone bankrupt because he got lucky in those two years. Two years are not enough to close the cycle, so maybe the investor only experienced good market conditions.

So, there is this aspect of longevity. One, longevity is something you want to look for yourself. Two, how long an investor has been around gives you some information about how reproducible their strategy is. With a strategy that looks successful but has only been around for a while, you do not know yet whether it is reproducible, which means if you were to adopt it, you do not have a high degree of certainty that you will get the same results.

John Mihaljevic: That is a great point. Related to that, I feel like the investment industry has invented things like risk-adjusted returns and beta, which, to me, look more like marketing tools to say, “Even though I haven’t been around long, my returns haven’t been that risky” based on whatever metric they want to use. It seems like there’s nothing as good as simply having a long-term track record. With Warren Buffett, I guess you could say his reported returns are the risk-adjusted returns because he’s been around so long that if there had been some major risks, he would have blown up by now. How do you view some of these risk-adjusted return measures, and do you think it is possible to try to ascertain with some confidence, even when there is not a long track record available?

Luca Dellanna: I largely share your thoughts about metrics, which I think are more like marketing tools or tools to increase the confidence in investors so that they’re more likely to invest or assume some risk they will not assume otherwise. I personally dislike using most metrics because they might fit the past but don’t tell you much about how they will fit the future. A lot is not considered in many metrics.

Take, for example, two investment portfolios, both with an average rate of return of, say, 20%, which is very good. They both have some metrics about risk and other things, but the first portfolio has been around for two years and second for 20 years. To me, the second portfolio has a much lower risk because of the fact that it survived for so long, which means it’s also more immune to things such as survivorship bias. However, that’s not captured by many metrics. I think people should never rely excessively on metrics. I often advise my clients to rely more on thought experiments, like not thinking, “What are the chances I have a big loss?” but rather think, “Let’s assume my portfolio has a very big loss. What’s the most likely reason?” Then you can make some considerations about that.

Another thought experiment I like is to think, “If 100 people take this portfolio, what’s the distribution of outcomes for those 100 people?” You’re shifting from thinking in terms of averages and thinking in terms of potential to thinking in terms of distribution of outcomes, which makes the bottom part of the tail much more visible. That’s the way I prefer to think about investments – in terms of thought experiments, in terms of premortems. You do not ask yourself how likely the possibility of failure is. You assume failure and ask yourself what the most likely cause could be and then you make some considerations about how likely it is to happen and what you can do today to prevent it.

John Mihaljevic: Some folks mentioned Monte Carlo simulations. What role could those play?

Luca Dellanna: I love Monte Carlo simulations as a tool. I think that’s very effective, for example, to compute the distribution of outcomes. It helps you capture things like irreversibility and ergodicity. The limitation of Monte Carlo tools is that they are only as reliable as the variables you put inside them. If you know all the variables and the uncertainty and are correct with that, then the Monte Carlo tool will be extremely effective. However, if you have high uncertainty on the variable you’re putting in, or at least high relative uncertainty, then Monte Carlo might be misleading. It can help you detect some blind spots, but it will not help you detect all the blind spots in your strategy.

It’s a helpful tool, but it’s not a tool you can blindly rely on, and sadly, most people underestimate how much uncertainty they have on their variables. For example, people think, “I know that variable is likely to be in the 2% to 4% range,” but that’s not the thing that matters. The thing that matters is what happens in the 5% of cases where it’s outside of that range. Is it, for example, 5% or 10%? In the 5% of cases where it’s outside the 2% to 4% interval, is it 1% or is it minus 10%? That’s what you really should think about.

John Mihaljevic: Based on your research, have you come to some practical conclusions about portfolio management in terms of how diversified a portfolio should be, how much leverage is “safe,” and anything else investors can apply when it comes to constructing their own portfolios?

Luca Dellanna: I’m not a professional when it comes to investment advice, so take what I’m saying with a grain of salt. My suggestion will be to think, first of all, what your real time horizon is. You may say your time horizon is 10 years, but unless you are 90 years old and your life expectancy is 10 years, your time horizon is not 10 years. Your time horizon is the top of the 90% confidence interval on your conditional life expectancy. For me and you, our real time horizon is probably something like 50 years.

Now the question is what’s the maximum amount of risk you can rationally take with such a long-time horizon. You may consider a strategy with a 1% chance of blowing up a rational one for a 10-year time horizon portfolio because maybe you’re thinking, “Yes, there is this little risk of blowing up, but the gains are so high.” Over 50 years, that’s definitely not worth it. The thing you want to consider is if you want to have a 99.9% chance of having a good portfolio after 50 years, which is your real time horizon, then the real amount of risk of blowing up you can take any single year is tiny, tiny, tiny. That’s one consideration. By the way, blowing up doesn’t necessarily mean you lose 100% – maybe it’s something like 90% or 80%, which could still qualify as blowing up.

The second consideration is, let’s say using this thought experiment, you discover that the yearly risk you can take of considerable losses is one in 10,000. Again, this seems too tiny, but if you’re there for the next 50 years, it’s not necessarily too tiny. Once you have a strategy, you need to think, “Let’s imagine 10,000 parallel words, and I need to have a positive outcome in 9,999 of those 10,000 worlds.” Then you ask yourself if your current strategy fits this criterion.

Those numbers are maybe a bit extreme. Some investors will have different numbers. Maybe you discover your acceptable risk is only 1% or whatever; the thought experiment is still valid. You ask yourself, “In how many parallel worlds do I get a positive outcome that I’m satisfied with?” and this should be, in my opinion, one of the compasses guiding your decisions. Once you’re okay with it, there are plenty of strategies you can consider. The point is to make your considerations for your real time horizon, which is your life expectancy, not 10 or 20 years. The second thing is to think in terms of parallel words, and you want to have a positive outcome in all of your parallel worlds.

John Mihaljevic: That’s very helpful, thank you. Anything else in the book you would like to highlight on the topic of ergodicity?

Luca Dellanna: One thing I talk about is the importance of not concentrating your risks over the time axis. I use an example that has nothing to do with investing, but I think it’s useful to understand the concept. I imagine I’m going on holiday with my wife, and we’ve decided to drive there. It’s a very long car drive, say, 12 hours, and if I drive without stopping for the night, I’m causing problems to cluster towards the end of the drive because then my wife and I will be the most tired. Maybe we will be the most frustrated, and the likelihood is that if something goes wrong in that last part of the drive, we’ll feel it very much. Because we are both tired and a bit frustrated, that makes it more likely that we have an argument, and if we have an argument while we are tired and frustrated, it makes it more likely to be a bad argument.

One simple way in which I can reduce this risk is to break the drive in two parts, have an overnight stay so that there is no point at which we are the most tired at the same time, which is a factor that might create a problem. This concept is also useful because we often think we have a certain capacity to make decision but the problem is our decision-making is usually better when we need it the least and it’s the worst when we are stressed because we have a situation that requires decision-making. Another problem, for example, is that usually our investors trust us the least the moment when we need their trust the most. Risks and problems tend to cluster in the same block of time, making risk multiply in a way that is not apparent in simulations or many risk models.

One thing you want to think about is how you can make sure that those risks are as distributed as possible over time. You probably know the specific tactics better than me. I know, for example, that some investors only require clients to make decisions like whether to stay invested or not once every quarter. I know that some investors try to focus on ways to spread the risk over time. If they know that certain periods will have concentrated risk, they take precautions in advance. So, think about this aspect, that risks tend to cluster together, and think how to decluster risks so that they do not happen all the same time. If you can do that, your decision-making will be the best when it’s required and your clients will be willing to give you trust when you need it.

John Mihaljevic: I guess the concept also applies over a lifetime when I think of one’s reputation, how we can use ergodicity to illuminate what I think most of us understand intuitively in terms of how we treat other people or cut corners in life.

Luca Dellanna: Yes, that’s an excellent point, John. Reputation is also very much non-ergodic in the sense that you do not really care about the average reputation of a person’s actions because it only takes one bad action to destroy the trust you have in someone or the trust people have in you. The problem is that this is tricky, and I use the example of lying in Winning Long-Term Games. Let’s imagine lying only has a 1% chance of getting you caught. This makes it seem a great strategy because it means that by lying, you have a 99% chance of getting away. However, if you lie every week, you have a 99.5% chance of getting caught over five years.

The reason I’m talking about this is because there are a few investors – and a few people in general – who take actions that put at risk their trust, but because the chances of destroying trust are small, maybe they get away with it for a few years, which makes them think it’s a great long-term strategy. However, it’s not because over the long term, you will get caught, your reputation will be destroyed, and that will be terrible.

Here’s where it gets tricky. Let’s say you truly believe that you should always be sincere with your clients, and you start working like that for one year, two years, three years. Then you notice there are a few competitors of yours who instead lie to their clients or maybe exaggerate some potential returns. Because of that, they are becoming more successful than you. At this point, you feel like you’re falling behind, like maybe their strategy is better. It takes a lot of determination to avoid switching from your good, long-term strategy to the worse strategy of these other people, which only looks better because we are examining it over the short term.

I always give the example of the casino croupier. In the casino, the croupier is the only person at the gambling table who has a money-making strategy. All the players have a strategy that is expected to lose money over time. However, every day, the croupier sees at least one player getting wildly rich, and they must resist the temptation to switch from their good, long-term strategy to the worse strategy of the players, which is a money-losing strategy even if today it looks like it produced a lot of returns.

The same applies when we look at our competitors. Perhaps they have a strategy that looks better in the short term, maybe a strategy of lying or exaggerating returns, but it looks better only because we’re seeing the short-term consequences. In the long term, it’s a worse strategy, but it takes resolution and long-term evaluations to have the determination to stay with our good long-term strategy, even when it feels like we’re falling behind in the short term.

John Mihaljevic: If we wanted to be a little cynical, we can say that a lot of clients or people in general tend to have short memories. A country that defaulted on its debt 10 years ago can now raise debt again from investors who weren’t involved before and don’t have that memory. Similarly, a hedge fund manager who blew up once goes out all of a sudden some years later and is able to raise a lot of money again. How can we work the short memory issue into this analysis? How do you think about that?

Luca Dellanna: There are two parts to the answer. First, from a societal point of view, I think journalism and similar professions should do a much better job of reminding people of what happened in the past and of the risks that are still there even though they haven’t manifested yet because of survivorship bias and luck. The second part is that investment funds and similar entities have to educate clients, make them understand the risk, make them understand that two percentages that look the same on the paper of return are not the same if they were achieved taking different risks. The risks are not always quantifiable because a lot of quantifiable looks at what manifested in the past, not necessarily what manifests in the future.

These are things people should be educated about. I know some people don’t have the language or the examples to educate, which is the main reason I wrote Ergodicity and Winning Long-Term Games. They contain language and examples people can use to educate others. The example of the skier and other examples in the book can be used when you’re talking to clients and explaining why this thing that looks successful is actually risky or why you’re aiming for a return that’s a bit lower than what your competitors are aiming for (because you can achieve it with much higher reproducibility). There are examples and stories you can use, and they go a long way in educating clients.

John Mihaljevic: I’m really curious about something, so let me ask you this final question. You are so productive and prolific that I’d love to hear about your writing process and how you manage to bring so much value to all of us.

Luca Dellanna: Thank you. I think my key to writing well is that I only write about things I’ve worked on in the past. All of my books come from my consulting work. When I notice that my clients have a recurring problem or a recurring question and there is a recurring solution that works, I know I have material for a book.

In my opinion, this is a good approach for two reasons. One, it’s more likely that the book’s contents are useful to the readers. Two, when you write about something you’ve discussed over and over with other people, writing becomes so much faster. This is why I’m able to produce books so fast – the writing process started years earlier with all the conversations I had with my clients, and that’ incredibly helpful. Some try to write in a vacuum. They don’t start with “I have something that would make a good book” but with “I want to write a book. What can I write it about?” This makes it less likely that the book will be about something useful. It also makes the writing process much more painful because now they need to think of what to write about and how instead of simply referring to conversations from the past.

John Mihaljevic: That’s a great approach. Luca, thank you so much for taking the time to have this conversation. I learned a lot, and I’m sure our members did as well. I hope to reconnect with you on another occasion to talk about one of your other great books.

Luca Dellanna: Thank you, John, it was my pleasure. I would also love to chat with you again.

About the interviewee:

A mechanical engineer by training, Luca Dellanna decided to quit his corporate job to become an independent researcher and author and shed light on the topics of nonlinearities on human collective behavior. Luca believes that those topics are essential for preventing human suffering, especially as the scale of our civilization keeps increasing.His style is concise and direct, focused on cause-effect relationships. He rejects top-down theories and explains most real-world phenomena with bottom-up hypotheses. Luca published his first book, “The Control Heuristic: Explaining Irrational Behavior and Resistance to Change”, in 2017. In the following year, he published another book titled “The World Through a Magnifying Glass: A New Theory to Explain Autism” and followed it up with “The Power of Adaptation”. Luca writes regularly on Twitter (@DellAnnaLuca). His personal website is luca-dellanna.com.

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