A classic case on incentives is Federal Express. The heart and soul of their system which creates the integrity of the product is having their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation can’t deliver a product of full integrity to FedEx customers.
And it was always screwed up at one time. They could never get it done on time. They tried everything you named it and nothing worked.
Finally, someone came along with the idea to pay all these people not so much an hour, but so much a shift and “bam”, it’s all solved. And when it’s done, they can all go home. Well, problems cleared up overnight.
So, getting the incentives right is a very, very important lesson. It was not obvious to FedEx what the solution was. But maybe now, it will hereafter more often be obvious to you.
As we’ve recognized that the market is efficient as a pari-mutuel system is efficient for the favorite to be more likely than the long shot to do well in racing, but not necessarily giving any betting advantage to those who bet on the favorite.
In the stock market, some railroad that’s beset by better competitors may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So, it’s just like a pari-mutuel system. Any fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasn’t so clear anymore what was going to work best for a buyer choosing between the two stocks. So it’s a lot like the pari-mutuel system and, thus, it gets very hard to beat.
So, what style should the investor use as a picker of common stocks in order to beat the market, in other words, to get an above average long-term result? A standard technique that appeals to a lot of people is called “sector rotation.” You simply figure out when oils are going to outperform retailers, when car manufacturer are going to outperform oils and so on. You just kind of dart around being in the hot sector of the market by making better choices than other people. And presumably, over a long period of time, you get ahead. However, there’s no truly known investor who got successful or really rich in this fashion. Maybe some people can do it and no one is saying they can’t. All that is known is so far no one can give an example of someone who got really rich and successful by practicing it consistently in the long run. And conversely, there’re many successful investors who did not do it this way.
The second basic approach is the one that Benjamin Graham used – much admired by Warren Buffet and Charlie Munger and many other successful value investors. He had this concept of value to a private investor – whereby what the whole enterprise would sell for if it were available. And that was calculable in many cases.
Then, if you could take the stock price and multiply by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business. This significant excess of real value per share that is working for you means that all kinds of good things can happen to you. You had a margin of safety as he puts it by having this big excess value going for you.
But he was, by and large, operating when the world was in shell shock from the 1930s which was the worst contraction in the world in about 600 years. Wheat in Liverpool got down to something like a 600-year low, adjusted for inflation. People were so shell-shocked for a long time thereafter that Benjamin could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on. And in those days, working capital actually belonged to the shareholders. If the employees were no longer useful, you just sacked them all, took the working capital and stuck it in the owner’s pockets. That was the way capitalism worked then.
In modern times, the accounting is not realistic because the minute the business starts contracting, significant assets are not there. Under social norms and the new legal rules of civilization, so much is owed to the employees that the minute the enterprise goes into reverse, some of the assets on the balance sheet are not there anymore.
However, that may not be true all the time. If you run a little auto dealership yourself and run it without any health plan, unions and so on, you can still take your working capital home and close your business. But in businesses like IBM, General Motors, they can’t or at least they didn’t. Just look at what disappeared from its balance sheet when it decided to change size both because the world had changed technologically and because its market position had deteriorated.
And in terms of blowing it, IBM is some example. Those were brilliant, disciplined people. But there was enough turmoil in technological change that IBM got bounced off the wave after “surfing” successfully for 60 years.
At any rate, the trouble with what is called the classic Ben Graham’s concept is that gradually the world wised up and those real obvious bargains disappeared. You could run your Geiger counter over the rubble and nothing clicked. But such is the nature of people who have a hammer – everything seems like a nail. So, Ben Graham followers responded by changing the calibration on their Geiger counters. In effect, they started defining a bargain in a different way. And they kept changing the definition so that they could keep doing what they’d always done. And it still worked pretty well. So the Ben Graham intellectual system was a very good one.
Of course, the best part of it all was his concept of “Mr. Market.” Instead of thinking the market was efficient, he treated it as a manic-depressive who comes by every day. In some days, Mr. Market comes by and says, “I’ll buy your interest at a price that’s way higher than you think it’s worth.” And you get the option of deciding whether you want to sell your interest to him, buy his interest or do nothing at all.
To Benjamin, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct. And it’s been very useful to many value investors over their lifetime.
However, his concept was not totally unflawed. If Warren Buffett had stayed totally with the classic Benjamin way, Berkshire would surely not be where they are now – not even close to it. And that’s because Graham was not trying to do what Berkshire did. For example, Benjamin didn’t want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use. And he didn’t feel that the man on the street could run around and talk to management and learn things. He also had a concept that the management would often couch the information very shrewdly to mislead. Thus, it was very difficult.
And with the way Warren Buffett started out as a pure Grahamites which was actually a fine way, he gradually got what is better insights to value investment. He realized that some company that was selling at 2 or 3 times book value could still be hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.
And once he gotten over the hurdle of recognizing that a business could be a bargain based on quantitative measures that would have otherwise horrified Benjamin, he started looking out for better businesses. For example, he got American Express and Disney when they got pounded down.