Sunday, May 27, 2007

Solving the man with a hammer syndrome

Charlie Munger always quoted the following symptom of human: “To a man with a hammer, everything seems like a nail.”

For most CFO or CEO of any operating business, they would more often than not come across a situation where they have to make a decision either to deploy capital in some newly available machinery or process in the market.

Imagine you are the CFO of a textile company which makes commodity yarn. The industry in which you operate is extremely competitive beset with excess capacity.

A leading textile machinery manufacturer’s marketing agent approaches you with a proposal to sell you a new loom which is more efficient than any other loom available in the market. He informs you that the new invention is far more efficient and that it’ll save your company a substantial sum of money every year, so that it will pay for itself in a very short span of time. To justify his claims, he presents you with the following figures: 1) The cost of the machine at $100 million, 2) expectancy lifespan of 10 years, 3) savings in operating costs for the next 10 years at $25 million annually, and 4) expected residual value of the machine at $10 million.

The CFO then verified the numbers presented to him and find them to be accurate. His company’s pre-tax hurdle rate (cost of capital) is 15% p.a.

Should the CFO’s company then place orders to buy these looms?

Using the skills in the Discounted Cash Flow model, the CFO quickly determine the Net Present Value, which is large and positive, and conclude that the loom should be purchased and installed as soon as possible.

The main problem with this approach is that it often leads to the wrong conclusions because of the over-use of the DCF model in finance and ignorance of appropriate models from other disciplines such as microeconomics, game theory and psychology.

Charlie Munger call this “the man with a hammer” syndrome. If all a man has is a hammer, he’s going to end up using it for all situations.

How can one then deal with this syndrome? Well, the best way, according to Mr. Munger, is to train oneself to “jump jurisdictional boundaries” and grab the most appropriate models from multiple disciplines that best solve the problem at hand. In his words, one must have a “latticework of models.”

The present problem needs a two-step analysis drawing on models from multiple disciplines before coming to a conclusion.

The first step involves using the DCF analysis, which the CFO has no problem at all. That part of the analysis has been done and shown in the table above.

It’s the second part which the CFO misses. He misses it because he isn’t trained to think in a multi-disciplinary manner.

That second part of the analysis requires him to answer the following question: How much of the cost savings that the new loom will deliver be kept by the business and how much of it will flow to the company’s customers?

Now that gets a bit tricky, isn’t it? It gets tricky because to answer that question one has to grab models from microeconomics – such as the model of competition. And, surely, when you look at it from that angle, it’s obvious, that given the nature of the textile industry’s competitive nature, arising out of surplus capacity and commodity attributes of the products, most of the cost savings from the new loom will flow to the customers, not the owners. In other words, whatever additional capital the business spent, the business will gain not much of the anticipated savings that was presented by the marketing agent of the new loom.

This will happen because once a textile company acquires the new loom and achieves the promised cost savings, it’ll tend to either lower its prices to gain market share, or keep prices unchanged to earn higher margins. Sooner rather than later, these two actions would get noticed by the company’s competitors and they would naturally rush to make the same investment in the new looms, in order to regain market share or to earn higher margins. Ironically, the very salesman who sold the loom to the original textile company will rush to sell it to its competitors and cite the original textile company cost-saving achievement as a reason for your competitors to buy his company’s new invention. After all, he is not in the business to make your production process more efficient. He is in the business of making money for his company. And Charlie would say: “Whose bread I eat, his song I sing.”

In this problem, competition i.e. the absence of a cartel will ensure that almost all of the efficiency gains end up in the pockets of the buyers of textiles, and not in the pockets of the owners of the textile companies.

Another irony arises out of the fact that this tragic outcome would occur even though all of the promised efficiency gains materialized. It’s not that the new looms aren’t any good. In fact they are so good that any advantage for the early buyers will prove to be temporary illusion because sooner or later everyone has to have one or they risk being perished.

Such is the nature of certain businesses where you have to keep on putting more and more money in just to stay where you are. (It’s like attending a concert and you find those in front of you taller and you tip your toes to get a better view. But sooner the ones in front too face the same problem and they tip their toes too.) And you can keep on investing money in projects which are calculated to have positive NPVs and high internal rate of returns and you can still end up earning substandard returns on capital that destroy shareholder’s value if the CFO does not recognize the danger of the “man of a hammer” syndrome.

On the other hand, if we were dealing with the world’s largest beverage company like The Coca Cola Co., an almost monopoly where the buyers of its drinks are price-insensitive addicts. In addition, such business has what Warren Buffett terms as having a certain untapped price advantage. If someone sold a more efficient machine to make Coke, then the cost savings from this new wonderful invention will not be passed on to the customers and instead be retained by the business. Rather, much of the post-tax cost savings would accrue to the benefit of Coca Cola’s shareholders.

Without jumping over the jurisdictional boundary of finance where DCF resides, into the jurisdictional boundary of microeconomics where the model of competition resides, the CFO cannot solve the problem at hand in a satisfactory manner and may make an unwise decision when it comes to the deployment of capital. CFO must not only be good at numbers, they must in fact to good at thinking in a broad spectrum in order to make a logical capital deployment decision.

In early 1980s, Mr. Warren Buffett faced a similar dilemma in the management of the unprofitable textile business of Berkshire Hathaway. He knew that the U.S. textile industry was going to become increasingly uncompetitive, primarily due to its high, and impossible to reduce, labor costs. He also knew that he had other opportunities in which he could invest capital where the prospects of earning superior returns were excellent, given the fundamental economics of those businesses then available.

Long before most capitalists would even consider the possibility, in 1985, Mr. Buffett decided to shut down the textile operations of Berkshire and redeploy the capital in better businesses. It proved to be one of the best business decisions he ever made although it is one of his worst decision ever made when he initially bought Berkshire. In a letter written to the shareholder’s of Berkshire in 1985, he reasoned:

“The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry wide. Viewed individually, each company’s capital investment decision appeared cost effective and rational; viewed collectively; the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.”

Mr. Buffett utilized the metaphor of a parade to illustract a well-known problem in game theory called “Prisoner’s Dilemma.”

Prisoner’s dilemma involves two suspects, A and B, who have been arrested by the police. The police have insufficient evidence for a conviction, and, after separated both prisoners, offer each the same deal: if one testifies for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives the full 10-year sentence. If both stay silent, the police can sentence both to only six months in jail for a minor charge. If each betrays the other, each will receive a two-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. However, neither prisoner knows for sure what choice the other prisoner will make. So the question this dilemma poses is: What will happen? How will the prisoners act? The dilemma is summarized in the following table.

The dilemma came about when one assumes that both prisoners only care about minimizing their own jail terms. Each prisoner has two options: to get a light sentence by cooperating with the police by betraying his accomplice, or to stay to the pact and keep quiet. The outcome of each choice depends on the choice of the accomplice, but the player must choose without knowing what their accomplice has chosen to do.

Let’s assume prisoner A is working out his best move. If his partner stays quiet, his best move is to betray as he then walks free instead of receiving the minor sentence. If his partner betrays, his best move is to betray, as by doing it he receives a relatively lesser sentence than staying silent. At the same time, the other prisoner’s thinking would also have arrived at the same conclusion and would therefore also betray.

If reasoned from the perspective of the optimal outcome for the group (of the two prisoners), the correct choice would be for both prisoners to cooperate with each other, as this would reduce the total jail term served by the group to one year total. Any other decision would be worse for the two prisoners considered together. When the prisoners both betray each other, each prisoner achieves a worst outcome than if they had cooperated.

In other words, actions that appear to be rational from an individual’s perspective sometimes become foolish, when viewed from a group’s perspective. The functional equivalent of the prisoner’s dilemma in our problem at hand creates miserable choices but would we have discovered that unless we had jumped over into the jurisdictional boundary of game theory? I think not.

So, we grabbed DCF from finance, and then jumped over its jurisdictional boundary into the territory called microeconomics, where we grabbed competition. Then again we jumped over the fence into the boundary of game theory where we grabbed prisoner’s dilemma.

Now we are one jump away from, last but not least, jurisdiction of psychology. And then we can stop hopping about and solve the problem.

One model we will grab from psychology is what Mr. Munger calls “bias from commitment and consistency.” When you have already made prior commitments to pet projects, you may find it hard, even impossible, to reverse your position and change course. If old reasons are no longer valid to support original decision, new ones shall be invented. Man, after all, is not a rational creature, but a rationalizing one.

Yet another model to be grabbed from psychology is called the “contrast effect.” One version of the contrast effect makes small, incremental escalations in commitments go unnoticed, particularly when these escalations are carried out over a long period of time.

It works in brainwashing techniques. And it also contributes to foolish business decisions.

If you’ve already sunk in $100 million in a bad capital investment project, an additional investment of $100 million will look very small in contrast to the much bigger total commitment already made and will therefore tend to go unnoticed.

This version of contrast effect is also known as the “boiling frog syndrome:” If you put a frog in boiling hot water, it will jump out instantly, but if you put a frog in room-temperature watch and then slowly heat it, it will boil and die.

Of course, the story of the boiling frog isn’t true. That metaphor, however, is highly appropriate because the human equivalent of the boiling frog is there in all of us.

Mr. Buffett and Mr. Munger could see that bias from commitment and consistency and the boiling frog syndrome from psychology often combine with the prisoners’ dilemma model from the game theory, making many businessmen take unwise decisions by continuing to sink more and more money in a lousy business instead of taking money out and redeploying it more productively elsewhere. He realized that in some industries the chief problem is that if you continue to remain in the game, then “you can’t be a lot smarter than your dumbest competitor.”

Thus, they wisely refused to play this game and withdrew his capital from the textile business and reinvested in businesses with much better fundamental economics like Coke, Gillette, Capital Cities, and Nebraska Furniture Mart. Over time, his decisions to shut down the textile operations of Berkshire and to reallocate the released capital elsewhere have made its stakeholders richer by tens of billions of dollars.

Mr. Buffett’s and Mr. Munger’s multidisciplinary mind helped them solve a complex business problem. If CFO could learn to apply such thinking style instead of just relying on a single model, there would be a lot more happy stakeholders around.

Otherwise, most CFO are destined to remain as the “man with the hammer.”


fishman said...

haha since when you add graphics to your post?! Nice innovation!

BUt more importantly is the content of your post... WOW!

Never thought of things that way, though I think I'm applying it.

For example with my Unit Trust, I plan to transfer out of equity when markets plunge into my blanced fund to lock in the profits. And use fresh funds to buy into equity fund as it goes into new lows.

Dunno if that sort of tactical movemetns qualifies cutting loses and reinvesting to maximise returns?! Your advice?

Berkshire said...

Thanks Fishmen, I came across the picture and I find it amusing, so I just included that and it's isn't easy to even find a picture that is so related.

If I were to buy any unit trust or funds for the matter, I would chose a fund that is tied up to the general index like S&P500, DJIA or STI. And also as important, is to find a fund that is low in cost.

musicwhiz said...

To identify good investments, we need professionals who are good in many fields and not just focus on one particular discipline. Thus, I agree with your article which says that knowledge from many fields is required in order to make an informed decision.

I have long realized that a simple IRR or ROI computation (which includes discounted payback method) is insufficient for a true analysis of a potential investment or a planned capex decision. Many factors come into play to make the problem even more complex and only the best managers can know how to handle it. This is why good PEOPLE are hard to find, because good decisions cannot be evaluated by a computer or a system, but requires a human brain to analyse and dissect.