Lecture 02

Multidisciplinary Thinking

Cost of machinery: Rs 10 cr.

Expected life of machine: 10 years

Annual savings: Rs 2.50 cr. p.a.

Expected residual value of the machine: Rs 1 cr.

Cost of capital: 15% p.a.

Accept or reject?

You are the CFO of a textile company which manufactures commodity yarn and operates in an extremely competitive market.Both industry, and your company, earns sub par return on capital.A textile machinery manufacturer approaches you with a proposal to sell you a new type of textile machine, which is more efficient than any machine invented till date.What does DCF teach you?

Accept or reject?

Which Tool Did You Use?

!

DCFWhere discipline does DCF belong to?!Corporate Finance

What did he do?

He SHUT DOWN the

Textile Operation!

WTF?

Is he crazy? Who is this guy?

Why did he do it?

Buffett does not have an MBA :-)!How did he solve the problem? Lets read his own words. And as I read the words, focus a bit on the highlighted text.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess

capacity exists.

Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries

whose workers are paid a small fraction of the U.S. minimum wage...

Commodity + Excess Capacity due to Competition = Perfect Competition [Microeconomics]

Over the years we had the option of making large capital expenditures in the

textile operation that would have allowed us to somewhat reduce variable costs... Each proposal to do so looked like an

immediate winner...

Measured by standard return-on-investment tests, in fact, these proposals

usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-

profitable candy and newspaper businesses...

But 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 industrywide...

Viewed individually, each companys 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)...

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-

growing amounts of capital...

After the investment, moreover, the foreign competition would still have

retained a major, continuing advantage in labor costs...

A refusal to invest, however, would make us increasingly non-competitive, even

measured against domestic textile manufacturers...

And so, Mr. Buffett shut down the textile business of Berkshire Hathaway

But what about cost accountants and their idea of shut down point?

Whats the problem with people who only use DCF or Cost Accounting concepts like shut down point?

To a Man with a Hammer, Everything Looks Like a Nail

[Buffett] knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product...

would all go to the benefit of the buyers of the textiles. Nothing was going to [come to us] as owners...

Thats such an obvious concept that there are all kinds of

wonderful new inventions that give you nothing as owners...

except the opportunity to spend a lot more money in a

business thats still going to be lousy...

!The money still wont come to you. All of the advantages from great improvements are going to flow through to the customers

Conversely, if you own the only newspaper in town and they were to invent more efficient ways of composing the newspaper...

then when you got rid of the old technology and got new, fancy computers, then all of the savings would come right through to the bottom line...

In all cases, the people who sell the machinery and even the internal bureaucrats urging you to buy the

equipment...

show you projections with the amount youll save at current prices with the

new technology...

However, they dont do the second step of the analysis which is to determine how much is going to stay home and how much is just going to flow through to the customer

Ive never seen a single projection incorporating that second step in my life. And I see them all the time...

Rather, they always read: This capital outlay will save you so much money that it will pay for itself in three years

payback period

So you keep buying things that will pay for themselves in three years

And after twenty years of doing it, somehow youve earned a return of only about four percent per annum. Thats the textile business...

And it isnt that the machines werent better. Its just that the savings didnt go to you...

The cost reductions came through all right. But the benefit of the cost reductions didnt go to the guy who bought the equipment...

Its such a simple idea. Its so basic. And yet its so often forgotten.

How did he decide?

Buffett doesnt suffer from man with a hammer

syndrome

He used several tools

All the wisdom in the world is not to be found in

one little academic department.

That would be a disastrous way to think and operate.

!

!

!

If all you have is one tool, you will tend to overuse it.

Buffett used several tools from MULTIPLE disciplines

Buffett jumped over

jurisdictional boundaries of

multiple disciplines

Which boundaries did Buffett jump over?

Which mental models did he employ from which disciplines?

Competition [Microeconomics]

1 2 3 4 5 6

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)...

Buffetts metaphor of the parade is the functional equivalent of which

mental model?

Prisoners Dilemma [Game Theory]

1 2 3 4 5 6

Actions that are rational at the individual level, if copied, become irrational at the group level.!http://en.wikipedia.org/wiki/Prisoner's_dilemma

In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor.

Return on Capital [Accounting]

1 2 3 4 5 6

Opportunity Cost [Microeconomics]

1 2 3 4 5 6

He compared his prospective investment for efficiency improvement in textile with those in newspaper and candy.!And the IRRs were LOWER in Candy and Newspaper. But he was going to RETAIN ALL OF THE BENEFIT of the investment in candy and newspaper and none of it in textiles.

Contrast Effect [Psychology]

1 2 3 4 5 6

Did not fall for the throwing good money after bad trap even though the money to be spent was small in comparison with money already spent.

Commitment & Consistency [Psychology]

1 2 3 4 5 6

Sunk costs are irrelevant. He did not think Oh I have already invested so much. Now I cant write it off.

Buffett used a framework of mental models

from multiple disciplines

Competition [Microeconomics]

Prisoners Dilemma [Game Theory]

Return on Capital [Accounting]

Opportunity Cost [Microeconomics]

Contrast Effect [Psychology]

Commitment & Consistency [Psychology]

Mental Models

A mental model is a representation

inside your head of an external reality

You observe something and then you try to relate to it a model inside your head.

Herb Simon

Nobel Laureate

Mental Models are his idea

!Simon influenced Charlie Munger about

mental models

One can train a man so that he has at his disposal a list or repertoire of the possible actions that could be taken under the circumstances...

A person who is new at the game does not have immediately at his disposal a set of possible actions to consider, but has to construct them on the spot, ... a time-consuming and difficult mental task...

The decision maker of experience has at his disposal a checklist of things to watch out for before finally accepting a decision.

Expert fire fighters, chess grandmasters seek patterns.

A large part of the difference between the experienced decision maker and the novice in these situations is not any particular intangible like judgment or intuition...

If one could open the lid, so to speak, and see what was in the head of the experienced decision-maker, one would find that he had. . . at his disposal...

repertoires of possible actions; that he had. . . checklists of things to think about before he acted; and that he had mechanisms in his mind to evoke these, and bring these to his conscious attention when the situations for decisions arose.

Most of what we do is to get people ready to act in situations of encounter consists of drilling in these lists into them sufficiently deeply so that they will be evoked quickly at the time of the decision.

Thats my job - to train you to think in a checklist style. Your checklist will have mental models, and you will use your experience (direct and vicarious) to relate what you see in the world to whats on your list of mental models.!The expert KNOWS what he has to do e.g. an experienced fire fighter- what appears to be intuition and gut feel and blink, is actually based on experience and models.

To think much better, youll need a checklist of

mental models

These mental models will come from multiple disciplines

Economics, Psychology, Accounting, Chemistry, Physics, Mathematics, Engineering and Evolutionary Biology.

http://www.thebrain.comMy latticework of mental models

!About 20 models from psychology

will become behavioral finance

Why do you need a checklist?

Because the human mind is like the

human egg

As soon as a sperm enters the egg, theres an automatic shut-off device that bars other sperms from getting in.

Mind jumps to conclusions: First conclusion bias

Is commodity price rise bad for

commodity users?

Example: steel price hike and its effect on auto

Youve got to have models in your head. And youve got to array your experience both vicarious and direct on this latticework of models...

Students who just try to remember and pound back what is remembered, well, they fail in school and fail in life. Youve got to hang experience on a latticework of models in your head.

To acquire general wisdom, you need:

1.A checklist of mental models

2.A good search engine in your brain i.e. a system of relating experience to the models on your checklist

Youre not to going to get very far in life based on what you already know...

Youre going to get ahead in life in what you learn after you leave here. -speaking to students at USC Law School

Direct Experience &

Vicarious Experience

You don't have to pee on an electric

fence to learn not to do it.

The man who does not read great books

has no particular advantage over a man who cannot

read them. - Mark Twain

We learn more from the great business magazines than we do anywhere else...

It's such an easy shorthand way of getting a vast variety of business experience just to riffle through issue after issue after issue covering a great variety of businesses...

And if you get the mental habit of relating what you're reading to the basic structure of the underlying ideas [i.e. mental models] being demonstrated, you'll gradually accumulate some wisdom about investing.

If you want to get smart, the question youve got to ask is why? why? why? And you relate the answers to a structure of deep theory. [Mental Models]

To acquire general wisdom, you also need:

3.Full attribution ethos; and

4.Extreme reductionism (like in algebra) to understand lollapalooza outcomes

e.g. 2x + 6y = 12 can be reduced to

x + 3y = 6.

If you dont attribute the models you are using to the discipline you are grabbing them from, you get a sloppy filing system in your brain.

Lollapaloooza = 1+1 = 3 e.g like in a chain reaction - critical mass - a model from physics.

Working backwards from lollapalooza !

If you want to rise in the world above others you just must use the mental model framework in a checklist style fashion - otherwise it will be an unequal contest like that of a one-legged man in an ass kicking contest.

EXAMPLE

Quote: lets all play carefully guys so that we can all win a little!

Mental Model:

Zero-sum game

Key phrase:

FUNCTIONAL EQUIVALENT

Can you name a couple of functional equivalents to a zero-sum game in finance?

Overpriced

Is not an offer for sale in an overpriced IPO the functional equivalent of a zero-sum game?

A stock buyback at a bargain price

Is not a stock buyback at a bargain price the functional equivalent of a zero-sum game?

Day trading

Are not day traders, in aggregate, the functional equivalent of a group playing a zero-sum game?

EXAMPLE

Economic law: If you want to sell more, you have to reduce the price. Provide two exceptions.

Exception # 1: Luxury goods

Pavlovian Association: [Psychology]

Exception # 2: Raise price, use extra money to bribe the intermediaries

Incentives: [Economics]

Incentive-caused bias (whose bread I eat, his song I sing): [Psychology]

e.g. penny stocks, IPOs, cocaine, time shares, overpriced-insurance, ANY

product or service with a FAT commission behind it

The FUNCTIONAL EQUIVALENTS of Boiler RoomsApplication of CIALDINI

Whats all this got to do with this guy?

David Ricardo

Ricardos idea: Comparative advantage !

Trade benefits trading partners. Trade is NOT a zero-sum game

!

But when intermediaries are bribed massively, does it not become the

functional equivalent of a zero-sum game?

Firms of old standing vied one with the other in foisting unremarkable rubbish on the guileless investor. from an article on investment bankers published in

1894.

foisting unremarkable rubbish on the guileless investor...

Examples of how even now, under the influence of fat incentives, investment bankers bring fraud companies to market.

EXAMPLE

Feedback Loops [Engineering]

Negative feedback: Bathroom Gyeser

Positive feedback: Nuclear Chain reaction

Negative feedback loops: from physiology- Body temperature, blood clotting, digestive system- SELF CORRECTING

Functional Equivalents?

Positive - Spiral, runaway, vicious circle - business success - e.g. wall mart

Business Cycles- Negative Feedback

Business cycles - booms follow busts follow booms - Feedback loop, power of incentives (psychology), envy (psychology), overoptimism (psychology), prisoners dilemma (game theory), Tobins Q (microeconomics).

Bank Runs (Positive Feedback)

Low prices and high volumes feed on each other

Dominant newspaper (Circulation and advertising feed on each other)

Positive Feedback

Business Cycles- Negative Feedback

Business cycles - booms follow busts follow booms - Feedback loop, power of incentives (psychology), envy (psychology), overoptimism (psychology), prisoners dilemma (game theory), Tobins Q (microeconomics).

Bank Runs (Positive Feedbacks)

Bank runs

Leverage in positive feedback loops

EXAMPLE

Regression to the Mean [Statistics]

Powerful model applicable in a bell curve world.

Coin flipping example

Mean as an attractor

Stock prices and Stock returns

Bull markets and Bear markets can obscure mathematical laws, they cannot repeal them. Buffett

Notice Buffetts extreme reductionism?

In the short run the market is a voting machine, but in the long run its a weighing machine. - Ben Graham

Many shall be restored that are now fallen and many shall fall that are now in honor - Ben Graham Quoting Horace

EXAMPLE

Define Ponzi Scheme [Mathematics]

One of historys greatest swindlers

Ponzi scheme is also called the pyramid scheme

A non-sustainable business model involving the exchange of money primarily for enrolling other people into the scheme, usually without any product or service being delivered.

The answer comes from mathematics. You will eventually run out of greater fools. What happened to dot coms?Ponzi Scheme is a special case of which MENTAL MODEL already discussed?See the POWER of using a mental model framework? You KNOW WHAT WILL HAPPEN.You become a BETTER predictor of future - u get an advantage over the rest of humanity who dont see ponzis where u can see them...Tiny advantages, magnified over a long time make huge differences in eventual outcomes - compound interest.

Functional Equivalents?

chain letters, robbing peter to pay paul, greater fools, venture cap (partly), yield traps in RIETS and other stocks, multi-level marking (Amway), pension funds (EMBEDDED PONZI), Floats

EXAMPLE

The Red Queen EffectIn Lewis Carrolls Through the Looking Glass, the Red Queen seizes Alice by the hand and draggs her, faster and faster, on a frenzied run through the countryside, but no matter how fast they run they always stay in the same place. Alice is understandably puzzled, and says, Well in our country you'd generally get to somewhere else - if you ran very fast for a long time as we've been doing. A slow sort of country! Says the Queen. Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!

From Deep Simplicity:!Kauffman is particularly fond of describing this in terms of an imaginary species of frog that feeds on an imaginary species of fly, and we will follow his example. There are lots of ways in which the frogs, who want to eat flies, and the flies, who want to avoid being eaten, interact. Frogs might evolve longer tongues, for fly-catching purposes; flies might evolve faster flight, to escape. Flies might evolve an unpleasant taste, or even excrete poisons that damage the frogs, and so on. Well pick one (hypothetical) possibility. If a frog has a particularly sticky tongue, it will find it easier to catch flies. But if flies have particularly slippery bodies, they will find it easier to escape, even if the tongue touches them. Imagine a stable situation in which a certain number of frogs live on a pond and eat a certain proportion of the flies around them each year!...Because of a mutation (or even just through the natural variations between individuals) a frog developes an extra sticky tongue. It will do well, compared with other frogs, and genes for extra sticky tongues will spread through the frog population. At first, a larger proportion of flies gets eaten. But the ones who dont get eaten will be the more slippery ones, so genes for extra slipperiness will spread through the fly population. After a while, there will be the same number of frogs on the pond as before, and the same proportion of flies will be eaten each year. It looks as if nothing has changed but the frogs have got stickier tongues, and the flies have got more slippery bodies.

In August 2000, Jerry Mayfield, a forty-one-year-old Louisiana policeman diagnosed with CML, began treatment with Gleevec. Mayfields cancer responded briskly at first. The fraction of leukemic cells in his bone marrow dropped over six months. His blood count normalized and his symptoms improved; he felt rejuvenatedlike a new man [on] a wonderful drug. But the response was short-lived. In the winter of 2003, Mayfields CML stopped responding. Moshe Talpaz, the oncologist treating Mayfield in Houston, increased the dose of Gleevec, then increased it again, hoping to outpace the leukemia. But by October of that year, there was no response. Leukemia cells had fully recolonized his bone marrow and blood and invaded his spleen. Mayfields cancer had become resistant to targeted therapy. ! Even targeted therapy, then, was a cat-and-mouse game. One could direct endless arrows at the Achilles heel of cancer, but the disease might simply shift its foot, switching one vulnerability for another. We were locked in a perpetual battle with a volatile combatant. When CML cells kicked Gleevec away, only a different molecular variant would drive them down, and when they outgrew that drug, then we would need the next-generation drug. If the vigilance was dropped, even for a moment, then the weight of the battle would shift. In Lewis Carrolls Through the Looking-Glass, the Red Queen tells Alice that the world keeps shifting so quickly under her feet that she has to keep running just to keep her position. This is our predicament with cancer: we are forced to keep running merely to keep still.

Inflation

=

Running Up on a Down Escalator

If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you wont eat richer.!High rates of inflation create a tax on capital that makes much corporate investment unwiseat least if measured by the criterion of a positive real investment return to owners. This hurdle rate the return on equity that must be achieved by a corporation in order to produce any real return for its individual ownershas increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.!

A Bad Business = Running Up on a Down Escalator

The worst business of all is the one that grows a lot, where youre forced to grow just to stay in the game at all and where youre re-investing the capital at a very low rate of return.

Ben Grahams Frozen Corporation

Frozen Corporation was a metaphorical company whose charter prohibited it from ever paying out anything to its owners or ever being liquidated or sold.!And Grahams question was, What is such an enterprise worth?

Munger Identifies Functional

Equivalents of Frozen

Corporation

I think there is a class of business where the eventual cash back part of the equation tends to be an illusion. There are businesses like that where you just constantly keep-pouring it in and pouring it in, but where no cash ever comes back.

A Drop of 95%

Company never made any real profitsDistributed dividends came not through real earnings but from new cash provided by stockholders and lenders.Rapid obsolescence = High Maintenance Capex

EXAMPLE

Take a look at this commercial. It has all the attributes of an effective commercial. See for yourself:!YouTube - Awesome "Buckle Up" PSA Commercial!http://www.youtube.com/watch?v=m6ZKVdKTWww

The PSA commercial on previous slide was persuasive, but was it right? Take a look at this:YouTube - Sam Peltzman on the Peltzman Effect!http://www.youtube.com/watch?v=7IB2xRfRHOA!Peltzman effect - Wikipedia, the free encyclopedia!http://en.wikipedia.org/wiki/Peltzman_effect!The Peltzman effect is a contributing factor in the explanation of Smeed's Law, an empirical observation that traffic fatality rates in many countries are correlated with the number of vehicle registrations per capita, and differing safety standards do not appear to be significant.!Peletzman effect is a mental model which tells you to not ignore the second or third order effects like the designer of the incentive scheme which rewarded students a $1 for catching a rat on campus after all other efforts to get rid of the rats failed. Well, pretty soon, the students were breeding rats!People not only respond to incentives, sometimes ones well-intentioned decisions result in perverse outcomes. We call that perverse incentives. Read more about this from:!http://en.wikipedia.org/wiki/Perverse_incentive

Functional Equivalents?

! ! Moral Hazard! ! Incentive compensation based on wrong parameters! ! ! ! Stock Options! ! ! ! Commission on total profits! ! ! ! Top Line! ! ! ! Market Share! ! ! ! Return on Capital!

!You can either control the price, or the

supply, but not BOTH!

!

See Will Indian Steel Disappear?

!

Black Markets License raj

Ration shops

http://www.blonnet.com/2004/08/31/stories/2004083100111100.htm!If you fix price too low, supply will vanish!If you fix the supply (e.g. license raj) and then try to impose price controls also, you will see a black market emerge.!Low price of diesel vs petrol vs CNG!Smugglers and black marketeers vs. Arbitrageurs

See the connections between mental models from multiple

disciplines?

Thank you