After doing a series of posts on this subject, recently, I presented my thoughts to students at MDI. That presentation can be downloaded from here and the slides along with my commentary are reproduced below.
Oh, I love those metaphors.
Once upon a time, I was reading an Aesop fable to my daughter.
The rabbit runs faster than the fox because the fox is only running for his dinner but the rabbit is running for his life.
I froze right there thinking
Hey Colgate is the rabbit and Unilever is the fox.
You see, Unilever had announced its intention to enter the toothpaste business. Market got spooked. Colgate stock fell.
An over-reaction obviously because
Colgate is the rabbit and Unilever is the fox
In a few weeks the market realised what Aesop had observed many centuries earlier. Colgate’s stock price recovered. Good trade. Thank you Aesop.
I have learnt that just as bacteria can’t grow exponentially for long, businesses too can’t grow exponentially for long regardless of what investment bankers say in their pitch books. I have discovered many hedgehogs who know just one thing, will over use it, and become supremely confident and a few foxes who use a multi-model framework, will use the appropriate ones to form their world views, and will never be absolutely sure of anything.
I have learnt the importance of cash in a portfolio from Buffett’s observation that if you want to shoot a rare, fast-moving elephant, you should always carry a loaded gun.
Aesop used the story of the swallow and other birds to teach me how evil spreads and why it’s terribly important to stop it early before it’s too late.
I have found opportunities when people throw out the baby with the bathwater or paint everything with the same brush.
Catching a falling knife is dangerous. And jumping out of a plane with a parachute which opens up 99% of the time ain’t worth it. If only the partners of LTCM had thought it that way, maybe they would have acted differently.
Victor Niederhoffer has observed that
In 1997, he bet heavily on Thai stocks using large amounts of leverage. Then the Asian financial crisis arrived and he blew up for the first time.
In the fall of 2001, he sold a large number of options, betting that the markets would be quiet, and they were, until two planes crashed into the World Trade Center. Niederhoffer blew up again.
Recently, he confessed
I made so many errors there it’s pathetic. I made one of my favorite errors: “The mouse with one hole is quickly cornered.” That is key. There are certain decisions you make in life that are irreversible, that lead you into a path you can’t get out of, and unless you have more than one escape clause, the adversary can gang up on you and destroy you.
Metaphors are useful. In fact you use them more often than you realise as George Lakoff and Mark Johnson write in their classic Metaphors We Live By. To see how, just imagine the conceptual metaphor ARGUMENT IS WAR and observe how it gets embedded in our everyday language.
Your claims are indefensible.”
“He attacked every weak point in my argument.”
“His criticisms are right on target.”
“I demolished his argument.”
“I’ve never won an argument with him.”
“You disagree? Okay, shoot!”
“If you use that strategy, he’ll wipe you out.”
“He shot down all of my arguments.
Metaphorical thinking is very powerful, says Roger von Oech, author of Innovative Whack Pack.
A wonderful harmony is created when we join together the seemingly unconnected.
A powerful way to join ideas together is to make a metaphor. You can do this simply by recognising similarities between unrelated phenomena. Indeed, this is how our thinking grows: we understand the unfamiliar by combining it to what we know. The first automobiles were called “horseless carriages.” Early locomotives were dubbed “iron horses.” Metaphors can also give us a fresh insight into a problem. For example, here are three metaphors for life. (1) Life is like a jigsaw puzzle but you don’t have the picture on the front of the box to use it as a guide. Sometimes, you’re not even sure if you have all the pieces. (2) Life is like a bagel. It’s delicious when it’s fresh and warm, but often it’s just hard. The hole in the middle is its great mystery, and yet it wouldn’t be a bagel without it. (3) Life is like a poker game. You deal or are dealt to. You bet, check, bluff, and raise. You learn from those you play with. Sometimes you win with a pair or lose with a full house. But whatever happens, it’s best to keep shuffling along.
What metaphors can you create?
You can extend the LIFE metaphor as George Lakoff and Mark Johnson do.
I’ve had a full life. Life is empty for him. There’s not much left for him in life. Her life is crammed with activities. Get the most out of life. His life contained a great deal of sorrow. Live life to the fullest.
I’ll take my chances. The odds are against me. I’ve got an ace up my sleeve. He’s holding all the aces. It’s a toss up. If you play your cards right, you can do it. He won big. He’s a real loser. Where is he when the chips are down? That’s my ace in the hole. He’s bluffing. The president is playing it close to his vest. Let’s up the ante. Maybe we need to sweeten the pot. I think we should stand pat. That’s the luck of the draw. Those are high stakes.
Sometimes metaphors clash so relying on the first one that comes to mind can be dangerous. For instance, when people think of first-mover advantage, they think of the early bird — you know the one who gets the worm?
Will that metaphor work every time. No!
To see why, think of
that second mouse— you know the one who got the cheese?
The big lesson here is that you must use metaphors but not overuse the ones that first come to your mind because that would make you look just like a man (or a woman) with a hammer.
Now, you wouldn’t want to be labeled that, would you?
Buffett tells us that the fundamental economics of a toll bridge are excellent. However, this post is not about a toll bridge. Rather, it’s about the “functional equivalents” of a toll bridge.
Now, apart from the reasons Buffett talked about, what are the other reasons that make a toll bridge a very good business model?
Now let’s think about what really happens on a toll bridge. If you stand at a vantage point high above the bridge, what do you see? Well, you see movement. You see traffic. And you see the toll barrier, i.e. the gateway. There has to be a gateway owned by someone and used by someone else to pass through. Vehicles passing through have to pay a toll. The toll keeper collects the money and opens the gate. Most of his effort came in making the toll bridge. Now, all he does is open the gate and collect the toll.
Now let’s see what we have. We have several key words or phrases to remember:
These terms constitute a “bridge” which will connect our physical toll bridge to the metaphorical one.
Do these terms remind you of something other than a physical toll bridge? Think about it for a while. What other business models require customers to pay the toll to use something that has no alternative in the mind of the users — something that involves movement of traffic and where the owner of the metaphorical toll bridge is the owner of a gateway?
In Orhan Pamuk’s best-loved novel “My Name is Red,” a chapter (“I am a Tree”) ends with this beautiful quote.
I thank Allah that I, the humble tree before you, have not been drawn with such intent. And not because I fear that if I’d been thus depicted all the dogs in Istanbul would assume I was a real tree and piss on me: I don’t want to be a tree, I want to be its meaning.
In the spirit of Orhan Pamuk’s metaphorical tree, our toll bridge is saying
I don’t want to be a toll bridge, I want to be its meaning.
Find other “toll bridges.” Here is a hint.
Post your thoughts. I will come back to finish this…
All right then. I have read your responses many of which were excellent!
It’s been such a long time. It feels good to be recognised at last. I am overwhelmed. You’ve figured out so many manifestations of me.
You spotted me in payment gateways like VISA and MASTERCARD. Billions of transactions go through me everyday.
You saw me in GOOGLE where advertisers pay me to make you discover them when you search for something that’s related to them. I am the gateway in the virtual world through which you end up going from where you are to where my customers want you to be.
In an earlier avatar, I used to be owned by newspaper and television tycoons. I was the gateway through which advertisers reached consumers but when GOOGLE arrived, I moved to greener pastures. As they say, the medium is the gateway.
You located me in the servers of the dominant stock (NSE) and commodity (MCX) exchanges, as well as transaction exchanges for second hand goods (EBAY). I am the gateway which allows billions of transactions to happen everyday and my owners take a cut every time a trade occurs.
You unearthed me in networks of gas pipelines (GAIL), electricity cables (POWERGRID). I am the gateway internet companies (BHARTI) use to make you pay for reading this. I am the network you use when you call your sweetheart or send him or her a gift (DHL).
Every year you notice millions of excited children rushing past me just to be close to a fictional character called Mickey Mouse.
Movie producers go through me to display their movies to you. Your iPhone has more than 50 apps bought from me — the iTunes store. Thousands of app writers pay me the toll to enable them to sell their apps to you. Hundreds of vendors use me — the amazon.com storefront — to sell their wares to you. They pay me a nice commission too, every time you buy.
If you are a company and you want to raise capital, you better go through me. I am the influential investment banker. I am the dominant credit rater. I can reduce your cost of capital. And I will collect my toll.
You found me in Religion too. I am the temple you give money to. Inside your mind, I am the
stairgateway to heaven.
You may think of me as evil, but look I am just a gateway who’s doing its job. You paid a bribe to a toll-keeper babu to move that environmental clearance file to that senior officer who has his own toll collector just outside her office. Yes, I know I am in trouble because of my friendship with a high-profile company. Arvind says I am its gateway for getting things done. Am I? I’ll leave that judgment to you.
So you see, I’ve been around. And I am awesome. But under what conditions do I become truly awesome? That happens if:
Now you know the criteria. But beware! There are many masqueraders out there pretending to be me. Why, only yesterday a brand was posing in front of you as me! Imposter!
Didn’t you know I don’t cost much to maintain? You don’t have to spend a fortune to take care of me. That’s not what happens with big brands. Their owners have to spend fortunes
investing in maintaining them — billions and billions of dollars every year. Brands are far more demanding than me. I don’t ask for much at all. My needs are few and far between. Just keep me in good shape by spending a little here and a little there and I will keep you happy year after year. When you think of me, think Vatican, not Coca-Cola.
There are some tiny toll bridges out there who aspire to be me one day. If you spot them early, and own them before they become big like me, you could become rich like me.
I can be yours, but first you’ll have to find me.
I got a mail from a student. Nikhil wrote:
Your approach to multidisciplinary thinking is highly pragmatic but it is an approach never taken in the entirety of our education. Throughout we are taught subjects individually and each of the problems that we are given is confined to the context of that particular subject only, even in our MBA the cases that we have usually try to deal with a business case within the context of a few concepts from a particular field such as marketing, finance or operations. Hence my problem is that I find it very difficult to be able to come out of the confines of one particular subject and think of a problem in a more holistic manner which would be useful in real life as well. The key issue is making a connect between the problem at hand and the list of mental models that you have stored away in the back of your head. Your functional equivalence approach is very useful but again how do you learn to apply it in situations? Can you guide me as to how I can start training myself to think in such a fashion, looking at a problem and coming up with a set of concepts to apply as in like the check-list you mentioned?
I promised Nikhil that I will write a teaching note. This is that note.
I am going to play a game based on ideas derived from Socrates and Charlie Munger. We will start with “Socratic Questioning” which is described as
disciplined questioning that can be used to pursue thought in many directions and for many purposes, including: to explore complex ideas, to get to the truth of things, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow out logical implications of thought, or to control the discussion.
Socratic Questioning relates to “Socratic Method,” which is:
a form of inquiry and debate between individuals with opposing viewpoints based on asking and answering questions to stimulate critical thinking and to illuminate ideas.
Charlie Munger started using these two Socratic devices in a variation he called Socratic Solitaire, because, instead of a dialogue with someone else, his method involves solitary play.
Munger used to display Socratic Solitaire at shareholder meetings of Wesco Corporation. He would start by asking a series of questions. Then he would answer them himself. Back and forth. Question and Answer. He would do this for a while. And he would enthral the audience by displaying the breadth and the depth of his multidisciplinary mind.
I am going to play this game. Or at least, I am going to try. Watch me play.
What are the rules? Here are some tips from Charlie.
So, that’s what I’ll do. I will pick up the newspaper and identify a story. I will then ask a question relating to the story which I will try to answer by relating what I read to multiple mental models in my head. As I do that, I will experience related thoughts. I will not control those thoughts. More questions will arise. I will continue to relate my thoughts and questions to mental models from multiple disciplines. I will allow my mind to wander from one discipline to another finding more questions and looking for answers. In seeking answers, I will need some tools.
I will use five tools: (1) My brain; (2) My computer; (3) Wikipedia; (4) Google; (5) a couple of cards from Creative Whack Pack; and (5) My Kindle.
Each of these has its own benefits and disadvantages. My brain cannot store everything, but is good at recognising patterns. I have a ton of stuff I have collected on my computer over the years and I am likely to find something interesting that is related to whatever I am investigating but my computer can’t possibly have everything that’s worth knowing on the subject. So, I’ll get leads and I will investigate by going to Wikipedia, which is a great free resource for research but I have to be careful about its accuracy. Google is a great search engine but it also produces results which can cause unnecessary distractions. On the other hand, my Kindle has a a better organised body of knowledge – my library of 396 books. Kindle has a search function which allows me to search for terms across all my e-books which solves the “I-know-I-have-seen-something-like-this-before-but-I-don’t-remember-where” problem in paper books. Moreover, I expect to serendipitously find things related to my search terms – things I did not know existed in my library but have popped up while I was searching. At the same time, I must be careful not to get too distracted.
So I have my tools near me. Now I need a topic.
Let these pictures give us the topic.
Oh Shit! Who died? Why are these women crying?
What’s going on here? What are these people doing? What’s that building in the background?
These people are protesting against the construction of a nuclear power plant on India’s East coast in a place called Kundankulam in Tamil Nadu. The building in the background is Kundankulam Atomic Power Station and the women in the earlier photograph are crying because they are petrified at the idea of living near a nuclear power plant. You can read more about the ongoing protests from here.
But wikipedia only tells us about this one project. Our task however, begins from here. Let me now put one of the cards from Creative Whack Pack on the table.
Let’s get curious like Leonardo da Vinci and ask some questions.
Why are these people protesting? What are they scared of? How can we learn more about what’s happening in Kundankulam? Are there any precedents? What do they tell us? Is is only about nuclear power or are there other situations where similar protests happen?
Before I attempt to answer these questions, let me first put my second card from Creative Whack Pack on the table.
Now, I am going to use my associative brain, together with my research tools to study this topic.
Here are some thoughts that immediately occur to me – in no particular order. I record them in a mind-mapping software. While playing socratic solitaire I am essentially brainstorming with myself, so organizing thoughts is not as important as capturing them in the first place.
While you read about these thoughts, also notice how my associative memory (connection with a mental model) works. Here are some thoughts.
Interesting ten thoughts, no? And they began after I saw a couple of vivid photos. Now I want to allow serendipity to help me even more. I will do this by employing the remaining two research tools: my computer and my kindle.
Over the years, I have accumulated so many documents on my computer that the space they take up adds up to about 300 gigabytes!
Now I know serendipity works beautifully. So let me search for the term “NIMBY” on my computer. Who knows what I might find? Let’s see.
Searching, searching, displaying search results…
Whoa! What an astonishing gem I found. Granted, it may not be directly related to NIMBY, but its bloody interesting to me especially in context of what’s happening in Indian power sector. What did I find?
I found extracts from talks given by Warren Buffett and Charlie Munger. Let me reproduce them here. Their words:
Buffett: Politicians don’t like to face major brownouts. They can try and blame it on someone else – and they may well be accurate in blaming it on someone else. But the public is going to, at least partially, blame political leaders if this country runs out of electricity – because it hasn’t run out of the ability to build generators. We could create all the generators we need to have plenty of electricity – and we could create the transmission lines and all of that.
But you do need a flow of capital to the industry. And the law restricts that flow to quite a degree, I would say.
Munger: Well, the production of electricity, of course, is an enormous business – and it’s not going away. And the thought that there might be something additional that we might do in that field is not at all inconceivable. It’s a very fundamental business.
You’re certainly right in that we have an unholy mess in California in terms of electricity. It reflects, I’d say, a fundamental flaw in the education system of the country; that so many smart people of all kinds – utility executives, governors, legislators, journalistic leaders – seemingly had difficulty recognising that the most important thing with a power system is to have a surplus of capacity. Is that a very difficult concept?
Everybody understands that if you’re building a bridge, you don’t want abridge that will handle exactly the maximum likely load and no more. You want a bridge that will handle a lot more than the maximum likely load. And that margin of safety is just enormously important in bridge-building.
Well, a power system is a similar thing. Why do all of these intelligent people ignore the single most obvious and important factor – and just screw it up to a fair-thee-well?
Buffett: Charlie’s obviously right in that from a societal standpoint, you’ve got perhaps three goals in what you would like your electric utility business to be. One is that you would like it to be reasonably efficiently operated. Secondly, since it does tend to have in many situations monopoly characteristics, you would want something that produced a fair return, but not a great return, on capital – enough to attract new capital. And then third, you’d want this margin of safety – this ample supply.
When you’ve got a long lead time to creation of supply –which is the nature of putting on generation capacity – you need a system that rewards people for fulfilling that obligation to maintain extra capacity. A regulated system can do that. If you give people a return on capital employed so that if they keep a little too much capital employed they get paid for it, then they’ll stay ahead of the curve – they’ll always have 15-20% more generating capacity than needed.
One of the disadvantages of that regulation and the monopoly nature is that it doesn’t have the spur to efficiency. They try to build it in various ways, but it’s difficult to have a spur to great efficiency if somebody can get a return on any capital they spend. Therefore, utility regulators have always been worried about somebody just building any damn thing and getting whatever the state-allowed return is.
But I’d say that the problems that would arise from, say, a little bit of sloppy management are nothing compared to the problems that arise from inadequate generation.
So in California, in my view speaking as an outsider, utilities had the incentive at one time to maintain a little extra generating capacity because they were allowed to earn a decent return on it – a return sufficient to attract capital.
But they you had, I think, the forced sell-off of something like half of their generating capacity. And they sold it at multiples of book value to a bunch of people who became generators who are deregulated and don’t have an interest in having too much supply. They’ve got an interest in having too little supply. So they totally changed the equation – because the fellow with the deregulated asset for which he paid 3 times book now has to earn a return on that 3 times book what the fellow was formerly earning under the regulated environment at 1 times book.
So he’s not going to build extra generating capacity. All that does is bring down the price of electricity. He hopes things are tight. If you’ve got a utility plant that was put in place at X and then you go out and encourage entrepreneurs to buy it at 3X, you can’t expect electricity prices to fall. So you’ve created a situation, in my view, where the interests of the utility companies have diverged in a significant way from the interests of society. And that was a very, very basic mistake. It just doesn’t make any sense to me – but maybe I don’t understand it fully.
I really think that the old system made more societal sense: Let people earn a good return (not a great return, but a return that attracts capital) on investment that has built into it incentives to keep ahead of the game on capacity because you can’t fine-tune it that carefully. And you do have this long lead time.
Now, what you do with the scrambled eggs now – with all the political forces back and forth… I think that you better have a system that encourages building extra capacity because you don’t know how much rainfall there will be in the Pacific Northwest and therefore, how much hydro will be available. And you don’t know what natural gas prices will do and, therefore, whether it’s advantageous for a gas-fired turbine to be operating.
The old system really strikes me as somewhat better than this semi-deregulated environment that we have more or less stumbled into. Charlie, what do you think?
Munger: Of course, even the old system got in some troubles. Everybody had the NIMBY syndrome – “Not In My Back Yard.” Everybody wanted new power plants to be anyplace not near me. If everybody feels that way and if the political system means that the obstructionists are always going to rule – which is true in some places in terms of zoning and other matters – you’re in deep trouble. If you let the unreasonable, self-centered people make all of the decisions of that kind, you may well get so that you just run out of power. That was a mistake.
And we may make that mistake with the oil refineries. We haven’t had many new big oil refineries in the last period. So you may get to do this all over again.
Shareholder: You talked about your interest in investing in new electrical capacity. Would you expound a little bit in terms of what you think would be a rational business model and a fair social model for doing so?
Munger: Well, of course, the energy situation in California is a disgrace. It’s a disgrace to our educators who turned out people who could make such dumb decisions in spite of going to the best colleges and the best business and law schools. It’s a disgrace to both political parties who sat around. It’s a disgrace to the executives that participated in making the decisions. There‚s enough disgrace to go around. There was an easy idea to retain when you’re running hospitals in the middle of a desert where it’s 110 degrees outside. It was not a radical, hard-to-grasp idea that the one thing the civilization always wanted was a surplus of generating power. Is that really difficult to understand? Well, of course it isn’t difficult. But all these people had these other models: If we simply have free enterprise‚ meaning deregulation, as they called it‚ it will automatically cause a surplus. Well, of course, it didn’t automatically cause a surplus. To have a surplus of generating capacity, you’ve got to have a surplus of well-fueled plants capable of generating the electricity.
And of course, there’s the system of allowing NIMBYism (Not In My Back Yard)‚ everybody wants the school, but not near me. So no new school is created for 10 years in Los Angeles and the kids are in unspeakable conditions. Everybody wants a power plant, but not near me. And if you just allow that kind of paralysis in our governmental system‚ We richly deserved this miserable result. We earned it fair and square by extreme stupidity and indifference. And we’re doing the rest of the country an immense favor. We’re like the canary in the mine that dies, but saves the other miners. State after state is looking at California and saying, Boy, have those guys done us a favor. That is one kind of stupidity we don’t want to have.
So, obviously, we need excess generating capacity. And we’ve got to reduce the pollution as much as we can. But once we’ve got it down as low as it’s feasible to get it, we’ve got to have the capacity. We also need conservation. We also need utility rates which encourage the right habits. There are perverse incentives built into the rates. And there are all kinds of ways that could have been done better. It’s obvious what should be have been done: the right incentives in the rates, always a surplus of power. This does not take great brain power. But we just mushed around in the same crazy way we did with the public schools‚ and we allowed something very important to go to hell. It was really awful behavior‚ awful cognition.
And what’s really bad is that you can go to modern academia right now and nobody’s ashamed of these recent bad results. They think if you teach about Beowulf, you’ve done your duty. And the fact that the people leave you and can’t think their way out of a paper sack is not their fault. But that’s not true. We should be graduating people from our educational institutions that can think better and behave better. Sometimes you have to stand up and do things that are against your own interests, but in the interests of the larger civilization. And we have all failed to a fair-thee-well.
That said, we’re going to need a lot more power. And there’ll be all kinds of creative ways to handle the thing. There will be some opportunities in the future. It’s a great, big permanent business. And electrical power is not going to be obsolete. There aren’t many fundamental things in nature. And one of them is electrical power‚ electromagnetism. It’s not going away.
Wow! Cool isn’t it? And how did I find this? By storing it when I read it many years ago, then forgetting about it, then while working on this project letting my mind wander and searching for NIMBY on my computer and finding it all over again!
Never ever underestimate the power of serendipity.
So what should we learn from the above extracts from Buffett and Munger?
Indian power tariffs just have to go up. The state electricity boards are bankrupt. If India wants more electricity it has to produce the right incentives. And allowing a decent rate of return isn’t sufficient. You have to ensure that the return is actually realized. If state electricity boards can’t and won’t pay electricity bills of generators, then the promised return is not earned, so India can forget about attracting private capital. Those half finished power plants which depended on “cheap” south-east Asian coal that became expensive later on won’t be finished unless tariffs were increased. It doesn’t matter what power purchase agreements say. If coal price is not allowed as pass-through the regulator or government can’t say too bad! If they do that, the plants won’t get finished and India must live with electricity shortage. Incentives matter.
If you keep on giving free electricity to farmers, then you will eventually get shortages. People will have perverse incentives to divert power from agricultural usage to non-agri usage. It’s very hard to stop it. Gujarat has done it. Every state must follow what it did. But do the politicians have the will (balls?) I doubt it. So until the politicians can be “convinced” that to get surplus power, the generators must be more than adequately incentivised, India power sector will suffer and India will suffer along with it. Nuclear power is cheap, and much safer as compared to coal power especially when health costs are concerned. Kundankulam Project must be finished.
Cool, now that I have given my sermon, I can move on to the last tool I will use for this exercise.
There are many reasons why my wife is jealous of my Kindle but one huge reason why I love it so much is it has an awesome feature. As I type this blog, I find that I have 440 books on my Kindle. That’s an enormous library isn’t it? When all my books were on paper, I had this problem which inevitably made me say these words:
Shit man, I have read about NIMBY in some of my books but I don’t remember which ones!
And then I would spend hours browsing through books looking for that elusive sexy girl called NIMBY but I could never find her. I had a faint recollection of spending some very enjoyable time her but I could not find her anymore.
Enter Kindle. End of problem. Kindle allows you to search across all your books on the device for NIMBY or SUZIE or any woman or idea or concept you want to search. It’s like a google search engine on your books.
So I will do that now. I will search for NIMBY on my Kindle.
Switch Kindle on. Go to Search. Type NIMBY. Hit enter. Searching searching searching. A list of book appears. I go though them one by one.
Whoa! Look what I found! This from an excellent book called The Little Book that Builds Wealth.
Moody’s, the slot machine industry, and the for-profit education industry are all examples of single licenses or approvals giving companies sustainable competitive advantages. But this kind of moat isn’t always based on one large license; sometimes a collection of smaller, hard-to- get approvals can dig an equally wide moat.
My favorite example of this is what I call the NIMBY (“not in my backyard”) companies, such as waste haulers and aggregate producers. After all, who wants a landfill or stone quarry located in their neighbourhood? Almost no one, which means that existing landfills and stone quarries are extremely valuable. As such, getting new ones approved is close to impossible.
Trash and gravel may not sound exciting, but the moat created by scores of mini-approvals is very durable. After all, companies like trash haulers and aggregate firms rely on hundreds of municipal-level approvals that are unlikely to disappear overnight en masse.
What really makes these locally approved landfills and quarries so valuable for companies like Waste Management and Vulcan Materials is that waste and gravel are inherently local businesses. You can’t profitably dump trash hundreds of miles from where it is collected, and you can’t truck aggregates much farther than 40 or 50 miles from a quarry without pricing yourself out of the market. (Trash is heavy, and gravel is even heavier.) So, local approvals for landfills and quarries create scores of mini-moats in these industries.
Contrast waste and gravel with another industry that has strong NIMBY characteristics—refining. Although there hasn’t been a new refinery built in the United States for decades, and local approvals for expansions of existing refineries are pretty tough to come by, the economic situation of a refinery isn’t nearly as good as that of a landfill or quarry. The reason is simple: Refined gasoline has a much higher value-to-weight ratio, and it can also be moved very cheaply via pipelines.
So, if a refinery tried to raise prices in a particular area, gasoline from more distant refineries would flow into the locality to take advantage of the higher prices. As a result, while there are regional variations in gasoline pricing, refiners generally can barely eke out high-single-digit to low-teens returns on capital over a cycle, while aggregate producers and waste haulers enjoy much steadier returns on invested capital in the mid to upper teens over many years.
Absolutely incredible!!! Isn’t it?
We started this journey with a couple of photos of emotionally distressed people. As we dug deeper into the likely causes of their distress, we encountered several models from psychology, engineering, and economics. By allowing our minds to wander a bit like Leonardo da Vinci and by employing a technique invented by Socrates and polished by Munger, we discovered possible explanations to something that needed an explanation using a multidisciplinary toolbox. We also used serendipity and the associative nature of our minds to unravel various facets of a gal called NIMBY.
Her most interesting facet, to an investor, was hiding in a book on investing in moats. How one thing leads to another! Now NIMBY will take me for a holiday to a bunch of very exotic islands called MOATS. I will tell you that story on another day. Right now I am going to have some fun with her.
Hello there. My name is Umbridge. I am a slimy, green frog.
No, not the one who you heard croaking in a movie you watched last month. Nor the one you saw hopping about in your balcony this monsoon. (You shouldn’t have screamed at poor Groffy! He jumped over and broke a leg.)
I am the frog who boiled. And this is my story.
It started in a classroom. You see, the advantage of being a frog on a business school campus is that you can just hop over to any prof’s classroom and attend lectures unnoticed. You don’t have to croak your presence when the attendance is called out. No one asks any questions from you. And of course there is no fee to pay.
Look at this way. I am the most literate frog you know. With this introduction, let me croak my story to you.
There is this professor on campus. He teaches a big class in the auditorium. 140 human students meaning that I have to avoid being squashed under 280 very heavy feet. That’s quite a feat by the way. And then I have to hop over those huge stairs unnoticed to get a good vantage point from where I can see the prof and the vivid slides he puts on the screen.
One September morning it was drizzling on campus. My friends and cousins were merrily mud wrestling in our favourite puddle. I was shoving my cousin Kermit’s neck under water while she was splashing her feet wildly unable to breathe. Suddenly, I heard two students rushing past us.
We gotta run dude. I don’t want to miss this class.
Why? What’s the hurry man? It’s only a class.
He’s going to tell the boiling frog story today! My senior told me not to miss it.
Ok man, let’s run!
And off they went.
Boiling frogs???? They boil frogs???
How could anyone do that? My anger rose so quickly that I barely noticed just how far my eyes had protruded. My eyeballs almost fell out of their wet and sticky sockets. If my nostrils had flared any more they would surely have burst apart. And my breathing. Why was I panting?
Stop this atrocity Umbridge! I let go of cousin Kermit who by now that desperately choking and croaking under the mud in my puddle. I had to get to the auditorium and quickly.
How far is it? About 1,500 hops. I better be on my way. Hop Hop Hop.
Ten minutes later, I am stationed at my favourite spot in the auditorium. The lecture is already in progress. The prof is speaking.
…And so, imagine that everyday I consume 100 calories more than I expend. Will I look fatter the next day? Of course not. Not even the day after or the week after. Will I?
But if you saw me after an year, you’d notice that I have gained some weight. And if you saw me after 3 years, you’ll notice that I am obese. But if you saw me every day, you won’t notice that I gone from being fit to being obese in 3 years.
Small incremental changes tend to go unnoticed. This is a very powerful idea, which Charlie Munger called the boiling frog syndrome. If you put a frog in hot boiling water, he will instantly leap out of the pan and be never seen again. But, if you put a frog in a pan with room temperature water and slowly turn up the heat, he would’t be able to tell the tiny incremental changes. He will boil and die as this video shows. Brace yourself when you watch it.
By the time, the video reaches 1:36, my heart is pumping so loudly that I almost feel it burst my chest walls and hit the prof smash in his face. This is disgusting! I need to puke.
But, wait a sec! The video continues and now there is no real frog being boiled! A hoax!
Whew! I am sighing with relief and students are gasping. The prof, who now has a wide grin on his face, is saying
I can assure you that there is no truth whatever in this story, but the human equivalent of the boiling frog is there in all of us. Indeed, Charlie Munger once said that many businesses die just like the boiling frog. Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny.
A metaphor! I smiled to myself. This is a cute prof. He is only talking metaphorically! There is no boiling frog. The video is a hoax too! Yay!!! I croaked out in relief.
The Prof is saying let me give you an example.
Take a look at these exhibits. They reflects a prosperous company. Why?
This is a profitable company having a market value of Rs 13,500 cr. Now take a look at these exhibits which display symptoms of a company in a precarious financial condition.
Unlike the earlier company, this company is highly leveraged with very low cash and bank balances. Now see it’s income statement.
Unlike the earlier company which was profitable, this company is into huge losses. It’s market cap at Rs 2,300 cr. is a small fraction of the market cap of the prosperous company you saw earlier.
Now let me tell you one thing: These two companies are the same at different times. This is what happened to MTNL over a span of about 6 years.
This is what Munger means when he likens businesses which die to a boiling frog. Cognition, misled by tiny changes involving low contrast, will often miss a trend that is destiny. Now you could see what happened to MTNL because I showed data pertaining to FY06 and then I showed you data pertaining to FY12. I exposed you to a high contrast effect, which always gets noticed. But investors who are looking at daily, weekly and quarterly information are likely to miss the tiny incremental changes or as Munger puts it, “miss a trend that’s destiny.”
So, the prof is asking, what’s the important lesson here? One student raises her hand.
Sir, this means that investors would be better off if they were exposed to lesser information and not more. Right?
Excellent answer! the prof says. Indeed there is a plenty of research done on this topic. In fact, way back in 1964, two researchers wrote a very interesting paper titled “Interference in Visual Recognition,” in which they described a fascinating experiment.
Take a look at the picture below. Do you see anything?
I see students shaking their heads. But I can see that it’s a fire hydrant. The one in the main building just outside the Director’s office. I have played hop skip and jump so many times on this hydrant. Why can’t they see it? Oh I get it? They aren’t frogs! Ha!
The Prof is saying.
This is a picture of an object which is out of focus. Human eyes can’t identify it in this state. Now imagine I divide this class into two groups. Both the groups will start by looking at the faded picture for 10 seconds. For one group, I will then bring the object into focus upto a point and then stop. I will do this in 20 tiny increments. For the other group too, I will bring this object into focus and stop at the same point at which I stopped for the first group, but the number of increments would be only 5. Now tell me which group will have more information?
A student replies, the first group! They will get to see a lot more data than the second group.
Right! But it turns out that the second group, which had less information, correctly guesses earlier what the object is. See this image.
He quotes from the paper
Pictures of common objects, coming slowly into focus, were viewed by adult observers. Recognition was delayed when subjects first viewed the pictures out of focus. The greater or more prolonged the initial blur, the slower the eventual recognition. Interference may be accounted for partly by the difficulty of rejecting incorrect hypotheses based on substandard cues.
It’s the same boiling frog syndrome again. When people see tiny incremental changes they take longer to recognise what’s going on. People who see just a few changes guess faster. Cool! So all those hourly bulletins issued by cousin Kermit titled “Likely Insect Whereabouts” are useless!
I should have known!
The Prof is now telling another story. This time it’s the story of Kodak.
A few months before kodak filed for bankruptcy, Lex of FT described situation briefly and beautifully:
The big story here is, of course, a simple tale with three parts: photography goes digital; Kodak doesn’t change with the times; the end.
Why did Kodak fail to change with the times. Part of the reason is the same boiling frog syndrome. To see how, let’s do a thought experiment.
Imagine that it’s 1998, just before digital cameras became popular. You are the CFO of Kodak and are enjoying the dominance of your company in the global photographic film market. The world is getting increasingly prosperous and film camera sales are booming because people want to preserve memories. More cameras means more demand for film. Life is good because Kokak is the dominant brand in the world.
One day an engineer walks in with what looks like a toy. He puts it on your table and makes an announcement:
This thing is going to kill us. This is a digital camera. The world will stop buying film cameras. We are going to die.
Now, since this is a thought experiment, let’s ignore the benefit of hindsight. We all know what happened to photographic film business but let’s ignore it for now. Put yourself in the shoes of Kodak’s CFO and give me four very plausible reasons which will convince you that the engineer is over-reacting to the threat from digitisation.
Student # 1: The Cost is too high. Digital cameras cost so much more than film ones. No one will buy them.
Student # 2: The quality sucks. The best digital cameras offer a maximum resolution of only 1.5 megapixel.
Student # 3: People will never watch photos on computers. They love printed albums.
Student # 4: People would never agree to store their memories on computers and take the risk of hard drive crashes and other disasters.
Great points! Now let’s see what happened to each of these objections. The cost went down, the quality got better and now you get 8 megapixel cameras inside mobile phones. New platforms like Facebook emerged on which you can do things with photos (sharing, commenting, tagging) which you couldn’t even have imagined as possible back in 1998. And as for security, online backup facilities, external hard drives, pen drives were invented.
So, you see every single objection to the possibility of digitisation killing the photographic film business turned out to be wrong. But notice that these changes did not happen in a day, or a quarter or a year. It took years. And the CFO and his colleagues, were just too close to all the noise (just like the people who were seeing too many images of the fire hydrant), that missed miss a trend that turned out to be Kodak’s destiny. It’s the same boiling frog effect again.
The boiling frog metaphor is a terribly powerful metaphor and can be applied in many situations. Take the case of the Indian government’s desperation to increase the price of diesel, which is being subsidised heavily because price hikes were not allowed earlier. And now, the government finds it very difficult to do anything about it.
Now imagine that the government had increased the price by just 20 paise a litre in a week. This would have gone unnoticed. In four weeks, the increase would have been 80 paise, and in a year, Rs 9.60, which is way more than Rs 5 increase implemented recently.
If the government had been psychologically astute, it could have used the boiling frog syndrome to implement a change in a manner which was much more likely to be accepted than the manner it actually chose. Partly as a consequence of this mis-step, it lost an ally. Not that she was worth keeping. Just saying.
We frogs surely have come a long way it seems! Humans are using us as examples of how to make people experience change! This was so cool, I am thinking but the Prof continues.
The idea of noise vs. signal has been further refined by the philosopher Nassim Taleb. He says
“Noise is what you are supposed to ignore; signal what you need to heed.”
“The more frequently you look at data, the more noise you are disproportionally likely to get (rather than the valuable part called the signal); hence the higher the noise to signal ratio. And there is a confusion, that is not psychological at all, but inherent in the data itself. Say you look at information on a yearly basis, for stock prices or the fertilizer sales of your father-in-law’s factory, or inflation numbers in Vladivostock. Assume further that for what you are observing, at the yearly frequency the ratio of signal to noise is about one to one (say half noise, half signal) —it means that about half of changes are real improvements or degradations, the other half comes from randomness. This ratio is what you get from yearly observations. But if you look at the very same data on a daily basis, the composition would change to 95% noise, 5% signal. And if you observe data on an hourly basis, as people immersed in the news and markets price variations do, the split becomes 99.5% noise to .5% signal. That is two hundred times more noise than signal —which is why anyone who listens to news (except when very, very significant events take place) is one step below sucker.”
The Prof also quotes Daniel Kahneman:
Investors should reduce the frequency with which they check how well their investments are doing. Closely following daily fluctuations is a losing proposition, because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and may be more than enough for individual investors. In addition to improving the emotional quality of life, the deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes. The typical short-term reaction to bad news is increased loss aversion. Investors who get aggregated feedback receive such news much less often and are likely to be less risk averse and to end up richer. You are also less prone to useless churning of your portfolio if you don’t know how every stock in it is doing every day (or every week or even every month). A commitment not to change ones position for several periods (the equivalent of locking in an investment) improves financial performance.”
So you see, you don’t have to suffer undesirable consequences of being boiled as a frog and you can use the metaphor to achieve desirable consequences of boiling other frogs.
But that’s not the end of the boiling frog story. There’s more. One big objection I have is that the boiling frog metaphor is used either to describe the absence of something undesirable being noticed by the one being boiled or used a tool to manipulate others. We have left out one very important application of the boiling frog syndrome. In fact, the negative connotation associated with the syndrome needs to change. You see, you can use the boiling frog syndrome to manipulate yourself. You can, and should become a boiling frog. Let me explain that with a couple of examples.
Take a look at this book.
This is a great book. 15 months years ago I was obese and unable to walk even one flight of stairs without losing my breath. Then I discovered this book and started using its techniques to start running. The book uses many techniques, of which one the major ones is boiling frog syndrome. You start with running just a few meters. The next day you a run a bit more then a bit more. In a few weeks, I was running 5 kilometres. In a few more, 10 km and before long i was running half marathons.
During this period, I also made changes in what I ate. My dieting and my running, both involved my treating myself like a boiling frog – small incremental changes. They went unnoticed at first, until people started noticing.
You see, all learning in that sense involves deliberate practice which occurs in tiny increments. Every day you add a bit to your knowledge and after many years of doing it right, you become an expert.
There’s another book I love on this subject.
I used this book, along with the book on marathon running to change my health and my shape. This book also teaches you how to become a boiling frog to achieve behaviour change that’s slow, goes unnoticed, and becomes permanent. The author quotes Lao Tzu
“A journey of a thousand miles must begin with the first step.”
“When you improve a little each day, eventually big things occur. When you improve conditioning a little each day; eventually you have a big improvement in conditioning. Not tomorrow, not the next day; but eventually a big gain is made. Don’t look for the big, quick improvement. Seek the small improvement one day at a time. That’s the only way it happens-and when it happens, it lasts.” -John Wooden, one of the most successful coaches in the history of college basketball
All changes, even positive ones, are scary. Attempts to reach goals through radical or revolutionary means often fail because they heighten fear. But the small steps of kaizen disarm the brain’s fear response, stimulating rational thought and creative play.
The class is now coming to an end and I, Umbridge the frog am feeling quite kicked about the whole thing! Can’t wait to hop back to my puddle and boast to cousin Kermit about just how far we frogs have come. We are now role models for humans to become better and better over time.
And that’s not too bad now is it?
In Part I of this series on floats, I wrote about how Berkshire Hathaway has been able to create less-than-free float from its insurance operations — a key reason for the company’s stupendous success. I also listed a few “general principles” on floats and showed how high-quality floats can become “unencumbered sources of value.”
In Part II, I expanded the discussion on Buffett’s attraction towards floats in a variety of business situations encountered by him in his long career, ranging from floats enjoyed by American Express and Blue Chip Stamps in his early years, to recent structured derivatives contracts created by him.
In this concluding part, I will shift focus away from Buffett (although I will use his thoughts on the subject) to other businesses that enjoy attractive floats.
Let’s start with HUL. Take a look at the company’s summarised balance sheet as on March 31, 2012.
Take a few moments to observe the above statement. I’ll wait for you.
Notice that HUL is debt free. Why? Let’s try to answer this question by reorganising the company’s balance sheet.
Each side of the HUL’s balance sheet — assets as well as liabilities — totals to Rs 11,407 cr. That’s not a co-incidence by the way. 🙂
Let’s focus on the asset side for now. Of the total assets, let’s segregate financial assets. These would be non-current investments (Rs 70 cr.), current investments (Rs 2,252 cr.), and cash and bank balances (Rs 1,996 cr.). These total to Rs 4,318 cr. So the total breakup of financial assets and operating assets is as under:
Financial Assets: Rs 4,318 cr.
Operating Assets: Rs 7,089 cr. (balancing figure)
Total Assets: Rs 11,407 cr.
Now, let’s look at the liability side of the balance sheet which shows how the total assets are financed. Here’s the breakup:
Equity: Rs 3,680 cr.
Debt: Rs Nil.
Float: Rs 7,727 cr. (balancing figure)
Total Liabilities: Rs 11,407 cr.
“Float?” Yes, float. Other People’s Money (OPM) which carries no interest. Hindustan Lever is debt-free because it has access to free money provided by other people. It does not need to borrow any money to finance its operations. That becomes rather obvious by re-looking at the following two figures:
Operating Assets: Rs 7,089 cr.
Float: Rs 7,727 cr.
Since this float, which is cost-less, is more than operating assets, can we infer that all of the company’s operations are financed with free money? Yes!
How could HUL achieve this feat? Let’s find out by quantifying the main contributor of the company’s float. Of the total float of Rs 7,727 cr., trade payables alone are worth Rs 4,844 cr, an amount which is more than sufficient to finance inventories and receivables aggregating to Rs 3,524 cr. Here’s the breakup:
Inventories: Rs 2,667 cr.
Receivables: Rs 857 cr.
Total: Rs 3,524 cr.
Trade payables: Rs 4,844 cr.
What does this mean? It means that HUL obtains trade credit from its vendors which is more than sufficient to finance its investment in receivables and inventory. That is, HUL operates on negative working capital, which is the key source of the company’s float.
How should we determine the importance of this float to HUL’s stockholders? By doing a thought experiment. Just like the importance of the person is realized when he/she is no longer there, let’s figure out the importance of HUL’s float by imagining that it’s not there. Let’s make the float of Rs 7,727 cr disappear. Poof! It’s gone!
But hang on a second. HUL still needs to have Rs 7,089 cr of operating assets, which need to be financed from somewhere and it’s source of free money — float — just evaporated. So, HUL needs to find alternate financing. There are only two sources: Debt and Equity. If HUL had to employ debt to replace float, then at current interest rates of 10% p.a. it would have to pay about Rs 700 cr. as interest, which if we consider, would have reduced its pretax profits from Rs 3,621 cr in FY12 to Rs 2,921. That’s a reduction of 19% in HUL’s pretax earnings.
Alternately, HUL could replace its float by issuing additional shares. Assuming it did so, at its current stock price of Rs 500, then in order to raise Rs 7,089 cr, HUL would need to issue 14 cr additional shares to its existing 216 cr shares. That’s an addition of 6% to its equity capital which would have resulted in no incremental earnings.
Either way we look at it, we can see that presence of float is quite important for HUL’s stockholders. Float prevents the company from the burden of interest-bearing debt. It also prevents the need to dilute equity.
Now’s lets look at another company — Nesco Limited — about which I had written a few years ago. Take a look at Nesco’s balance sheet as on 31 March 2012.
You’ll notice that just like HUL, Nesco too a debt-free company. Why? To answer that question, let’s reorganise Nesco’s balance sheet — just as we did in HUL’s case.
Each side of the Nesco’s balance sheet — assets as well as liabilities — totals to Rs 381 cr.
Let’s focus on the asset side for now. Of the total assets, let’s segregate financial assets. These would be current investments (Rs 210 cr.) and cash and bank balances (Rs 4 cr.). These total to Rs 217 cr. So the total breakup of financial assets and operating assets is as under:
Financial Assets: Rs 214 cr.
Operating Assets: Rs 167 cr. (balancing figure)
Total Assets: Rs 381 cr.
Now, let’s look at the liability side of the balance sheet which shows how the total assets are financed. Here’s the breakup:
Equity: Rs 290 cr.
Debt: Rs Nil
Float: Rs 91 cr. (balancing figure)
Total Liabilities: Rs 381 cr.
Nesco’s operating assets of Rs 167 cr. are financed to the extent of Rs 91 cr. by OPM, which carries no interest. Was this float not available, Nesco would necessarily have to raise this money from debt and/or equity. Either alternative would have reduced earnings per share, as was the case in HUL discussed earlier.
So, how could Nesco obtain this float? Let’s find out by quantifying its main contributors. Of the total float of Rs 91 cr., advances & security deposits from customers alone are worth Rs 57 cr and trade payables are worth Rs 8 cr. These two items, which total to Rs 65 cr. are more than sufficient to finance inventories and receivables which total to Rs 13 cr. Here’s the breakup:
Inventories: Rs 5 cr.
Receivables: Rs 8 cr.
Total: Rs 13 cr.
Advances & security deposits from customers: Rs 57 cr.
Trade payables: Rs 8 cr.
Total: Rs 65 cr.
Nesco has three businesses each of which use float. Exhibition organizers who book Nesco’s exhibition center pay the company advance money to book space for various exhibitions. They also pay security deposits. Similarly, for occupying its commercial buildings, Nesco’s tenants pay security deposits to the company. Finally, for its manufacturing business, the company enjoys trade credit. Moreover, neither the exhibition business nor the commercial building business has any receivable or inventories, so the aggregate of trade credit and advances & security deposits exceed the aggregate investment in inventories and receivables.
Just like in the case of HUL, Nesco too, then, enjoys a negative working capital which is the key source of the company’s float. The only difference between the two situations is that while in HUL’s case, trade credit provided the float, while in Nesco’s case advances & deposits from customers primarily provide the float.
We’ll come back to a more detailed discussion about trade credit and customer advances & deposits. For the time being let’s recall how Warren Buffett thinks about float as an attractive source of financing. A key lesson from Buffett on this is:
If you get access to an enduring and free (or less-than-free) float — whether it comes from insurance underwriting, derivatives contracts, trading stamps, travelers’ cheques, stored value cards, deferred taxes or any other source — then assets financed with such a float will become “an unencumbered source of value” for your stockholders. This will happen because (1) the assets financed with such a float would still be valued on the basis of their expected future earning power; but (2) the true value of the liability represented by the float will be far lower than its carrying value, provided the float is both costless and long-enduring.
Those two factors — cost and duration — determine how attractive a float it. The lower the cost approaches zero, and the longer the duration approaches eternity, the more the float resembles a perpetual, zero coupon bond which, as I discussed in Part I, will be worth almost nothing as a liability which is really cool because assets financed from the float could be worth a lot, just as happened in the case of Berkshire Hathaway.
Conversely, the higher the cost approaches the cost of alternate financing, and the lower the duration of the float, the less attractive it becomes. Under such circumstances, liabilities which are source of float should be valued fully on the balance sheet of company having access to that float.
Costless and long-enduring floats, then, are a very attractive form of financing — more attractive than debt, and more attractive than additional equity. We saw this in our HUL “thought experiment” above. Buffett agrees with this line of thinking. When asked about the relative attractiveness of low-cost floats vs other forms of financing, he said:
“Our insurance companies have had a terrific experience on cost of float‚ and we’d like to develop it just as fast as we can. Right now we’ve have no interest in issuing a bond because we have more money around than we know what to do with, and it comes from low-cost float. But if a time came when things were very attractive and we’d utilized all the money from our float and retained earnings and we still saw opportunities, we might very well borrow moderate amounts of money in the market. It would cost us more than our float was costing us, but it would still provide us with incremental earnings. But we would try to gain more float under those circumstances, too.”
The correct way to think about floats, then, is to think of them, simply as a form of leverage. Leverage, however, is traditionally associated with interest-bearing debt. But a free float is also a form of leverage, isn’t it? After all, it’s OPM and that’s what leverage means. Just like low-cost debt can lever up the return on invested capital, a free, or low-cost float can lever up the return on operating assets and that’s what Buffett meant when he wrote:
Any company’s level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” — that is, the degree to which its assets are funded by liabilities rather than by equity.”
“Funded by liabilities rather than equity.” He used the word “liabilities” and not “debt. That’s key. The more of an asset that you can fund with a free float, the less the need to fund it with expensive debt or equity becomes.
Why, then, do businesses ever borrow money to fund their operations? Why don’t they just use free floats? The obvious answer to this question is that most businesses do not operate with a negative working capital. They simply don’t have free floats.
Recall that negative working capital arises when money tied up in inventories and receivables are more than offset by funds provided by customers by way of advances & deposits and also by trade credit. Let’s now return to the discussion of these two important contributors of free floats: Trade credit and advance payments & deposits from customers.
Trade credit is given to a firm by its vendors. Advance payments & deposits are given to a firm by its customers. Why, as was the case with HUL, would a firm enjoy substantial trade credit which more than finances its inventories and receivables? And why, as was the case with Nesco, would a firm get paid in advance by its customers and also receive substantial deposits from them, which, when taken together, more than offset its investment in inventories and receivables?
The answer to both these questions is “Market Power” — the power of a firm over its vendors (who give it large amounts of trade credit) and its customers (who give it large amounts of advance payments & deposits) in quantities large enough to ensure that the firm can operate with negative working capital, as we found in the case of Nesco. The super powerful ones can operate with negative net operating assets (where float exceeds investment in inventories, receivables, and fixed assets), as we found in the case of HUL.
Where does this “market power” come from? It primarily comes from two sources: (1) shortages; and (2) moats.
We have little interest in floats produced from shortages-derived market power. That’s because such floats are likely to be temporary, fair weather friends. To see how, think of a shipping company during a shipping boom when freight rates are sky high and every shipper is drowning in cash. The freight rates are high because of shortage. This shortage delivers market power to the ship owners, who can demand, and obtain, not only high freight rates, but also advance payments from their customers. These advance payments from customers, will temporarily reduce working capital requirements because receivables will turn into advance payments received.
Alas, such a happy environment is unlikely to last. The entry barriers in shipping are low, even though the gestation period is high. It’s only a matter of time when the supply of new ships will create a glut. Such a glut will have two consequences. One, freight rates will fall. And two, power will shift from shipping companies to their customers, who will now refuse to make advance payments and will insist on very lenient credit terms. For shipping companies, advance payments from customers will disappear, and will be replaced by receivables from customers. There will be dire consequences so far as working capital requirements are concerned: When its float disappears, a shipping company will typically find it hard to stay afloat unless it replaces the free source of finance with debt, or equity. This is happening now in global shipping industry.
This kind of power shift in a value chain is not limited to the shipping industry. You will find it in automobile industry, in textiles, in chemicals — in fact, you’ll find it in any commodity industry having low entry barriers.
In such situations, being impressed with temporary low-cost float during good times, could be a costly mistake. The lesson for long-term investors is clear: Beware of floats derived from shortages in commodity-type industries having low entry barriers. Recall, this lesson is consistent with Buffett’s belief that a float is attractive only if its cheap and enduring and a float produced from temporary shortages is anything but.
Let’s now talk about the second source of market power — one which is cheap and enduring, and one which should interest us a lot: Moats.
Buffett uses the metaphor of a “moat” to illustrate a business’s superiority “that make life difficult for its competitors.” A truly great business, says Buffett, must have an enduring moat around its economic castle that protects its excellent returns on invested capital. He writes:
“What we’re trying to find is a business that for one reason or another — because it’s the lost-cost producer in some area, because it has a natural franchise due to its service capabilities, because of its position in the consumer’s mind, because of a technological advantage or any kind of reason at all – has this moat around it. And you throw crocodiles and sharks and piranhas in the moat to make it harder and harder for people to swim across and attack the castle.”
Finally, we have reached the point which I wanted to make at the very beginning of this long series! Professors are rarely known for their brevity 🙂
The point is this: Floats and Moats go together.
Think about it. What kinds of companies can operate with negative working capital (e.g. Nesco) or even negative net operating assets (e.g. HUL)? What power do such companies possess over their customers and suppliers, who happily (or even unhappily) finance their working capital (Nesco), or even the entire capital (HUL) employed by the business?
The answer, of course, is companies which possess enduring moats. While, HUL’s moat is derived from the company’s brands and distribution network, Nesco’s moat in its exhibition center business is derived from scarcity.
HUL’s moat is much more powerful than Nesco’s and that’s reflected in its negative net operating assets. All of HUL’s operating assets are financed by its float, while only part of Nesco’s assets are. Nevertheless, float in both cases levers up return on invested capital for both the companies.
To see how floats lever up returns on invested capital, consider that one of the consequences of a solid moat is that it enables a business possessing such a moat to earn excellent returns on its invested capital. Earning excellent returns on invested capital, in fact, is a pre-requisite for spotting a moat, according to Buffett. He writes:
“A good moat should produce good returns on invested capital. Anybody who says that they have a wonderful business that’s earning a lousy return on invested capital has got a different yardstick than we do.”
Notice, he used the term “invested capital” which is the capital provided by investors — debt as well as equity — and does not include funds provided by floats. He did not use the term “total assets” although most great businesses possessing enduring moats will have good returns on assets and on invested capital.
How can a business earn excellent returns on invested capital? There are only two ways to do it: (1) maximise the numerator i.e. returns; and/or (2) minimise the denominator i.e. invested capital.
A moat (whether derived through pricing power or a sustainable low-cost advantage) can help the business achieve (1). A free, or a low-cost float (derived, of course, from an enduring moat) can help it achieve (2). How so? Let’s see how this happens in case of HUL and Nesco.
For FY12, HUL earned pre-tax profits of Rs 3,500 cr. On total assets of Rs 11,407 cr., this translates into a return on assets of 31%, which is fantastic. But, when we recognize that out of total assets of Rs 11,407 cr., float contributed Rs 7,727 cr., leaving only the balance 3,680 cr. to be financed by equity, then the pre-tax profits on equity get levered up to 95%.
Similarly, for FY12, Nesco earned pre-tax profits of Rs 97 cr. On total assets of Rs 381 cr., this translates into a return on assets of 25%. But, when we recognize that out of total assets of Rs 381 cr., float contributed Rs 91 cr., leaving only the balance Rs 290 cr. to be financed by equity, then the pre-tax profits on equity get levered up to 33%.
Think of it this way. A business may employ a large amount of assets, but such a business — because it has an enduring moat may enjoy significant market power over its vendors and customers. The business exercises its power over its vendors by insisting on, and getting away with, very lenient credit terms from them. In addition, power is also exercised over customers by insisting upon, and getting away with, receiving advance payments & deposits from them. The vendors and customers don’t have a choice. They have to adhere to the terms dictated by the business because for them, there is no other alternative. This market power, exercised in the manner described, results in the ability of the business to operate with negative working capital which reduces, or sometimes even eliminates, the need for stock and bond investors to invest anything in the firm’s operating assets. Invested capital (the denominator) is minimised, which results in a jump in return on that capital.
Let me give you another example — this time from USA.
Each side of the Amazon.com’s balance sheet — assets as well as liabilities — totals to $25 billion. The breakup of asset side is as under:
Financial Assets (Cash and cash equivalents and marketable securities): $10 billion
Operating Assets: $15 billion (balancing figure)
Total Assets: $25 billion.
Here’s the breakup of the liability side:
Equity: $8 billion
Debt: $ Nil
Float: $17 billion (balancing figure)
Total Liabilities: $25 Billion.
Amazon.com enjoys a float of $17 billion even though it employs only $15 billion of operating assets! No wonder it’s a debt-free company. But, how does it get so much float?
The main contributor towards Amazon.com’s float is accounts payable of $11 billion, which, when compared with inventories of $5 billion and accounts receivable of $3 billion result in a negative working capital of $3 billion. By keeping inventories low, by ensuring customers pay amazon.com quickly, and by taking longer to pay its vendors, Amazon.com has been able to build a huge float. In addition, the successful Amazon Prime service and sale of gift certificates enables the world’s largest online retailer to collect funds from customers in advance.
In 2011, amazon.com pre-tax earnings were $934 million, which when compared with total assets of $25 billion translate into a return of only 3.7%, but when compared with Equity of $8 billion, gets levered up to 12% ROE. Considering the prevailing low interest rates in USA, that’s not bad at all.
Amazon.com is a wonderful example of a situation where return on assets is mediocre, but return on equity is good, simply because the company has access to large amounts OPM on favourable terms. It’s the float which makes amazon.com profitable and it’s the float that keep the company debt-free. If you were to value amazon.com, you’ll have to think very hard about two questions: (1) How likely is it that amazon.com’s float is truly costless; and (2) How long will it last?
if you look carefully at the worlds’s debt-free companies (e.g. look at BHEL, BEL, EIL, Wipro, Infosys, Intuitive Surgical, and Apple) a pattern emerges. Many of these companies will, apart from being debt-free have the following additional characteristics:
In other words, where there are large enduring floats, you will find moats. This makes moat hunting an objective exercise, doesn’t it? Apart from looking for signs of moats indicated by high switching costs, low-cost advantages, intangible assets, and network effects as Pat Dorsey does in his wonderful book “The Little Book that Builds Wealth,” you may also spot an enduring moat by simply looking for the above pattern.
Finally, in your hunt for long-term high-quality businesses, as you witness the proximity between floats and moats, you will also discover that all floats are not the same. In particular, you will discover the following general principles:
Happy Moat Hunting!
Acknowledgements: I’d like to thank Priyank Sanghavi and Ankur Jain with whom I had extensive and very helpful interactions on the subject of floats and moats which helped me formulate my thoughts on the subject.
Note: This post is a continuation of a previous post titled “Flirting with Floats: Part I.”
While cheaper-than-free float provided by astute insurance underwriting is the kind of float Buffett loves the most, there are other floats he has “flirted” with during the course of his long career.
Perhaps it started with American Express.
Between 1964 and 1966, Warren Buffett bet 40% of his partnership’s capital on American Express’ (Amex) stock, which had been battered down by the company’s involvement in the then infamous Salad Oil Scandal. Buffett’s investment of $13 million gave his partnership a 5% stake in the company, implying a total market cap of about $260 million at that time.
I searched for and found out Amex’s annual report for 1964. I urge you to read it. Apart from the fact that both its main businesses (travelers’ checks and credit cards) were doing extremely well, you will notice three additional points by studying its balance sheet on page 27: (1) The presence of $263 million of cash; (2) absence of interest-bearing debt; and (3) Travelers’ checks outstanding totaling to $525 million (a liability).
Those $525 million travelers’ checks represent float. People pay for travelers’ checks upfront and cash them later. The lag between purchase and their subsequent cashing may last a few days or even a few years (and sometimes they never get cashed). In the meantime, Amex gets to use the float for its business – free funds which otherwise it would have had to pay for.
Even though the Salad Oil Scandal had decimated the company’s stock price, as it did not have any interest-bearing debt, and had substantial cash to pay for the losses arising out of the scandal, all that Buffett needed to examine was the probability of it’s float disappearing. That, of course, would have happened only if the millions of holders of Amex’s travelers’ checks lost the trust behind the “American Express” brand.
In Buffett’s biography, “Snowball,” the author, Alice Schroeder, writes:
“The company’s value was its brand name. American Express sold trust. Had the taint to its reputation so leaked into customers’ consciousness that they no longer trusted the name? Buffett started dropping in on Omaha restaurants and visiting places that took American Express cards and Travelers Cheques. He put Henry Brandt on the case. Brandt scouted Travelers Cheque users, bank tellers, bank officers, restaurants, hotels, and credit-card holders to gauge how American Express was doing versus its competitors, and whether use of American Express Travelers Cheques and cards had dropped off. Back came the usual foot-high stack of material. Buffett’s verdict after sorting through it was that customers were still happy to be associated with the name American Express. The tarnish on Wall Street had not spread to Main Street.”
Despite the scandal, Buffett had figured out that Amex’s float was not going away. Without mentioning the investment, he hinted to his partners what he had done, by writing:
“We might invest up to forty percent of our net worth in a single security under conditions coupling an extremely high probability that our facts and our reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”
I would speculate that if, instead of $525 million of cost-less float given to Amex by millions of its customers, American Express had $525 million of bank debt, Buffett would have stayed away from the stock. Bankers, he would have reasoned, could have easily recalled their loans from the scandal-ridden company resulting in a death spiral. But all of the customers holding travelers’ checks wouldn’t line up outside the company’s offices to cash them all. For them, the scandal was a non-event.
Buffett was right. Amex’s stock price trebled within the next two years as Wall Street slowly figured out what Buffett already had.
There is an important lesson about floats from the examples of Blue Chip Stamps and Amex: Float provided by millions of small customers can be quite enduring.
Amex’s float is similar to that enjoyed by banks on funds of customers they get to keep for free. Bankers are known to fight each other over floats represented by “non interest bearing current accounts” of large corporate customers. Free money, even for just a few days is worth fighting for, isn’t it? And then, of course, there is the case of very large sums of unclaimed deposits lying with India’s public sector banks. That’s float too.
What’s fascinating is how Amex’s float on travelers’s checks – something that attracted Buffett to the stock- became almost inconsequential over time, even though its dollar amount soared. As of the end of 1964, Amex had a total of about $525 million worth of Travelers’ checks outstanding, or 445% of its $118 million revenue for that year. That’s a big number. By the end of 2011, the company’s revenues had soared to $25 billion, while total travelers’ checks outstanding as of that year’s close were $5 billion, or just 20% of revenues. Paradoxically, the company’s credit and charge card businesses overtook the traveler’s checks business, which is now in terminal decline. Even so, Amex marched on and its the tag line for its travelers’ checks commercials (“Don’t leave home without them”) was altered to suit the commercials for its charge card. The new tag line became: “Don’t leave home without it.”
By 1968, Buffett sold out his 5% stake, which cost him $13 million for about $33 million. Many years later, he got back in the stock. By the end of 2004, Berkshire had bought a 10% stake costing it $1.4 billion. (That’s a good example of opportunity cost!).
The big problem for Buffett with Amex’s float was that he could only get a passive stake in it by buying his 5% stake. He could never control it.
All of that that changed when he, along with his friends bought Blue Chip Stamps.
In her excellent book, “Damn Right!: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger,” the author, Janet Lowe, relates the 1967 story:
“An early precursor to frequent flyer miles in the 1950s and 1960s, trading stamps, such as Green Stamps, Blue and Gold, and Blue Chip, were handed out as a customer incentive by merchants. Retailers deposited money at Blue Chip in return for their stamps, then the money was used to operate the stamp company and to purchase the merchandise handed out when stamps were redeemed. Shoppers were given a certain number of stamps for each dollar spent in a store, which they pasted into books, then redeemed for prizes such as toddler toys, toasters, mixing howls, watches, and other items. Because it took time to accumulate enough stamps to redeem merchandise-and because some customers tossed the stamps in the back of a drawer, forgot them, and never did redeem them-the float built up.”
Lowe explains how Buffett ended up buying into Blue Chip:
“Charlie and I talked a lot about investment ideas,” said Rick Guerin. “I’d react about Blue Chip Stamps in the newspaper, and I had an idea,” Charlie said, ‘I’ll take you to my friend who knows more about float than anyone.’” When Guerin was introduced to Warren Buffett, Rick realized, as he had when he first met Munger, that he was talking to someone exceptional. Rick was pleased when Buffett immediately saw the same potential value of Blue Chip’s float that he had seen. Just by investing the float alone, the company could amount to something. Buffett, Munger, and Guerin slowly began accumulating shares, with Buffett buying the stock both for his personal account and for the Buffett Partnership.”
I couldn’t help but notice one of the comments in this video:
“Thank you so much for posting this. My mother died about a year ago and in one of her cookie jars I found a stash of S&H green stamps. She never redeemed enough for so much as a plastic pitcher, but it was always fun saving them up. Ah, memories.”
The green stamp capitalist would respond with nostalgia: “Ah, Float.”
There’s a fascinating aspect to the Blue Chip story. The company, which was later merged into Berkshire, acquired See’s Candy for $25 million in 1972 at a time when See’s total capital employed was $8 million. Revenues for that year were $30 million and pre-tax earnings were less than $ 5million. By 2007, as Buffett proudly noted in his letter for that year’s performance, See’s revenues had grown to $383 million, and pre-tax earnings were $82 million and yet the capital employed to run that business was just $40 million.
This means, wrote Buffett, “we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us.”
Buffett used Blue’s Chip’s float to acquire See’s and See’s float (as I shall explain later) to buy more businesses. He discovered that an enduring but free float, is a financial fountain that keeps pouring out cash.
But the really big (after insurance) attractive float that Buffett found, was given to him by the U.S. Treasury.
Berkshire owns marketable securities having market values far in excess of their acquisition prices. Taxes on gains realized on sale are payable only after the sale is made. If Buffett was to sell these securities, Berkshire would have to pay a very large tax bill. However, if he refuses to sell, and their market values continues to rise over time, then taxes not-due-but-which-would-have-been-due-if-he-had-sold-today would still need to be estimated and recorded as “deferred taxes” on Berkshire’s balance sheet. As of end 2011, these liability totaled to a staggering $ 38 billion.
For Berkshire, this $38 billion is also a form of float – functional equivalent to an interest-free loan from the U.S. Treasury. Buffett explained this power of delayed taxes by giving a wonderful example in his 1989 letter:
“Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. The sole reason for this staggering difference in results would be the timing of tax payments.”
Is this “float” which appears as a liability on Berkshire’s balance sheet really worth its value as calculated by accountants? No, it isn’t. Just as was the case with insurance float, where fair value of the liability was much lower than its book value, Buffett explained:
“We would owe taxes of more than $1.1 billion were we to sell all of our securities at year-end market values. Is this $1.1 billion liability equal, or even similar, to a $1.1 billion liability payable to a trade creditor 15 days after the end of the year? Obviously not – despite the fact that both items have exactly the same effect on audited net worth, reducing it by $1.1 billion.
On the other hand, is this liability for deferred taxes a meaningless accounting fiction because its payment can be triggered only by the sale of stocks that, in very large part, we have no intention of selling? Again, the answer is no.
In economic terms, the liability resembles an interest-free loan from the U.S. Treasury that comes due only at our election…”
To summarize, neither the insurance float, nor the float represented by deferred taxes on the liability side of Berkshire’s balance sheet are worth their book values. In his “Owner’s Manual” Buffett explains this again:
“Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $100 billion.
Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.”
As of the end of 2011, Berkshire’s balance sheet carries assets having an aggregate book value of $392 billion. About $100 billion of these assets have been financed by the best form of OPM which either costs Berkshire nothing (deferred taxes), or it pays Berkshire for having it (insurance float)!
For me, it’s very instructive to observe how Buffett has flirted with various kinds of floats throughout his career. The seductive appeal of free (or less-than-free) money is all too alluring. He explained the logic in his 1995 letter:
“Any company’s level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” – that is, the degree to which its assets are funded by liabilities rather than by equity. Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly – to a degree that is not generally well-understood – because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms.“
Buffett hasn’t stopped looking for attractive floats. He once denounced derivatives as “financial weapons of mass destruction” but when he became aware that some of the esoteric derivative contracts could be a source of attractive float, he embraced them.
In his 2008 letter, Buffett disclosed that Berkshire was a party to 251 derivative contracts consisting of equity puts, credit default swaps, and others. Describing these contracts, Buffett noted:
“As of yearend, the payments made to us less losses we have paid – our derivatives “float,” so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake.”
Aha! We get to see the same combination we saw in Berkshire’s insurance float – an underwriting profit (implying less-than-free float), and freedom to invest that float in buying undervalued assets.
In his 2010 letter, Buffett again emphasized these points:
“The thought processes we employ in these derivatives transactions are identical to those we use in our insurance business. You should also understand that we get paid up-front when we enter into the contracts and therefore run no counterparty risk.”
“In aggregate, we received premiums of $3.4 billion for these contracts. When I originally told you in our 2007 Annual Report about them, I said that I expected the contracts would deliver us an “underwriting profit,” meaning that our losses would be less than the premiums we received. In addition, I said we would benefit from the use of float…”
“It appears almost certain that we will earn an underwriting profit as we originally anticipated. In addition, we have had the use of interest-free float that averaged about $2 billion over the life of the contracts. In short, we charged the right premium, and that protected us when business conditions turned terrible three years ago…”
“What is sure is that we will have the use of our remaining “float” of $4.2 billion for an average of about 10 more years. (Neither this float nor that arising from the high-yield contracts is included in the insurance float figure of $66 billion.) Since money is fungible, think of a portion of these funds as contributing to the purchase of BNSF.”
Money is fungible, says Buffett. As I described in Part I, if Buffett can figure out a way to borrow money for free or even less than that, and if he can get to keep that money for a long long time without putting up collateral, then the fair value of those liabilities on Berkshire’s balance sheet are far below their book values. Under those conditions, as Buffett himself put it in his 2007 letter, “our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”
Attractive floats, then, are “unencumbered sources of value” for shareholders of companies which get to enjoy them.
Are there other business models which have access to cheap floats? Yes indeed, there are, and they go by the name of “moats.”
You see, Floats and Moats go together. That’s the subject matter of a subsequent post.
To be concluded…
There is a company which has the world’s strangest bond outstanding. Strange, because this bond has no maturity date. Stranger, because the bond issuer pays no interest on it. Strangest, because year after year, the issuer gets paid to have this bond on its balance sheet.
What better source of financing is there than one in which neither do you have to return the borrowed money, nor are you charged any interest to use it? In fact, you are paid to use it!
This is not a small bond issue in some obscure little country. As of end December 2011, this bond had a book value of about $71 billion and the issuer is an American company having a current market cap of $205 billion.
I am, of course, referring to the “float” enjoyed by the insurance businesses of Warren Buffett’s Berkshire Hathaway. “Float” in the insurance business, says Buffett, “arises because most policies require that premiums be prepaid and, more importantly, because it usually takes time for an insurer to hear about and resolve loss claims.”
This float, which has grown from $17 million in 1967 to an astounding $71 billion by the end of 2011, is a key reason behind Warren Buffett’s fame and fortune.
Float, as he explains is “money we hold but don’t own,” which, by the way, is how one would describe “other people’s money” or “OPM”, of which debt is the most common form.
The problem with plain-vanilla debt, however, is that its quite onerous for borrowers. When you borrow money conventionally you have to: (1) pay back the loan by some definite date; (2) pay the lender interest on the money borrowed over the course of the loan period; and (3) put up adequate collateral until full repayment of loan has been made. How very onerous!
Over the last 45 years, Berkshire’s insurance float enabled the company to effectively borrow huge amounts of cash, with no set repayment date, and with no tangible collateral put up. Even more astonishing is the fact that this money cost Berkshire less than nothing.
How did this happen?
For a typical insurer, the premiums it takes in do not cover the losses and expenses it must pay. That leaves it running an “underwriting loss” – the cost of float – which is the functional equivalent of interest on conventional debt. An insurance business is profitable over time if the cost of its float is less than the cost the company would otherwise incur to borrow funds. The business will have a negative value if the cost of its float turns out to be higher than market rates for money.
For Berkshire, the cost of its float, over the long term, has been less than zero. The net result of all this is that Berkshire has not only been able to borrow funds at a cost which is less than that of the U.S Treasury, it has been been paid to borrow that money.
It’s already well-known that the value of this large float with a negative cost has been huge for Berkshire’s owners. After all, access to tens of billions of dollars of less-than-free capital in the hands of one of the world’s greatest allocators-of-capital, has to be winning combination, isn’t it?
However, no matter how good an allocator-of-capital Warren Buffett is, that has little to do with the value of Berkshire’s insurance float to its owners. That’s because of a principle of finance (MM on Capital Structure) according to which the value of a firm’s assets have little to do with how they are financed. So, we mustn’t let Buffett’s brilliant track record in capital allocation influence us on how we should think about Berkshire’s insurance float. But we do need to understand just how does that float create value for Berkshire’s owners. That’s because, once we have understood how to evaluate Berkshire’s float, we will use that knowledge to understand other types of floats in a variety of business models.
Berkshire’s cost-less float can be best understood by comparing it with other forms of financing. When compared with plain-vanilla debt, it is obvious that borrowed funds which cost money, require posting of collateral, and which have to be repaid by a definite date are vastly inferior to Berkshire’s float which suffer from none of these disadvantages.
It’s when we compare Berkshire’s insurance float with equity, things gets really interesting. Buffett explained this point in his 1995 letter:
“Since our float has cost us virtually nothing over the years, it has in effect served as equity. Of course, it differs from true equity in that it doesn’t belong to us. Nevertheless, let’s assume that instead of our having $3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we would have owned no more assets than we did during 1995. We would, however, have had somewhat lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The net result – more shares, equal assets and lower earnings – would have materially reduced the value of our stock. So you can understand why float wonderfully benefits a business – if it is obtained at a low cost.”
He explained it again in his 1997 letter:
“Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”
And again in his 2007 letter:
“Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $59 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, insurance underwriting is volatile, swinging erratically between profits and losses. Over our entire history, however, we’ve been profitable, and I expect we will average break-even results or better in the future. If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”
And finally in his 2011 letter:
“So how does this attractive float affect intrinsic value calculations? Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability.”
The lessons in these four excerpts from Buffett’s letters are just about all we need to know to evaluate not just quality of Berkshire’s float, but that of just about any other float. Here, then, are a few general principles:
One way to see how the true value of an attractive float is far lower than its accounting value is to use the “inversion” trick often used by Charlie Munger by looking at the problem from the float provider’s viewpoint.
Imagine that you subscribe to a bond issued by a company at Rs 100. Imagine further that this bond carries no interest, and has no definite repayment date. For the moment, suspend your disbelief and ignore the question “Why the hell would I ever buy subscribe to such bond?” Just assume that you did.
How would you value this “perpetual, zero coupon bond?” What price would any rational person pay you for your bond? Almost nothing, isn’t it?
Now let’s invert the situation again and at look at this example from the viewpoint of the bond’s issuer. The bond appears as a liability on the issuer’s balance sheet at Rs 100. Now, if the corresponding asset on your balance sheet is almost worthless, should not the true value of this liability also be almost worthless from the issuer’s viewpoint? Of course it should!
Now let’s add a twist. Imagine that for some reason the company must pay back Rs 100 it owes you, but that it can find someone else to give money to it on identical terms so that even if you get paid, the company’s overall liability on account of the float remains unchanged. In effect, the company gets to use OPM to retire a liability represented by OPM. Even if some of the older providers of OPM have to be made whole, they are paid through refinancing on identical terms by newer providers of OPM. If this sounds like a ponzi scheme (without its derogatory connotation), then you’re right on spot!
That’s precisely what Buffett meant when he wrote the above-mentioned extract in his 2011 letter, which I am reproducing here with emphasis on key words:
“Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability.”
So long as one is certain that the size of a free float will not diminish over time because it resembles a “revolving fund,” one should value such a book liability at virtually nothing. And when that happens, then assets financed by such a float become “unencumbered.” This is what Buffett meant in his above-mentioned 2007 quote which I reproduce again with emphasis on key words:
“Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $59 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, insurance underwriting is volatile, swinging erratically between profits and losses. Over our entire history, however, we’ve been profitable, and I expect we will average break-even results or better in the future. If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”
This insight – as to how do assets, when financed with cost-less floats become unencumbered, will be instrumental in our understanding the role of floats in evaluating the economics of businesses outside of the insurance industry.
That’s the subject matter of a subsequent post.
To be continued…
Many students of security analysis believe that valuing “surplus cash” on a company’s balance sheet is an easy task. Just add the nominal value of the surplus cash to the value of the operating business derived from some other method like DCF. Alternatively, take the market value of the firm and deduct the nominal value of surplus cash to arrive at market’s assessment of the fair value of firm’s operating business – called Enterprise Value (EV).
In other words, surplus cash can simply be added to the the fair value of the business estimated by the analyst to arrive at value of firm or it can be deducted from its market value to arrive at EV.
After all, a dollar is worth a dollar, no more, and no less. Isn’t it?
Using the idea of “dollar auction,” I have, over the last 11 years, routinely auctioned Rs 100-notes for as high as Rs 600 in my class. The red-faced winning bidder at the end of each such auction becomes the laughing stock for his/her classmates.
How can educated students value a currency note for more than its nominal value? The dollar auction game combines several psychological tendencies such as envy, deprival super reaction, low contrast effect, reciprocity, and social proof, resulting in a comical illustration of the prisoner’s dilemma again and again in my classroom. Under certain circumstances, as the dollar auction game shows, its rational for an individual to overpay for a Rs 100 note.
What about other situations where the nominal value of surplus cash residing on a company’s balance sheet differs from its fair value? While accountants and auditors would prefer to use nominal value (for them, its better to be precisely wrong than to be approximately right), we, as security analysts must consider the possibility that sometimes, or maybe even often, a dollar is not really worth a dollar.
So, what are the general principles to keep in mind while valuing surplus cash?
First, know what is surplus and what’s not. Money lying in bank accounts or mutual funds, but which are provided by customers (see advance from customers and/or deposits on the liabilities side of the balance sheet) are not surplus. This “other people’s money” is not surplus to the needs of the business. “Surplus” means that if you take it out, you don’t have to replace it. You can’t take out money taken from customers as advances without feeling the need to inject it back in the business. Although there are huge advantages of holding this type of “other people’s money” (that’s the subject matter of a future post), such advantages do not convert operating cash to surplus cash. For example, at this time, cash on the balance sheets of companies like EIL or BEL is not necessarily surplus because of large advances from customers as source of that cash.
Similarly, cash in some seasonal businesses may be surplus in lean seasons but required for conducting business for busy seasons. Such cash must not be treated as surplus even if the balance sheet date happens to lie in a lean season.
Second, other things remaining the same, a $100 bill in the hands of a value creator is worth more than $100 to his investors. Conversely, the same $100 is worth less than $100 in the hands of a value destroyer. Be wary of cash on the balance sheet of companies which have a demonstrated track record of value destructive allocation-of-capital decisions (primarily dividend policy, acquisitions, expansion, and diversifications).
Capital allocation skills matter.
Third, other things remaining the same, a $100 bill in the hands of scoundrel is worth less than $100 to his investors. Conversely, the same $ 100 is worth more than $100 in the hands of the honest manager. Be wary of cash on the balance sheets of companies run by crooks. Cash on Infosys’ balance sheet is worth more than cash on Aftek’s balance sheet.
Corporate governance matters.
Fourth, the further the cash is kept from the investor who has to put a value on it, the less valuable it becomes to him. This happens, for example, in the cash of holding companies which have subsidiaries which have subsidiaries which have the cash. In other words, the closer the cash resides near the pockets of the investors, the closer to it’s nominal value, should be its fair value to investors, other things remaining the same.
Distance from the owners matters.
Those, then are the general principles I think about when I think about surplus cash.
Investment returns are typically measured in the form of returns per unit of risk.
“Risk” however does not mean the same thing to different people.
To most financial academics, risk is a measure of volatility, a proxy of which is the famous beta. At the other extreme is Warren Buffett who thinks of risk as “probability of permanent loss of capital” and who claims that beta has nothing to do with risk.
While the debate on the meaning of risk between academics/finance practitioners who follow CAPM (a model that equates beta with risk) and value investors who follow Buffett is not going to end anytime soon, I propose that one should also think about measurement of investment returns based on “return per unit of stress.”
For proprietary investors (and maybe for all investors), stress should figure in one’s investment strategy, much more than it does, perhaps, even more than financial risk, because stress is a killer and high stress situations – whether they carry high or low investment risk – will always carry a high risk to one’s health. In fact, one can now measure how many years of one’s life is cut short by being exposed to a high stress life.
In my view, its no co-incidence, that day traders (who have very stressful lives) and who look like this…
… will possibly not live very long, while spiritual, long term investors like John Templeton (who lived till he was 95) have calm and serene faces and look like this:
If one was to think about stressful way of investing vs. a relatively stress-free way of investing, what would the differences look like? The following table offers some suggestions.
Low or No Stress
|Investing in Highly Leveraged Companies||Investing in Zero or Low Debt Companies|
|Borrowing to buy stocks||Never borrowing for buying straight equities|
|High Frequency Trading & Day Trading||Long Term Investing|
|Shorting||Long Only Investing|
|Business exposed to Negative Black Swans e.g. Banking and Commodity Trading||Businesses not exposed to black swans|
|Corporate Governance Issues||No Corporate Governance Issues|
|High P/E for Growth Stocks||Low P/E for Growth Stocks|
|Hostile Takeovers||Passive Investing|
|Dealing in F&O||Staying Away from F&O|
|Trading on Inside Information||Avoiding inside information|
|Event Driven Investing||Moats Driven Investing|
Once you start incorporating return per unit of stress in your investment thinking, the trade-offs become obvious. You would start settling for investment situations which offer a satisfactory return per unit of risk and stress over those which offer high returns per unit of financial risk but low returns per unit of stress. You will slow down and start appreciating the slow process of long-term, stress-free compounding as opposed to nerve-wracking, adrenalin laden high frequency operations in the stock market.
My advice to those who ignore the stress part of the equation but focus only on returns per unit of risk: You cannot take it away with you, so what’s the point of all that stress, just for the money?