You Can't Predict Who Will Change The World

[this article by Nassim Taleb published in Forbes]

Before the discovery of Australia, Europeans thought that all swans were white, and it would have been considered completely unreasonable to imagine swans of any other color. The first sighting of a black swan in Australia, where black swans are, in fact, rather common, shattered that notion. The moral of this story is that there are exceptions out there, hidden away from our eyes and imagination, waiting to be discovered by complete accident. What I call a "Black Swan" is an exceptional unpredictable event that, unlike the bird, carries a huge impact.

It's impossible for the editors of Forbes.com to predict who will change the world, because major changes are Black Swans, the result of accidents and luck. But we do know who society's winners will be: those who are prepared to face Black Swans, to be exposed to them, to recognize them when they show up and to rigorously exploit them.

Things, it turns out, are all too often discovered by accident--but we don't see that when we look at history in our rear-view mirrors. The technologies that run the world today (like the Internet, the computer and the laser) are not used in the way intended by those who invented them. Even academics are starting to realize that a considerable component of medical discovery comes from the fringes, where people find what they are not exactly looking for. It is not just that hypertension drugs led to Viagra or that angiogenesis drugs led to the treatment of macular degeneration, but that even discoveries we claim come from research are themselves highly accidental. They are the result of undirected tinkering narrated after the fact, when it is dressed up as controlled research. The high rate of failure in scientific research should be sufficient to convince us of the lack of effectiveness in its design.

If the success rate of directed research is very low, though, it is true that the more we search, the more likely we are to find things "by accident," outside the original plan. Only a disproportionately minute number of discoveries traditionally came from directed academic research. What academia seems more masterful at is public relations and fundraising.

This is good news--for some. Ignore what you were told by your college economics professor and consider the following puzzle. Whenever you hear a snotty European presenting his stereotypes about Americans, he will often describe them as "unintellectual," "uneducated," and "poor in math," because, unlike European schooling, American education is not based on equation drills and memorization.

Yet the person making these statements will likely be addicted to his iPod, wearing a T-shirt and blue jeans, and using Microsoft Word to jot down his "cultural" statements on his Intel-based PC, with some Google searches on the Internet here and there interrupting his composition. If old enough, he might also be using Viagra.

America's primary export, it appears, is trial-and-error, and the innovative knowledge attained in such a way. Trial-and-error has error in it; and most top-down traditional rational and academic environments do not like the fallibility of "error" and the embarrassment of not quite knowing where they're going. The U.S. fosters entrepreneurs and creators, not exam-takers, bureaucrats or, worse, deluded economists. So the perceived weakness of the American pupil in conventional studies is where his or her very strength may lie. The American system of trial and error produces doers: Black Swan-hunting, dream-chasing entrepreneurs, with a tolerance for a certain class of risk-taking and for making plenty of small errors on the road to success or knowledge. This environment also attracts aggressive tinkering foreigners like this author.

Globalization allowed the U.S. to specialize in the creative aspect of things, the risk-taking production of concepts and ideas--that is, the scalable part of production, in which more income can be generated from the same fixed assets through innovation. By exporting jobs, the U.S. has outsourced the less scalable and more linear components of production, assigning them to the citizens of more mathematical and culturally rigid states, who are happy to be paid by the hour to work on other people's ideas.

Let us go one step further. It is high time to recognize that we humans are far better at doing than understanding, and better at tinkering than inventing. But we don't know it. We truly live under the illusion of order believing that planning and forecasting are possible. We are scared of the random, yet we live from its fruits. We are so scared of the random that we create disciplines that try to make sense of the past--but we ultimately fail to understand it, just as we fail to see the future.

The current discourse in economics, for example, is antiquated. American undirected free-enterprise works because it aggressively allows us to capture the randomness of the environment--the cheap Black Swans. This works not just because of competition, and even less because of material incentives. Neither the followers of Adam Smith nor those of Karl Marx seem to be conscious of the prevalence and effect of wild randomness. They are too bathed in enlightenment-style cause-and-effect and cannot accept that skills and payoffs may have nothing to do with one another. Nor can they swallow the argument that it is not necessarily the better technology that wins, but rather, the luckiest one. And, sadly, even those who accept this fundamental uncertainty often fail to see that it is a good thing.

Random tinkering is the path to success. And fortunately, we are increasingly learning to practice it without knowing it--thanks to overconfident entrepreneurs, naive investors, greedy investment bankers, confused scientists and aggressive venture capitalists brought together by the free-market system.

We need more tinkering: Uninhibited, aggressive, proud tinkering. We need to make our own luck. We can be scared and worried about the future, or we can look at it as a collection of happy surprises that lie outside the path of our imagination.

Nassim Nicholas Taleb is an applied statistician and derivatives trader-turned-philosopher, and author of The Black Swan: The Impact of the Highly Improbable.

Kaboose and US Autoparts - Pass

Reviewed US Autoparts and Kaboose today, both are passes.

US Autoparts is a pass because:
1. Poor operating metrics - management has missed guidance two quarters in a row and inventory is increasing faster than sales
2. Poor visibility - it's not clear how it's growing its top line due to obfuscation with the acquisition of Partsbin.
3. Management? - Not clear how Shane Evangelist (a superstar at Blockbuster) will translate to managing autoparts. Seems this is a block-and-tackle job at this point.

Kaboose is a pass because:
1. Really low traffic: Kaboose, the flagship site had 1.5MM uniques, down from a year prior. They spent $140mm acquiring Bounty, a UK site, that had 153K uniques in Apr 08 (per Nielsen UK).
2. Stiff competition: Babyzone (600K uniques) will be going up against Babycenter (2.7mm uniques with higher nearly twice as many pv's per unique), J&J's website.

I don't feel Kaboose has take-out potential, like CNET and Greenfield had. CNET is a bellweather with unquestionably solid traffic, though their forward growth was hazy. Greenfield at the Ciao asset with 50% yoy comp shop growth. Kaboose?

CNET acquisition metrics

On CNET transaction from Tommy Weisel analyst Lloyd Walmsley

Transaction Overview: The transaction value of $1.7bn net of cash (excluding any NOL benefit or synergies) equates to 4.0x revenue and 20.0x EBITDA using our 2008 estimates (and 3.9x and 21.5x on consensus estimates). Using 2009 multiples, the transaction equates to 3.6x revenue and 14.5x EBITDA on our estimates (and 3.5x and 16.6x on consensus estimates). The price equates to $13.60 per global unique user and $55.50 per domestic unique user based on the latest comScore data. The transaction is expected to close in 3Q and contains a breakup fee of 2%.

Comparable Transactions: Recent relevant transactions include Walt Disney / Club Penguin, which went for $350mn and 14x trailing EBITDA. Other notable transactions relevant to this deal include Microsoft’s bid for Yahoo! at $44.6bn or 18x forward EBITDA, NBC / iVillage in March 2006 at $596mn in transaction value, or 22x forward EBITDA, and News Corp. / IGN Entertainment in September 2005 at $650mn, or 30x forward EBITDA (in an environment of significantly higher trading multiples for Internet media companies).

Savvian actually had a 2005 press release on the original IGN acquisition - done right before they went public.

Based on IGN's trailing 12-month Ebitda of $9.69 million for the period ended June 30, the $650 million price represents a 67.4 times multiple. One industry source said that due to huge growth at IGN, News Corp. based its projections on the coming year, which this person said amounted to an Ebitda multiple closer to 30 times. Nonetheless, the price is still high for a company that has yet to record a profit. As of March 31, the company had accumulated a deficit of $23.3 million.

Their registration indicated $$28.8mm revenue 1H 2005, so if they did $60mm FY 2005 that would make the offer more than 10x revenue.

Li Lu talk at Columbia

Josh shared some notes from a Li Lu (Himalaya Capital) talk at Columbia. He asked that the notes not be distributed, so this is, for the record, the top take aways from his notes:
1. "Some of my biggest early winners were from value line" (in addition to the usual list of business readings). So that makes him, Joel Greenblatt and Pabrai. (Greenblatt uses Valueline in an example in his You Can Be A Stockmarket Genius book - along with the Beardstown Ladies!) Just checked the web and pricing is $500-1000 per year.
2. Deathcare as an industry with promising returns
3. "I worked as an associate in banking at DLJ for one year then started Himalaya. The best way to learn is to make the mistakes yourself. I started with my own money and a few others."
4. "A good way to tell if an industry is good is to look at the most brilliant successes and most miserable failures. If the most miserable failures are still okay, that’s probably a pretty good industry."

#4 might be a good exercise with any industry, such as railroad car manufacturing...

Muni bond funds

On Wealthtrack interview recently Randy Forsyth (Barrons Online editor) and Whitney Tilson discussed the subprime situation, and Randy concluded that given expected weak returns on MM funds throughout rest of 2008 muni funds are a good investment.

Risk of owning muni bond fund: If insurers get down graded by ratings agencies, barring bailout, (or bankrupt) could cause muni downgrade. This would force institutions that own munis to sell them because such institutions may have investment mandate to own double-A or better, for example, and bonds sold to single-A could force selling, causing your fund to get marked down. Now, if you own the bonds, it doesn’t matter how it’s rated – the municipalities are not going away. You can hold the bond funds to maturity – the fund will take mark down, but as long as fund holds the muni bonds and didn't speculate in CDOs or other derivatives rooted in bonds, then fund should recover. Note best bond funds never took insurance into account – only looked at underlying assets.

Given recent declines in bond fund values, could be good time to initiate small position. E.g., VWITX (Vanguard Intermediate Term Tax Exempt bond fund) closed at $13.18 per share, close to Q4 low of $13.13. Now, in Aug it was in $12.90s, so the market has tested lower values. But this would be one to hold until the markets look better, and the income would be tax free.

According to Randy, very unusual situation where top quality tax-free muni bonds pay same yield as taxable Treasuries. Best way for consumers to participate are through bond funds.

Dodge & Cox Stock

Nov 2006 Kiplinger article on Dodge & Cox. Their D&C Stock fund recently opened (Feb 4) after being long closed since 2004. Redemptions due to cold feet caused by recent volatility have apparently been the reason for the re-opening (from website):

Since mid-2007 the volatile investment environment has created what we believe to be many interesting long-term equity and fixed income opportunities. This environment, coupled with weak short-term relative returns, may have contributed to recent redemption activity. Our intent in reopening the Funds is to better balance subscription and redemption activity, so we can capitalize on attractive opportunities while maintaining current positions. We believe there is capacity to accommodate reasonable growth into the foreseeable future.

The Kiplinger interview: The Dodge and Cox Mystique
By Manuel Schiffres From Kiplinger's Personal Finance magazine, November 2006
In its 76-year history, Dodge & Cox has launched precisely four mutual funds. The firm doesn't advertise and has no marketing department. Yet investors are so taken with its funds that it has had to shut half of its tiny lineup to new customers to stanch the flood of money.

Obviously, results attract customers, and Dodge & Cox's results have been marvelous. D&C Stock, the biggest fund, with assets of $57 billion, has clipped Standard & Poor's 500-stock index seven straight years (including the first eight months of 2006). Over the past 15 years, its annual return of 15% tops the S&P 500 by an average of four percentage points per year. D&C Income, which invests mostly in high-quality, medium-term taxable bonds, has outpaced its average peer in 16 of the past 17 years. Balanced, the oldest fund, dating to 1931, has been in the top 20% of similar funds in each of the past six years. And International has surpassed its average rival in each of its five years of existence.

What's behind the success of Dodge & Cox? Its funds are helped by remarkably low fees. Staff turnover is almost nonexistent -- another plus. And the firm's unrelenting focus on buying undervalued stocks and bonds is legendary. But what sets the firm apart from most mutual fund shops is its method of picking stocks and bonds: Before a security is added to one of the funds, it must be vetted by one of three committees.

To peer behind the curtain, we chatted in San Francisco with the firm's president, John Gunn, a 34-year veteran who is the firm's chief executive and chief investment officer, and Diana Strandberg, who joined in 1988 and who, like Gunn, is on the committees that oversee the three stock funds.

KIPLINGER'S: What's the key to your success? Is it those fuddy-duddy investment-policy committees?
GUNN: We started as a firm to manage an individual's entire wealth. We try to preserve and enhance the client's wealth over a four- to five-year time horizon. And the first principle that comes out of that is a sort of investors' Hippocratic oath: Do no harm. As for stock picking specifically, we ask ourselves, Do we want to become a part owner of a company looking out four or five years?
But don't other fund companies follow the same principles?
GUNN: We look at the longer-term earnings prospects, but we also focus on valuation. The two are joined at the hip. Let's go back to 2000. The megacap stocks -- those with market capitalizations of roughly $100 billion or more -- were about 33% of the S&P 500 and we basically had zero in those stocks. From a valuation perspective, about 25% of the market sold at roughly 15 times sales and 85 times trailing earnings, and we had nothing in those stocks. Another 37% or 38% of the market sold at 3.5 times sales and 30 times earnings, and we had about 9% of assets in the lower-value part of those stocks. So, in the middle of the biggest, wildest speculation ever, almost all of our holdings were in the remaining third or so of the market -- mostly in "old economy" stocks selling at about 80% of revenues, and one-third in financial stocks selling at about 13 times earnings./story_pics/gunnstrandberg.jpg" align=left>
You're certainly not closet indexers.
GUNN: We also don't have a momentum bone in our body. We believe that previous share-price activity has nothing to do with future price activity.
Do you assemble your portfolios stock by stock? Or do you make calls on the big picture?
GUNN: We look at long-term forces that we think are pushing the global economy in a certain direction at a certain speed. We believe that the two biggest forces -- things that have been going on for many years now -- are rapid technological innovation, especially in communications, and growth of the developing world. The end of the Cold War has allowed more and more of the world's population to participate in free-market economies, to see how the other half lives, to produce and consume more.
Do you have a limit on the price-earnings ratio you are willing to pay?
GUNN: There is no fixed rule. But we are skeptical of companies with high market-capitalization-to-sales ratios.
Do you pay more attention to market-cap-to-sales ratios than you do to P/Es?
GUNN: The P/E is essentially the price-to-sales ratio divided by the net profit margin [profits divided by sales]. A stock can have a low P/E with high net margins and high price-to-sales ratios. So, we try to look behind the P/E to understand it better. For example, Microsoft, which is selling at about 18 times earnings, is starting to show up in a lot of value portfolios. It's a wonderful company, but we don't own it. Microsoft sells at about six times sales because it has 30%-plus net margins. But what we're increasingly learning is that you don't necessarily have to buy Microsoft products. You can get a lot of them from Google. And then you've got Linux and all sorts of other stuff. So, to me, the 30% net margins at Microsoft are a great big cake in the rain.
So focusing on price is the main reason for your success?
GUNN: It's not just that. Another factor is that we add about one or two new people a year coming out of business school and, basically, nobody ever leaves, so the cumulative intellectual capital keeps growing here. Essentially, we have three portfolios -- a domestic stock portfolio, an international stock portfolio and a fixed-income portfolio -- and everybody knows what's in these portfolios. Including the research assistants, we've got 43 people -- 86 eyes -- looking at the stock portfolios. That's an amazing advantage. We also benefit enormously from our low fees.
Does the committee approach really add that much to the process?
STRANDBERG: The committee's job is not to come up with the idea. In our model, an individual advocates, and you bring a group together to make the decision on something that is being advocated. The person advocating a stock puts his or her recommendation in a written report -- here's what I recommend, at x price, for these reasons, and here are the main concerns, with all the supporting analysis and financials. So you bring all these eyeballs into the room to look at an idea and vet it. You want to have lots of different camera angles. Moreover, this system allows you to build staying power. Persistence is the single most important factor behind our long-term returns. The persistence to be able to stay the course, to hang on to the stocks that go down and to stay out of chasing the stuff that goes up. We can see when a stock is going down. The key is, would you buy more of it? Has it become a better value? That conviction is key.
Do you need to have everyone on one of the committees enthusiastic about a stock before you buy?
GUNN: We don't wait for that. In order to get into a portfolio, we need a couple of people to be enthusiastic and everyone else can be sort of neutral. It is an unwritten law because we don't otherwise formally vote.
Does Stock have any big sector bets?
GUNN: The biggest overweight in Dodge & Cox Stock is not a traditional sector. I'm referring to technology companies that trade at 1.2 times sales or below. Those companies represent 1.5% of the S&P 500, and they're about 16% of the fund.
Such companies as?
GUNN: Hewlett-Packard, Sun Microsystems, Sony, Matsushita, Xerox and Hitachi.
You just mentioned three Japanese companies. They're in the domestic fund?
GUNN: Absolutely. But let's look at Hewlett-Packard. We did most of our buying of HP when Carly Fiorina was CEO and the stock was in the high teens [it traded in mid September at $36]. The company was selling at two-thirds of sales, and it had a really huge beating heart. It has a global footprint and dominance in the consumables business, such as printer cartridges. And as the developing world grows, those countries will need more computing power. A company like HP should be a big beneficiary. We still think the stock is very interesting. It now sells at a little more than one times sales, but we think the company has excellent prospects.
In what other ways are you taking advantage of the growing wealth of developing nations?
STRANDBERG: We own Femsa [Fomento Económico Mexicano], a beer brewer and one of the world's largest Coca-Cola bottlers. We also own companies, such as Nestlé and Nokia, that have very strong businesses in the developing world.
Your turnover is extraordinarily low. What does it take to get you to sell a stock?
STRANDBERG: Everything is driven by valuation in relation to our three- to five-year outlook for earnings and cash flow. So, if the price appreciates to the extent that only good news is priced in -- everything needs to work out well to support the current price -- we would probably be trimming or selling. This is a good thing -- selling because the stock went up. Remember, we believe that past price movements have nothing to do with future price movements. Whether the share price went from $10 to $20 or from $30 to $20 is irrelevant. The question is whether the stock, at $20, is likely to be a good investment based on our expectations for earnings and cash flow looking out three to five years. If so, we're adding to our position; if not, we're trimming. Now to fuzz things up a bit, sometimes we trim because the valuation, while appealing, is no longer interesting in relation to alternatives.
GUNN: As the valuation range has narrowed from that extraordinary situation in 2000 -- when we had 97% of our portfolio in roughly one-third of the market -- we have been upgrading our holdings. Some of our holdings then were in companies that weren't all that wonderful. For instance, we were in Whirlpool. It was run by competent people, but it's in a sort of slug-it-out, low-profit-margin business without a hell of a lot of growth. We are now able to buy dominant companies with strong growth prospects at attractive valuations -- for example, Citigroup -- that we couldn't get near five years ago.
Dodge & Cox International appears to be holding several U.S. companies. What's the rationale?
STRANDBERG: Our prospectus allows us to hold up to 20% of assets in U.S. companies, and we have 5% of our fund in such companies.
What are the U.S. companies in International?
STRANDBERG: In two of the cases, News Corp. and Schlumberger, it's just a matter of technicalities. The third stock is Avon Products. Lily Beischer, our analyst, wrote up the company. When an analyst writes up a report, it is distributed to the entire investment team, even though one committee or the other will meet to formally review it. So we're all reading this report and saying, Holy smoke. Not only do we think the stock has an attractive valuation, but two-thirds of Avon's sales are outside the U.S. and about half its sales and earnings are in emerging markets. Hello!

The temperament of the investor

A quote that evokes the temperament of the investor:

When I consider the many agitations encountered by man, the perils and pains he exposes himself to, in court, in war, where so many argumentations, passions, brutal and sometimes evil enterprises, etc., are born, I often say that all the unhappiness of man comes from a single source which is his inability to rest alone in a small room. A man who has enough to live by, if he but knew how to live at home and at ease, would take to sea, or lay siege to any place...One searches for conversations and the distractions of games only because one cannot remain at home with pleasure.

Blaise Pascal, Pensée