Seeking Wisdom

by Peter Bevelin

  The business has initial cash earnings (earnings+ amortization of goodwill) of

  $40 million and an assumed average annual growth rate in cash earnings of 10% for 10 years. This translates into $104 million in cash earnings in year 10. Assume the market pays an average multiple of 15 for this type of business. This implies

  $1.56 billion in market value in year 10. If John compares this figure with the present market value, his implied yearly return is 4.5%. John compares this return with the return from other available investment opportunities. A business may have a great track record, but if the math doesn't work, stay away.

  What scenario achieves a 15% annual rate of return?

  How much must the ice cream manufacturer earn to generate a 15% annual rate of return for John? If the present market value compounds at 15%, what does this imply and is it reasonable?

  A present market value of $1 billion and an annual return of 15% imply $4 billion in market value in year 10. This is what $1 billion will grow to in 10 years if it grows 15% per year. An average multiple of 15 implies $270 million in cash earnings in year 10. This translates into an average annual growth rate in cash earnings of 21% (from a base of $40 million). A profit margin of 15% implies

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  $1.8 billion in sales year 10. He can continue with implied future sales volume, number of users and usage, market share, etc.

  John then asks: What causes this future value? What does this imply in numbers today? Is it reasonable regarding evidence of track record in growth, earnings, profit margins, market size/volume growth, market share, competitive advantage, etc? Which factor has the greatest impact on future cash earnings and thereby value? What forces can change this scenario? How can the company lose its advantages?

  If the company doesn't make money today, what future free cash flow is implied by their market value if I want a 10% return?

  In the midst of the Internet mania, Warren Buffett said:

  When we buy a stock, we always think in terms of buying the whole enterprise because it enables us to think as businessmen rather than stock speculators. So let's just take a company that has marvelous prospects, that paying you nothing now where you buy it at a valuation of$500 billion... For example, let's assume that there's only going to be a one year delay before the business starts paying out to you and you want to get a 10% return. If you paid $500 billion, then $55 billion in cash is the amount that it's going to have to

  be able to disgorge to you year after year after year. To do that, it has to make perhaps $80 billion, or close to it, pretax. Look around at the universe of businesses in this world and see how many are earning $80 billion pretax - or $70 billion or $60 or $50 or $40 or even

  $30 billion. You won't find any.

  Whether a business sells nails or telecom equipment, if more money is going out than coming in, on a present value basis, it is worthless. As Warren Buffett says, "Value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get."

  He continues:

  There's plenty of magic in short term in rising P/E multiples and the games people play with accounting and so on. But in the end, you can't get more out of a business between now and its extinction than the business makes. And actually you'll make something less depending on who your business managers are, how often there's turnover in the security and how much you pay the investment manager and so on.

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  - NINE -‌

  EVIDENCE

  It is undesirable to believe a proposition when there is no ground whatsoever for supposing it true.

  - Bertrand Russell

  Evidence helps us prove what is likely to happen or likely to be true or false. Evidence comes from facts, observations, experiences, comparisons, and experiments.

  The methods of science

  There are in fact two things: science and opinion; the former begets knowledge, the latter ignorance.

  - Hippocrates

  "What experiment can I do to figure this out?"

  In 1986, the space shuttle Challenger exploded on launch, killing all astronauts aboard. After the disaster, NASA put together a commission where Richard Feynman showed that the fuel booster rockets were not safe when the temperature was cold. The temperature at takeoff was 32 F. During a launch, vibrations cause the rocket joints to move. Inside the rocket joints there were rubber O-rings that are used in a certain key stage in the space shuttle's fuel delivery system.

  Richard Feynman did a simple experiment with a rubber O-ring from the Challenger rocket. He squeezed the rings in a C-clamp and dipped them in a glass of ice water (32 F) and showed that the rubber didn't expand. Since there was no resilience in the rubber at 32 F, the O-ring could not fill the gap in the expanding rocket booster joints. It consequently caused an explosion of the booster and the space shuttle.

  This also illustrates that an experiment doesn't have to be complicated.

  Do what scientists do: Strive for objectivity. Scientists try to describe the world as it is, not as they want it to be. They seek to answer "why" and "how" questions and try to predict natural phenomena and processes by using methods of scientific integrity. Adam Smith said in An Inquiry into the Nature and Causes of

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  the Wealth of Nations: "Science is the great antidote to the poison of enthusiasm and superstition."‌‌‌

  The scientific process involves the following steps (of course, trial and error, luck and intuition also matters - scientists use any methods that help them solve a problem):

  Problem or observation - We try to figure something out. We have a problem or we observe some phenomena and wonder what happens and why (what matters is what actually happens).

  Guess why- We try to find a possible solution or an explanation (a hypothesis of why or how something happens) that can be proved or disproved by testing it against experiment and observation. Maybe some rule or model can solve the problem or explain our observation. Our guess must be measurable and agree with nature and proven evidence.

  Predict consequences - We work out all logical consequences of our guess and see what would be implied if our guess was right.

  Test - "If I do this, what will happen?" Testability is key. We compare the implied consequences of our guess with experiment, evidence and observation. We repeat the experiment against error, fraud, coincidence, and change in circumstances or environment. We report our results honestly. The more evidence that agrees with our guess, the more likely the guess was right. If the guess disagrees with experiment or evidence, it is wrong. As Richard Feynman says:

  It does not make any difference how beautiful your guess is. It does not make any difference how smart you are, who made the guess, or what his name is - if it disagrees with experiment it is wrong.

  Darwin realized that for an observation to be of any use, it must be tested for or against a theory, hypothesis or model (if we don't "guess why", there can be no experiments since a test has nothing to guide it). On board the HMS Beagle, in a letter to his friend Henry Fawcett, Darwin wrote:

  About thirty years ago there was much talk that geologists ought only to observe and not to theorize; and I well remember someone saying that at this rate a man might as well go into agravel pit and count the pebbles and describe the colours. How odd it is that anyone should not see that all observation must be for or against some view if it is to be of any service!

  We don't merely observe some behavior; we observe with some purpose in mind or in light of some theory or with some background about what is important to

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  look for. It is the same when we search for information. Charles Munger says:‌

  ... you have to have some idea of why you're looking for the information. Don't read annual reports the way Francis Bacon said you do science ... where you just collect endless [amounts of] data and then only later do you try to make sense ofit. You have to start with some ideas of reality. And then you have to look to se
e whether what you're seeing fits in with that basic thought structure.

  Occam's Razor is a principle attributed to the 14th Century logician William of Occam: "Entities should not be multiplied unnecessarily." If we face two possible explanations which make the same predictions, the one based on the least number of unproven assumptions is preferable, until more evidence comes along. Occam doesn't rule out other explanations. To paraphrase Albert Einstein: "Theories should be as simple as possible, but no simpler."

  Finding evidence from the past

  Study the past if you would divine the future.

  - Confucius

  john is thinking of hiring a new manager. Does the managers past record matter?

  Warren Buffett says:

  The best judgment we can make about managerial competence does not depend on what people say, but simply what the record shows. At Berkshire Hathaway, when we buy a business we usually keep whoever has been running it, so we already have a batting average. Take the case of Mrs. B. who ran our Furniture Mart. Over a SO-year period, we'd seen her take $500 and turn it into a business that made $18 million pretax. So we knew she was competent ... Clearly, the lesson here is that the past record is the best single guide.

  Then you run into the problem of the 14-year-old horse. Let's say you buy The Daily Racing Form and it shows that the horse won the Kentucky Derby as a four-year-old. Based on past performance, you know this was one hell of a horse. But now he's 14 and can barely move. So you have to ask yourself, "Is there anything about the past record that makes it a poor guideline as a forecaster of the future?"

  The following questions help us decide if past evidence is representative for the future:

  Observation: Will past/present behavior continue? How long can it continue?

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  Explanation: Why did it happen in the past or why does it happen now? How did it happen? We must understand the reasons why a past outcome occurred. What are the key factors? This demands that we understand the equation - the key variables involved and their relationships. Start with a hypothesis. Compare the implied consequences of our explanation of causes with appropriate evidence‌‌‌‌

  - for and against.

  Predictability: How predictive (representative) is the past/present evidence for what is likely to happen in the future? Are the conditions now and in the future likely to change? Make sure that the evidence isn't random. What worked in the past could have been the result of chance.

  Continuation and Change: What is required to make the past/ present record continue or to achieve the goal (look at the equation again)? What must happen? What must not happen? What forces can change it or cause what we don't want? Likely? Antidotes to what we don't want to happen?

  Certainty and Consequences: How certain am I? What single event am I betting on that must happen or not happen? What are the consequences of being wrong?

  Falsify and disprove

  All our commonsense ideas should always be open to criticism.

  - Karl Popper (Austrian-British philosopher, 1902-1994)

  Scientific results always have some probability attached to them. Tomorrow may bring new evidence. Instead of verifying a statement, it is sometimes better to prove it false. A single piece of evidence in favor of a statement does not prove its truth - it only supports it. But a single piece of evidence against it will show that it is false. Albert Einstein said: "No number of experiments can prove me right; a single experiment can prove me wrong."

  "All swans are white. "

  How could we test this statement? We could open our eyes, and go out looking for non-white swans. If we find one swan that is not white we have disproved the statement. The more swans we find to be white, the more support the statement has. But it is not proven. One black swan and the statement is rejected.

  "The universe is no more than 10,000 years old."

  What experiment can we perform to falsify this statement? We can look up at the sky and observe stars that are millions of light-years away. This means we are seeing them as they were millions of years ago.

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  "The medical treatment worked. Tm cured. " "Compared to what?"

  How can we test whether a cure is due to treatment, good salesmanship, the power of suggestion, or the patient's imagination? To reduce error and bias, medical research uses a randomized, double blind placebo-controlled study. Research subjects are randomly divided in two groups that match each other in age, physical status and other factors. One group receives the treatment and the other group the placebo. Neither the research subjects nor the researchers know who's getting the treatment or the placebo. Then the researchers compare the effects.

  "There is no risk in using this medicine. "

  That there is no evidence of harm (or benefit) isn't the same as evidence that something is safe (or harmful). Only safe (or harmful) based on what we know so far. Compare archaeology - just because something hasn't been found doesn't mean it won't be found.

  Disprove ideas. Charles Darwin always looked at the possibility that he was wrong:

  I had, also, during many years, followed a golden rule, namely, that whenever a published fact, a new observation or thought came across me, which was opposed to my general results, to make a memorandum of it without fail and at once: for I had found by experience that such facts and thoughts were far more apt to escape from the memory than favourable ones. Owing to this habit, very few objections were raised against my views which I had not at least noticed and attempted to answer ...

  I think that I have become a little more skillful in guessing right explanations and in devising experimental tests; but this may probably be the result of mere practice, and of a larger store of knowledge. I have as much difficulty as ever in expressing myself clearly and concisely; and this difficulty has caused me a very great loss of time; but it has had the compensating advantage of forcing me to think long and intently about every sentence, and thus I have been led to see errors in reasoning and in my own observations or those of others.

  "Since a lot of evidence agrees with my explanation, I must be right. "

  Not necessarily, the same evidence may agree with other explanations. Look for evidence that disproves your explanation.

  Don't spend time on already disproved ideas or arguments or those that can't be disproved. Ask: What test can disprove this? For example, someone tells us that there is life on planet Zeta. This can't be tested. That doesn't mean there is

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  no life on the planet. It only means that there is no way we can test it today.

  Theories based on observations have priority over theories alone since observations can disprove theories. Galileo Galilei based his theories on observations in the debate whether the sun revolved around the Earth.

  Engage in self-criticism. Question your assumptions. Explain the opposite of your beliefs. Ask: Assume I'm wrong, how will I know? Why may an opposite theory be correct? Assuming my answer is correct, what would cause me to change my mind? Then, look for that evidence.

  Often we don't see our weaknesses and thus are not motivated to improve. Therefore, encourage the right people to give objective feedback that will help us improve.

  Look back and measure how you are doing against your original expectations.

  Find your mistakes early and correct them quickly before they cause harm.

  The next tool forces us to be objective. Charles Munger says on backward thinking:

  The mental habit of thinking backward forces objectivity - because one of the ways you think a thing through backward is you take your initial assumption and say, "Let's try and disprove it."

  That is not what most people do with their initial assumption. They try and confirm it. It's an automatic tendency in psychology- often called "first-conclusion bias". But it's only a tendency. You can train yourself away from the tendency to a substantial degree. You just constantly take your own assumptions and try and disprove them.

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  -
TEN -

  BACKWARD THINKING

  Alot of success in life and success in business comes from knowing what you really want to avoid - like early death and a bad marriage.

  Charles Munger

  Avoid what causes the opposite of what you want to achieve.

  "You must always invert," said the 19th Century German mathematician Karl Jacobi when asked the secret of his mathematical discoveries. Whenever we try to achieve a goal, solve problems, predict what is likely to happen or likely to be true or false, we should think things through backwards.

  At the weekly meeting with his managers, John asked· "What actions could our company take to destroy as much value as possible in as short time as possible?" "Treat the employees badly. Reward bad work. Don't appeal to the employee's self interests but to a goal no one understands. Don't inform people what the company stands for, what rules apply, and the consequences for breaking them. Make sure people don't know their areas of responsibility. Put the right person in the wrong place. Don't let people know if they achieve a goal. Everything should be impossible to measure. Never tell people why something should be done.